Fund.finance Lecture 5 Investment Decision 2012

8/22/2019 Fund.finance Lecture 5 Investment Decision 2012

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Capital budgeting and Investment Criteria

Topic cover

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Capital budgeting/investment decision

Net present value (NPV)

Internal rate of return (IRR)

Payback period (PP); Discount payback period(DPP)

Profitability index (PI)

Equivalent annual cost/annuity (EAC/EAA)



CFO DECISION TOOLS

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Profitability

Index, 12%

Payback, 57%

IRR, 76%

NPV, 75%

Book rate of

return, 20%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Survey Data on CFO Use of Investment Evaluation Techniques

SOURCE: Graham and Harvey, “The Theory and Practice of Finance: Evidence

from the Field,” Journal of Financial Economics 61 (2001), pp. 187-243.



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WHAT IS CAPITAL BUDGETING DECISION?

The process of identifying,analyzing, and selecting investmentprojects whose returns (cash flows)are expected to extend beyond oneyear.

Capital budgeting/investmentdecision is the central to the

success of any firm



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PROCESS OF CAPITAL BUDGETING DECISION

Make decision of Accept or Reject a project

1. Identify promising/potential projects

2. Estimate cash flows of promising projects

3. Choose method to evaluate NPV, IRR, PP,etc.



PROJECT CLASSIFICATIONS

• Analyzing project investment is not costless, depend, so thelevel of details should depend on certain types of projects:

• Replacement: to continue current operation or to reduce

cost• Expansion of existing products or markets

• New products

• Safety and environment projects

• Research and development• Exploration

• Others

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Mutually Exclusive vs. Independent Project

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• only one of several potential projectscan be chosen, e.g. acquiring anaccounting system.

• =>RANK all alternatives and select the

best one.

MutuallyExclusiveProjects:

• More than one promising projects

can be chosen: accepting or rejectingone project does not affect thedecision of the other projects

• => RANK all and choose good ones

IndependentProjects:



NET PRESENT VALUE NPV)

NPV: Present value of future cash flows minus initial

investments.

Where:

C0 : Initial InvestmentCt : Cash Flow at time tt : time period of the investmentr : “opportunity cost of capital”: Expected rate of return given up by investing in a

project

***The Cash Flow could be po sit ive or negative at any t ime per iod

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NPV C C

r

C

r

C

r

t

t

0

1

1

2

21 1 1( ) ( )...

( )



CalculatingNPV?

1. Estimate initial costs

2. Estimate future cashflows: how much? and

when?

3. Estimate discount rate

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NET PRESENT VALUE NPV) Cont.)



• NPV Rule: Accept all projects with a positive NPV =>increase shareholders wealth

Example

Suppose we can invest $50 today and receive $60 in one year.What is our increase in value given a 10% expected return?

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Profit = -50 + 60

1.10

$4.55

Initial Investment

Added Value

$50

$4.55

NPV Cont.)



Example

You have the opportunity to purchasean office building. You have a tenant

lined up that will generate $16,000 per year in cash flows for three years. Atthe end of three years you anticipateselling the building for $450,000.

Assume opportunity cost is 7%. Howmuch would you be willing to pay forthe building?

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NPV Cont.)



If the building is being offered for sale at a price of $350,000, would you buy the building and what isthe added value generated by your purchase andmanagement of the building? 12

0 1 2 3Present Value

14,953

14,953

380,395

$409,323

$16,000 $16,000$16,000

$450,000

$466,000

NPV Cont.)



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Ranking Criteria

From the highest NPV

Minimum Acceptance Criteria

Accept if NPV >0

NPV Cont.)



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Disadvantages: Advantages:

NPV Cont.)



INTERNAL RATE of RETURN IRR)

• IRR : discount rate at which NPV = 0

• IRR method: select all projects that have an internal rateof return greater than opportunity cost of capital.

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0

)1(

...

)1()1( 2

2

1

10

t

t

IRR

C

IRR

C

IRR

C C NPV



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You can purchase a building for $350,000. The investment willgenerate $16,000 in cash flows (i.e. rent) during the first three years. Atthe end of three years you will sell the building for $450,000. What is theIRR on this investment?

0 350 000 16 000

1

16 000

1

466 000

1

1 2 3

, ,

( )

,

( )

,

( ) IR R IR R IR R

IRR = 12.96%

Calculating IRR by using a spreadsheet

Year Cash Flow Formula

0 (350,000.00) IRR = 12.96% =IRR(B3:B7)

1 16,000.00

2 16,000.00

3 466,000.00

IRR Cont.)



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Ranking Criteria

Choose the highest IRR

Minimum Acceptance Criteria

Accept if IRR > required rate of return

IRR Cont.)



IRR Vs. NPV

Co C1 C2 C3 IRR NPV@7%

Project A -350 16 16 466 12.96% ??

-200

-150

-100

-50

0

50

100

150

200

0 5 10 15 20 25 30 35

Discount rate (%)

N P V ( ,

0 0 0 s )

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IRR=12.96%

NPV and IRR will generally give the same decision.



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• NPV and IRR will generally give the same decision,exceptions:

– Non-conventional cash flows – cash flow signs

change more than once

– Mutually exclusive projects• Initial investments are substantially different

• Timing of cash flows is substantially different

IRR Vs. NPV (Cont)



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Problemswith IRR

1. MultipleIRRs

2. Are WeBorrowingor

Lending??

3. The ScaleProblem

4. TheTimingProblem

IRR (Cont.)



Problem with IRR Cont.)

• Pitfall 1: Multiple rate of return

Conventional cash flow: cash flow signs change only once time=>only one IRR

Unconventional cash flow: cash flow signs change more than once =>

multiple rate of return.

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15121260

............10910

C C C C

050018002000-C

018005002000-B

50005005002000-A

CCCCProject 3210



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• The following cash flow generates NPV=0 at both IRR% of

(-44%) and +11.6%.

15121260

............10910

C C C C

600 NPV

300

0

-30

-600

Discount Rate

IRR=11.6%

IRR=-44%

Which IRR shouldwe use?




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• There are two IRRs for this project: IRR1 = 0%; IRR2 = 100%

($100.00)

($50.00)

$0.00

$50.00

$100.00

-50% 0% 50% 100% 150% 200%Discount rate

N P V

0 1 2 3

$200 $800

-$200

- $800

Which one should

we use?




• Pitfall 2: Borrowing or lending project:

• IRR > opportunity cost of capital (10%), but should accept project

B?

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364%50500,1000,1364%50500,1000,1

%10@Project 10

B

A

NPV IRRC C




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• Pitfall 3: The Scale Problem

• Would you rather make 100% or 50% on your

investments?

• What if the 100% return is on a $1 investment,

while the 50% return is on a $1,000

investment?




• Pitfall 3: The Scale Problem (Cont.)

Which o f the two p rojects should the f i rm accept?

Reason: IRR ignore project scale

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818,11%75000,30000,20

182,8%100000,20000,10

%10@Project 10

E

D

NPV IRRC C

NPV method:accept project E

IRR method:accept project D




• Pitfall 4: The Timing Problem

The fo l lowing two pro jects i l lustrate th is p roblem

Examp le: two propo sals w i th cash f low as fo l lowing table:

Project Co C1 C2 C3 IRR NPV @7%

Project A -350 400 14.29% $24

Project B -350 16 16 466 12.96% $59

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NPV method:accept project B

IRR method:accept project A




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50

40

30

2010

0

-10

-20

N P V $

, 1 , 0

0 0 s

Discount rate, %

8 10 12 14 16

IRR= 14.29%IRR= 12.96%

IRR= 12.26%

Crossover point

IRR Vs. NPV (Cont)

A

B

IRR method: always choose B

NPV method: choose A or B depend on discount rate



Summary of Internal Rate of Return IRR)

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Advantages: Disadvantages:



Payback Period PP)

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Payback period (PP)

How long does it take the project to “pay

back” its initial investment?

Payback Period = number of years to recoverinitial costs

only accept projects that “payback” in the desiredtime frame (cutoff period)



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Example

Examine the three projects and note the mistake wewould make if we insisted on only taking projects with a payback period of 2 years or less.

502050018002000-C

58-2018005002000-B

2,624350005005002000-A

10%@ NPV

Period

Payback CCCCProject 3210

NPV method:accept project

A&C

PP method:accept project

B&C

PP vs. NPV



Payback Period PP) Cont.)

• Minimum Acceptance Criteria: set by management

Ranking Criteria: set by management

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• Ignores the time value of money • Ignores cash flows after the payback period

• Biased against long-term projects

• Requires an arbitrary acceptance criteria

• A project accepted based on the payback criteria may not have a positive NPV

Disadvantages:

• Easy to understand • Biased toward liquidity

Advantages:



Discounted Payback Period DPP)

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Discounted Paybackperiod (DPP)

How long does it take the project to “pay back” its initial

investment taking the time value of money into account?

DPP method: a project accepted if the time of recovering

initial investment on the discounted basic equal or less than

specified number of years.



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• DPP consider time value of money

Advanced compared to PP::

• Still ignore any cash flows after payback period

• Biased against long-term projects• Requires an arbitrary acceptance criteria

• A project accepted based on the payback criteria may nothave a positive NPV

Disadvantage:

DPP Cont.)



The Profitability Index PI) Rule

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We cannot use NVP method to rank projects.

What happen if firm faces the capital rationing?

Capital Rationing - Limitset on the amount of funds

available for investment.

Soft Rationing - Limits onavailable funds imposed by

management.

Hard Rationing - Limits onavailable funds imposed bythe unavailability of funds

in the capital market.



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Example

We only have $300,000 to invest. Which do we select?

Proj NPV Investment PI

A 230,000 200,000 1.15B 141,250 125,000 1.13

C 194,250 175,000 1.11

D 162,000 150,000 1.08

727,500 650,000

Based on NPV, we choose al l but we do no t have enough

capital

InvestentInitial

NPVPI

The Profitability Index PI) Rule Cont.)



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Examp le - cont inu ed Proj NPV Investment PI

A 230,000 200,000 1.15

B 141,250 125,000 1.13

C 194,250 175,000 1.11

D 162,000 150,000 1.08

Select projects with highest Weighted Avg PI

WAPI (B&D projects) = 1.13(125) + 1.08(150) + 0.0 (25)

(300) (300) (300)= 1.01




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Examp le - continued Proj NPV Investment PI

A 230,000 200,000 1.15

B 141,250 125,000 1.13

C 194,250 175,000 1.11D 162,000 150,000 1.08

Select projects with highest Weighted Avg PI

WAPI (B&D projects) = 1.01WAPI (A project) = 0.77

WAPI (B&C projects) = 1.12




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Minimum Acceptance Criteria: Accept if PI > 0

Ranking Criteria:Select alternative with highest PI

Disadvantages:Problems with mutually exclusive investments

Advantages:May be useful when available investment funds are limitedEasy to understand and communicateCorrect decision when evaluating independent projects




Equivalent Annual Annuity EAA)

• What happen if firm have two unequal projects?

• Equivalent Annual annuity/Cost (EAA/EAC) - Thecash flow per period with the same present value asthe cost of buying and operating a machine.

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Example

Given the following costs of operating two machinesand a 6% cost of capital, select the lower costmachine using equivalent annual annuity method.

Year

Mach. 1 2 3 4 PV@6% E.A.A.

F -15 -4 -4 -4G -10 -6 -6

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-25.69-21.00

- 9.61-11.45

Equivalent Annual Annuity EAA) Cont.)



Example (with a twist)Select one of the two following projects, based onhighest “equivalent annual annuity” (r=9%).

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4.107.81.820

2.69.52.59.415

Project 43210

B

A

EAA NPV C C C C C

2.82

2.78

.87

1.10

Equivalent Annual Annuity EAA) Cont.)



Conclusion

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Guiding principles for criteria:

• Depend on cash flow, not accounting profit

• Consistent with the goal of maximizing shareholders wealth

• Consider time value of money

• Account for the risk of the project

E l f I t t R l



Example of Investment Rules

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Compute the IRR, NPV, PI, and payback period for the

following two projects. Assume the required return is 10%.

Year Project A Project B

0 -$200 -$150

1 $200 $50

2 $800 $100

3 -$800 $150



Example of Investment Rules (Cont.)

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Project A Project B

CF0 -$200.00 -$150.00PV0 of CF1-3 $241.92 $240.80

NPV = $41.92 $90.80

IRR = 0%, 100% 36.19%

PI = 1.2096 1.6053



Project A Project B ($200)

($100)

$0

$100

$200

$300

$400

-15% 0% 15% 30% 45% 70% 100% 130% 160% 190%

Discount rates

N P V

IRR 1(A) IRR (B) IRR 2(A)

Cross-over Rate

Example of Investment Rules (Cont.)



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PI 12%

Book rate of

return 20%

Payback 57%

IRR 76%

NPV 75%

0 20 40 60 80 100

%Survey evidence on the percentage or CFOs who always, or almost always, use a particular technique forevaluating investment projects

Source: Reprinted from J. R. Graham and C. R. Harvey, “The Theory and Practice of Finance from the field,”

Journal of Financial Economics 61 (2001), pp. 187 – 243,©2001 with permission from Elsevier Science.

why in real life managers

still use PP method as wellIRR?



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why in real life managers

still use PP method as wellIRR?

Fund.finance Lecture 5 Investment Decision 2012

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