RWJ chapter 6.ppt

7/24/2019 RWJ chapter 6.ppt

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Chapter 5: Net present value andother investment rules

Corporate Finance

Ross, Westerfield, andJaffe


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Outline

1. Net present value (NPV)

2. The payba! period "ethod#. The disounted payba! period "ethod

$. The %nternal rate of return (%RR)

&. The profitability inde'


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Good decision criteria

oes the rule ta!e the ti"e value of "oney

into onsiderationoes the rule ad*ust for ris!

oes the rule tell us +hether and by ho+"uh the pro*et add value to the fir"


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A proposed project

our o"pany is loo!in- at a ne+ pro*et that

has the follo+in- ash flo+s. ear / initial ost, C.0 1,.

ear 1/ 310 #,.

ear 2/ 320 &,. ear #/ 3#0 4,.

The appliable disount rate is 15.


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1stmethod: the NPV rule

NPV 0 PV 6 C./ the differene bet+een the

present value of the invest"ent7s future netash flo+s, i.e., benefits, and its initial ost.

%deas/ (1) an invest"ent is +orth underta!in-if it reates value for its o+ners, and (2) an

invest"ent reates value if it +orth "orethan it osts +ithin the ti"e value of "oneyfra"e+or! (hapter $).


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Decision rule

%f NPV 8 0 , aept the pro*et.

%f NPV 9 , re*et the pro*et. : positive NPV su--ests that the pro*et is e'peted

to add value to the fir", and the pro*et shouldi"prove shareholders7 +ealth.

;eause the -oal of finanial "ana-e"ent is toinrease shareholders7 +ealth, NPV is a -ood"easure of ho+ +ell this pro*et +ill "eet this -oal.


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Project NPV


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Judging the NPV rule

oes the NPV rule ta!e the ti"e value of

"oney into onsiderationoes the NPV rule ad*ust for ris!

oes the NPV rule tell us +hether and byho+ "uh the pro*et add value to the fir"


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inall!" the! listen

3


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#nd

method: pa!$ac% period

Payba! period/ the a"ount of ti"e reDuired

for an invest"ent to -enerate after=ta' ashflo+s suffiient to reover its initial ost.


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Decision rule

:n invest"ent is aepted (re*eted), if

payba! period 9 (8) so"e speified nu"berof ti"e period.

The utoff is arbitrarily hosen by the"ana-er or the entrepreneur.


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Project pa!$ac% period


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&he decision

The payba! period is lon-er than 2 years

and shorter than # years. %f the utoff is 2 years, +e7d re*et the pro*et.

%f the utoff is # years, +e7d aept thepro*et.


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Judging the pa!$ac% period rule

oes the payba! period rule ta!e the ti"e

value of "oney into onsiderationoes the payba! period rule ad*ust for ris!

oes the payba! period rule tell us +hetherand by ho+ "uh the pro*et add value to

the fir"


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&he good and the $ad

:dvanta-e/6

Easy to understand and o""uniate.isadvanta-es/

6 %-nores the ti"e value of "oney.

6 3ail to onsider the ris!ness of the pro*et, no i.

6 ReDuires an arbitrary utoff point.

6 %-nores ash flo+s beyond the utoff.

6 ;iased a-ainst lon-=ter" pro*ets, suh as RFs.


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'rdmethod: discounted pa!$ac% period

isounted payba! period/ the len-th of

ti"e reDuired for an invest"ent7s disountedash flo+s to eDual its initial ost.


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Decision rule

:n invest"ent is aepted (re*eted), if

disounted payba! period 9 (8) so"espeified nu"ber of ti"e period.

:-ain, the utoff is arbitrarily hosen.


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Project discounted pa!$ac% period


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&he decision

The disounted payba! period is lon-er

than 2 years and shorter than # years. %f the utoff is 2 years, +e7d re*et the pro*et.

%f the utoff is # years, +e7d aept thepro*et.


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Judging discounted pa!$ac% period

oes the payba! period rule ta!e the ti"e

value of "oney into onsiderationoes the payba! period rule ad*ust for ris!

oes the payba! period rule tell us +hetherand by ho+ "uh the pro*et add value to

the fir"


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:dvanta-e/6

Btill fairly easy to understand and o""uniate.6 Ta!e TVG into onsideration.

isadvanta-es/6 ReDuires an arbitrary utoff point.

6 %-nores ash flo+s beyond the utoff.6 ;iased a-ainst lon-=ter" pro*ets, suh as RFs.


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(th

method: )**

%RR/ the disounted rate that "a!es the NPV

of an invest"ent Hero.


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Decision rule

:n invest"ent is aepted (re*eted), if the

%RR 8 (9) the reDuired rate.


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Project )**


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&he decision

The o"puted %RR is 1I5, +hih is hi-her

than the 15 reDuired rate. Thus, +e aeptthe pro*et.


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Judging the )**

oes the %RR rule ta!e the ti"e value of

"oney into onsiderationoes the %RR rule ad*ust for ris!

oes the %RR rule tell us +hether and by ho+"uh the pro*et add value to the fir"


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NPV vs+ )**

3or "ost pro*ets, NPV and %RR lead to the sa"eonlusion.

Pratitioners really li!e to use %RR beause this"easure -ives pratitioners a -ood idea about at+hat rate they are able to earn. no+in- a return isintuitively appealin-.

%RR provides a "easure about the value of a pro*et

to so"eone +ho doesn7t !no+ all the esti"ationdetails. %f the %RR is hi-h enou-h, one "ay not need to

esti"ate the reDuired return at all.


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A ,arning

Typial %RR alulations build in reinvest"ent

assu"ptions. This "a!es pro*ets loo! better than they

atually are.


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-ut" non.uni/ue )** solutions


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0esson

;efore you use your %RR esti"ate, al+ays

verify the result +ith the NPV result. %n real life, NPV and %RR are the 2 "ost

popular deision rules used by "odern (bi-)C.B. orporations. :nd, they tend to be used

to-ether.


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5th

method: the proita$ilit! inde2

Profitability inde' (P%) 0 PV K C..


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Decision rule

3or a pro*et, +e aept the pro*et only if P%8 1.

3or "utually e'lusive pro*ets, pratitionersso"eti"es hoose the pro*et +ith the hi-hestP%. Lo+ever, this approah is proble"ati.

%f there is no apital onstraint, one shouldhoose the pro*et +ith the hi-hest NPV fro"the "utually e'lusive pool.


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Project P)


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:dvanta-es/6

Related to NPV, -enerally leadin- to identialdeisions.

6 Easy to understand and o""uniate.

isadvanta-e/

6 Bhould not be used for "a!in- "utually e'lusivedeisions.


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*eal options

Bo far, you !no+ that NPV is the bestriterionM %RR is another al"ost eDually -oodand i"portant one.

;ut these analyses "ainly addressindependent pro*ets +hose aeptane orre*etion has no i"pliations on theaeptane or re*etion of other pro*ets.

When pro*ets have (real) options, NPV and%RR "ay perfor" poorly.


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An e2ample: timing option

Buppose that the NPV for a developer to built abuildin- on a vaant land nowis positive. The

si"ple version of the NPV rule +ould lead to theonlusion that the developer should build thebuildin- no+.

%n real life, the developer "ay hoose to +ait. 3orinstane, the developer "ay believe that this is not

the best ti"in- (althou-h the NPV is positive). Thedeveloper "ay +ant to +ait for another fe+ years+hen the real estate "ar!et is stron-er to realiHe a"uh lar-er NPV at that ti"e.


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3ore real options

%n real life, there are several "ore types ofreal options that +ill "a!e apital bud-etin- aeven "ore o"ple' tas!.

hapter I, pp. 221=22$ has an introdution toanother t+o types of real options/ (1) theoption to e'pand, and (2) the option toabandon.

% bet these +ill be treated in your inter"ediateorporate finane ourse.


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Assignment

The :; o. is onsiderin- e'pandin- its prodution apaity by#5. The e'pansion +ill reDuire 2 "illion initially. The net ash

flo+ fro" this e'pansion is $ "illion for the first year. The netash flo+s are e'peted to -ro+ at a rate of &5 eah year for $years, but then slo+ to a #5 -ro+th thereafter. The :; o.esti"ates that the ost of apital (i.e., reDuired return) for thise'pansion is >5.

Tas!/ +rite a report ans+erin- (1) should :; o. e'pand Why

(2) %f the "ar!et interest rate inreases and thus the ost of apitalfor this e'pansion inreases to 125, +ould your reo""endationhan-e

ue in a +ee!.


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4nd.o.chapter

onept Duestions/ 1=11, 1#, and 1$.

uestions and proble"s/ 1=$, I=O, 12, 1$(a),1$(b), 1&, 14(a), 14(b), 1I, 1>(a), and 1>(b).

RWJ chapter 6.ppt

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