T9.1 Chapter Outline Chapter 9 Net Present Value and Other Investment Criteria Chapter Organization...

T9.1 Chapter Outline

Chapter 9Net Present Value and Other Investment Criteria

Chapter Organization

9.1 Net Present Value

9.2 The Payback Rule

9.3 The Average Accounting Return

9.4 The Internal Rate of Return

9.5 The Profitability Index

9.6 The Practice of Capital Budgeting

9.7 Summary and Conclusions

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Irwin/McGraw-Hill copyright © 2002 McGraw-Hill Ryerson, Ltd.

Irwin/McGraw-Hill copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 2

Capital Budgeting

In Chapter 1 we defined capital budgeting as ‘the process of planning and managing a firm’s investment in fixed assets’

...probably the most or at least one of the most important issues in corporate finance.

Identifying investment opportunities which offer more value to the firm than their cost - the value of the future cash flows need to be greater than the investment required

estimating the size, timing and risk of future cash flows is the most challenging aspect of capital budgeting


Investment Criteria

NPV - Net Present Value the difference between an investment’s market value and its cost

Payback - the length of time it takes to recover the initial investment

Discounted Payback the length of time required for an investment’s discounted cash

flows to equal its initial cost

Average Accounting Return - AAR an investment’s average net income divided by its average book

value

Internal Rate of Return the discount rate that makes the NPV of an investment equal to

zero


Investment Critieria cont’d

The Profitability Index- “PI’ ‘The present value of an investment’s future cash flows divided by

its initial cost

- also known as the benefit/cost ratio


T9.2 NPV Illustrated

Estimate future cash flows, calculate the PV of these cash flows and then compare to cost of project to arrive at NPV

Assume you have the following information on Project X:

Initial outlay -$1,100 Required return = 10%

Annual cash revenues and expenses are as follows:

Year Revenues Expenses

1 $1,000 $500

2 2,000 1,000

Draw a time line and compute the NPV of project X.


T9.2 NPV Illustrated (concluded)

0 1 2

Initial outlay($1,100)

Revenues $1,000Expenses 500

Cash flow $500

Revenues $2,000Expenses 1,000

Cash flow $1,000

– $1,100.00

+454.55

+826.45

+$181.00

1$500 x 1.10

1$1,000 x 1.10

2

NPV


T9.3 Underpinnings of the NPV Rule

The foundation of the NPV approach:

A “firm” is created when securityholders supply the funds to acquire assets that will be used to produce and sell a good or a service;

The market value of the firm is based on the present value of the cash flows it is expected to generate;

Additional investments are “good” if the present value of the incremental expected cash flows exceeds their cost;

Thus, “good” projects are those which increase firm value - or, put another way, good projects are those projects that have positive NPVs!

Conclusion - Invest only in projects with positive NPV’s.


Payback Rule

‘length of time it takes to recover the initial investment’ how long does the investment take before I recover my initial

investment? - a break-even in an accounting sense but not in an economic sense

The Payback ‘Rule’ - an investment is considered acceptabe if the payback is less than some prespecified time frame

shortcomings of the payback rule vs the NPV ignores time value of money - simply adds up future cash flows ignores risk differences - payback is calculated the same way for

projects that are risky and ‘safe’ projects determining the cut-off - what should the payback be?? Ignores the cash flows beyond the payback cut-off


T9.4 Payback Rule Illustrated

Initial outlay -$1,000

Year Cash flow

1 $200

2 400 3 600

Accumulated

Year Cash flow

1 $200 2 600 3 1,200

Payback period = 2 2/3 years


Discounted Payback

The same basic concept in how long does it take to recover the original investment but in this case the future cash flows are discounted.

‘the length of time it takes for an investment’s discounted cash flows to equal its initial cost.’

break-even in an economic sense

What are its shortcomings? Cash flows beyond the cut-off point are ignored the cut-off point still has to be arbitrarily established


T9.5 Discounted Payback Illustrated

Initial outlay -$1,000

R = 10%

PV of Year Cash flow Cash flow

1 $ 200 $ 182 2 400 331 3 700 526 4 300 205

Accumulated Year discounted cash flow

1 $ 182 2 513 3 1,039 4 1,244

Discounted payback period is just under 3 years


T9.6 Ordinary and Discounted Payback (Table 9.3)

Cash Flow Accumulated Cash Flow

Year Undiscounted Discounted Undiscounted Discounted

1 $100 $89 $100 $89

2 100 79 200 168

3 100 70 300 238

4 100 62 400 300

5 100 55 500 355


Average Accounting Return

‘An investment’s average net income divided by its average book value’ or

‘Some measure of average accounting profit/some measure of average accounting value’

....’a project is acceptable if its average accounting return exceeds a target average accounting return

Advantages easy to calculate readily available accounting information

What are its shortcomings? Ignores time value of money - the average return does not

differentiate between near term returns vs. Returns in the distant future

focuses on net income and book value instead of cash flow and market value


T9.7 Average Accounting Return Illustrated

Average net income:

Year

1 2 3

Sales $440 $240 $160

Costs 220 120 80

Gross profit 220 120 80

Depreciation 80 80 80

Earnings before taxes 140 40 0

Taxes (25%) 35 10 0

Net income $105 $30 $0

Average net income = ($105 + 30 + 0)/3 = $45


T9.7 Average Accounting Return Illustrated (concluded)

Average book value:

Initial investment = $240

Average investment = ($240 + 0)/2 = $120

Average accounting return (AAR):

Average net income $45

AAR = = = 37.5% Average book value $120


Internal Rate of Return or ‘IRR’

‘the discount rate that makes the NPV of an investment equal to zero’

- sometimes called the discounted cash flow or ‘DCF return’

The IRR ‘rule’ suggest that an investment is acceptable if the IRR exceeds the required return.

A viable alternative to the NPV model Used extensively in practice - provides a return figure when

analyzing investments as opposed to a $ figure more difficult to calculate - requires trial and error


Internal Rate of Return

What are the shortcomings of the IRR approach? Non -conventional cash flows make the calculation much more

difficult Mutually exclusive Investments - meaning we can accept one

project but not another that is under consideration


T9.8 Internal Rate of Return Illustrated

Initial outlay = -$200

Year Cash flow

1 $ 50 2 100 3 150

Find the IRR such that NPV = 0

50 100 150

0 = -200 + + + (1+IRR)1 (1+IRR)2 (1+IRR)3

50 100 150

200 = + + (1+IRR)1 (1+IRR)2 (1+IRR)3


T9.8 Internal Rate of Return Illustrated (concluded)

Trial and Error

Discount rates NPV

0% $100

5% 68

10% 41

15% 18

20% -2

IRR is just under 20% -- about 19.44%


Year Cash flow

0 – $275 1 100 2 100 3 100 4 100

T9.9 Net Present Value Profile

Discount rate

2% 6% 10%

14% 18%

120

100

80

60

40

20

Net present value

0

– 20

– 40

22%

IRR


Assume you are considering a project for which the cash flows are as follows:

Year Cash flows

0 -$252

1 1,431

2 -3,035

3 2,850

4 -1,000

T9.10 Multiple Rates of Return


T9.10 Multiple Rates of Return (continued)

What’s the IRR? Find the rate at which the computed NPV = 0:

at 25.00%: NPV = _______

at 33.33%: NPV = _______

at 42.86%: NPV = _______

at 66.67%: NPV = _______


T9.10 Multiple Rates of Return (continued)

What’s the IRR? Find the rate at which the computed NPV = 0:

at 25.00%: NPV = 0

at 33.33%: NPV = 0

at 42.86%: NPV = 0

at 66.67%: NPV = 0

Two questions: 1. What’s going on here? 2. How many IRRs can there

be?


T9.10 Multiple Rates of Return (concluded)

$0.06

$0.04

$0.02

$0.00

($0.02)

NPV

($0.04)

($0.06)

($0.08)

0.2 0.28 0.36 0.44 0.52 0.6 0.68

IRR = 1/4

IRR = 1/3

IRR = 3/7

IRR = 2/3

Discount rate


T9.11 IRR, NPV, and Mutually Exclusive Projects

Discount rate

2% 6% 10%

14% 18%

60

40200

– 20– 40

Net present value

– 60

– 80

– 100

22%

IRR A IRR B

0

140

12010080

160

Year

0 1 2 3 4

Project A: – $350 50 100 150 200

Project B: – $250 125 100 75 50

26%

Crossover Point


Profitability Index - ‘PI’

‘The present value of an investment’s future cash flows divided by its initial cost’

measures ‘bang for the buck’ or the value created per dollar invested

Shortcomings does not recognize total market value added (as does the NPV

approach) - thus when comparing mutually exclusive investments it can lead to incorrect decisions


T9.12 Profitability Index Illustrated

Now let’s go back to the initial example - we assumed the following information on Project X:

Initial outlay -$1,100Required return = 10%

Annual cash benefits:

Year Cash flows

1 $ 500

2 1,000 What’s the Profitability Index (PI)?


T9.12 Profitability Index Illustrated (concluded)

Previously we found that the NPV of Project X is equal to:

($454.55 + 826.45) - 1,100 = $1,281.00 - 1,100 = $181.00.

The PI = PV inflows/PV outlay = $1,281.00/1,100 = 1.1645.

This is a good project according to the PI rule. Can you explain why?

It’s a good project because the present value of the inflows exceeds the outlay.


T9.13 Summary of Investment Criteria

I. Discounted cash flow criteria

A. Net present value (NPV). The NPV of an investment is the difference between its market value and its cost. The NPV rule is to take a project if its NPV is positive. NPV has no serious flaws; it is the preferred decision criterion.

B. Internal rate of return (IRR). The IRR is the discount rate that makes the estimated NPV of an investment equal to zero. The IRR rule is to take a project when its IRR exceeds the required return. When project cash flows are not conventional, there may be no IRR or there may be more than one.

C. Profitability index (PI). The PI, also called the benefit-cost ratio, is the ratio of present value to cost. The profitability index rule is to take an investment if the index exceeds 1.0. The PI measures the present value per dollar invested.


T9.13 Summary of Investment Criteria (concluded)

II. Payback criteria

A. Payback period. The payback period is the length of time until the sum of an investment’s cash flows equals its cost. The payback period rule is to take a project if its payback period is less than some prespecified cutoff.

B. Discounted payback period. The discounted payback period is the length of time until the sum of an investment’s discounted cash flows equals its cost. The discounted payback period rule is to take an investment if the discounted payback is less than some prespecified cutoff.

III. Accounting criterion

A. Average accounting return (AAR). The AAR is a measure of accounting profit relative to book value. The AAR rule is to take an investment if its AAR exceeds a benchmark.


T9.14 The Practice of Capital Budgeting


T9.15 Chapter 9 Quick Quiz

1. Which of the capital budgeting techniques do account for both the time value of money and risk?

2. The change in firm value associated with investment in a project is measured by the project’s _____________ .

a. Payback period

b. Discounted payback period

c. Net present value

d. Internal rate of return

3. Why might one use several evaluation techniques to assess a given project?


T9.15 Chapter 9 Quick Quiz

1. Which of the capital budgeting techniques do account for both the time value of money and risk?

Discounted payback period, NPV, IRR, and PI

2. The change in firm value associated with investment in a project is measured by the project’s Net present value.

3. Why might one use several evaluation techniques to assess a given project?

To measure different aspects of the project; e.g., the payback period measures liquidity, the NPV measures the change in firm value, and the IRR measures the rate of return on the initial outlay.


T9.16 Solution to Problem 9.3

Offshore Drilling Products, Inc. imposes a payback cutoff of 3 years for its international investment projects. If the company has the following two projects available, should they accept either of them?

Year Cash Flows A Cash Flows B

0 -$30,000 -$45,000

1 15,000 5,000

2 10,000 10,000

3 10,000 20,000

4 5,000 250,000


T9.16 Solution to Problem 9.3 (concluded)

Project A:

Payback period = 1 + 1 + ($30,000 - 25,000)/10,000

= 2.50 years

Project B:

Payback period = 1 + 1 + 1 + ($45,000 - 35,000)/$250,000

= 3.04 years

Project A’s payback period is 2.50 years and project B’s payback period is 3.04 years. Since the maximum acceptable payback period is 3 years, the firm should accept project A and reject project B.


T9.17 Solution to Problem 9.7

A firm evaluates all of its projects by applying the IRR rule. If the required return is 18 percent, should the firm accept the following project?

Year Cash Flow

0 -$30,000

1 25,000

2 0

3 15,000


T9.17 Solution of Problem 9.7 (concluded)

To find the IRR, set the NPV equal to 0 and solve for the discount rate:

NPV = 0 = -$30,000 + $25,000/(1 + IRR)1 + $0/(1 + IRR) 2

+$15,000/(1 + IRR)3

At 18 percent, the computed NPV is ____.

So the IRR must be (greater/less) than 18 percent. How did you know?


T9.17 Solution of Problem 9.7 (concluded)

To find the IRR, set the NPV equal to 0 and solve for the discount rate:

NPV = 0 = -$30,000 + $25,000/(1 + IRR)1 + $0/(1 + IRR)2 +$15,000/(1 + IRR)3

At 18 percent, the computed NPV is $316.

So the IRR must be greater than 18 percent. We know this because the computed NPV is positive.

By trial-and-error, we find that the IRR is 18.78 percent.

T9.1 Chapter Outline Chapter 9 Net Present Value and Other Investment Criteria Chapter Organization...

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