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Chapter8Notes.doc.docxChapter 08 – Net Present Value and Other Investment Criteria
Chapter 08 – Net Present Value and Other Investment Criteria
Chapter 08 – Net Present Value and Other Investment Criteria
Chapter 8
NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA
ANNOTATED CHAPTER OUTLINE
Slide 8.2 Key Concepts and Skills
Slide 8.3 Chapter Outline
Tip: A logical prerequisite to the analysis of investment opportunities is the creation of investment opportunities—unlike the field of investments, where the capital budgeting relies on the work of people in the areas of engineering, research and development, information technology, and others for the creation of investment opportunities. As such, it is important to suggest that you keep in mind the importance of creativity in this area, as well as the importance of analytical techniques. Capital budgeting involves the creation, as well as the analysis, of growth opportunities
Firm value comes primarily from the asset side of the balance sheet; i.e., value is created primarily via good investment decisions.
Consider that “investment assets” include intangibles such as human capital and intellectual property, as well as tangible assets in the form of plant and equipment.
Slide 8.4 Capital Budgeting
Stress the importance of capital budgeting in determining the long-term direction of the firm.
Slide 8.5 Good Decision Criteria
These are the decision criteria by which each method in the chapter will be evaluated.
Slide 8.6 Net Present Value
Net present value—the difference between the market value of an investment and its cost. While estimating cost is usually straightforward, finding the market value of assets can be tricky. The principle is to find the market price of comparables or substitutes.
Tip: It is often helpful to stress the word “net” in net present value. It is not uncommon for some to carelessly calculate the PV of a project’s future cash flows and fail to subtract out its cost (after all, that is what the programmers of Lotus and Excel did when they programmed the NPV function). The PV of future cash flows is not NPV, rather NPV is the amount remaining after offsetting the PV of future cash flows with the initial cost. Thus, the NPV amount determines the incremental value created by undertaking the investment.
Slide 8.7 Net Present Value
The basic NPV formula. Since up to now, we’ve avoided cash flows at time t = 0, be sure to note that the summation begins with cash flow zero—not one.
The second version is shown to lead into Excel’s NPV function. And with a typical project’s cash flows, CF0 is negative while the rest are positive.
Slide 8.8 NPV—Decision Rule
NPV is the only approach we cover that directly relates a project to the impact on firm value.
Tip: Here’s another perspective on the meaning of NPV. If we accept a project with a negative NPV of –$2,422, this is financially equivalent to investing $2,422 today and receiving nothing in return. Therefore, the total value of the firm would decrease by $2,422. This assumes that the various components (cash flow estimates, discount rate, etc.) used in the computation are correct.
Tip: In practice, financial managers are rarely presented with zero NPV projects. In most large firms, capital investment proposals are submitted to the Finance group from other areas for analysis. Those submitting proposals recognize the ambivalence associated with zero NPVs and are less likely to send them to the Finance group in the first place.
Conceptually, a zero-NPV project earns exactly its required return. Because firm value is completely unaffected by the investment, there is no reason for shareholders to prefer either one.
However, several real-world considerations may come into play in these decisions. For example, adjusting for risk in capital budgeting projects can be problematic. And, some investment projects may have benefits that are difficult to quantify but exist, nonetheless. Consider an investment with a low or zero NPV that enhances a firm’s image as a good corporate citizen or helps a firm move into new markets.
Slide 8.9 Sample Project Data
This sample project will be used for each of the decision rules so you can compare the different rules and see what problems and conflicts can arise.
Slide 8.10 Computing NPV for the Project
We will learn how to estimate the cash flows in Chapter 9.
We will learn how to estimate the required return in Chapter 12.
For now, consider both of these as given, while we learn the methodologies.
Slide 8.11 Computing NPV for the Project—Using the TIBAII+
Using the TI BAII+ Cash Flow worksheet introduced in Chapter 5.
Slide 8.12 Calculating NPV with Excel (Excel link)
Excel’s NPV function does NOT include cash flow 0! Actual “netting” must be handled manually outside the NPV function. This is illustrated in cells D10 and D11.
Slide 8.13 Net Present Value
Shows the formulas again to emphasize how calculators and Excel handle NPV calculations.
Slide 8.14 Rationale for the NPV Method
One of the primary strong points of the NPV method is that it is directly related to the increase in shareholder wealth.
The decision rule is simple: Accept if NPV > 0.
Slide 8.15 NPV Method
The NPV method meets all the desirable criteria for analysis and should ALWAYS be the dominant decision method. If conflicts between the results of the different methods exist (and we’ll show that they can), then the decision should be made based on the NPV result.
Slide 8.16 Payback Period
Payback period—length of time until the accumulated cash flows equal or exceed the original investment, i.e., how fast you recoup your initial investment.
Payback period rule—investment is acceptable if its calculated payback is less than some arbitrarily selected target number of years.
Slide 8.17 Computing Payback for the Project
The payback period is year 3 if you assume that the cash flows occur at the end of the year, which we do with all of the other decision rules.
If we assume that the cash flows occur evenly throughout the year, which is typical for this method, then the project pays back in 2.34 years.
Slide 8.18 Decision Criteria Test—Payback
Answer = NO to all
• No discounting involved.
• Doesn’t consider risk differences.
• Determines the cutoff point.
• No indication of impact on firm value.
• Cannot rank projects.
• Bias for short-term investments.
Real-World Tip: While the payback period is widely used in practice, it is rarely the primary decision criterion. As William Baumol pointed out in the early 1960s, the payback rule serves as a crude “risk screening” device—the longer cash is tied up, the greater the likelihood that it will not be returned. The payback period may be helpful when comparing mutually exclusive projects. Given two similar projects with different paybacks, the project with the shorter payback is often, but not always, the better project.
Real-World Tip: Interestingly, the payback period technique is used quite heavily in determining the viability of certain investment projects in the health care industry. In health care, the technology is rapidly changing with extremely expensive equipment and an increasingly competitive industry. An equipment purchase may be complicated by the fact that, while the machine may be able to perform its function for, say, 6 years or more, new and improved equipment is likely to be developed that will supersede the “old” equipment long before its useful life is over. Demand from patients and physicians for “cutting-edge technology” can drive a push for new investment. In the face of such a situation, many hospital administrators then focus on how long it will take to recoup the initial outlay, in addition to the NPV and IRR of the equipment.
Slide 8.19 Advantages and Disadvantages of Payback
Beyond its obvious drawbacks, the overriding problem with payback is that it asks the wrong question. The firm is looking for projects that will increase firm value, and this criterion picks the project that will recoup the initial investment the quickest—not the same thing.
International Note: Firms that have operations in countries with volatile politics may also be concerned with quick paybacks. When there is always a possibility that the government may seize your assets, you want to make sure that you have recouped your investment as quickly as possible.
Tip: One of the criticisms of payback is that it doesn’t account for time value of money. Discounted payback was developed to counter this problem. The basic idea is to compute the PV of each of the cash flows, using the appropriate discount rate, and determine how long it takes for the investment to pay back on a discounted basis. You still have an arbitrary cutoff and ignore the cash flows beyond the cutoff period. Because you are computing present values anyway, you may as well go ahead and compute the NPV because you have already lost payback’s simplicity.
Slide 8.20 Average Accounting Return
Average accounting return = measure of accounting profit / measure of average accounting value. In other words, it is a benefit/cost ratio that produces a pseudo rate of return. However, due to the accounting conventions involved, the lack of risk adjustment, and the use of profits rather than cash flows, it isn’t clear what is being measured.
The text gives the following specific definition:
AAR = average net income / average book value
AAR rule = accept if AAR > target return
Slide 8.21 Computing AAR for the Project
Computations use the Sample Project data from slide 8.9 repeated here. This is the one method that uses the net incomes (NI) and average book value given.
Some may ask where you came up with the 25%. This is one of the drawbacks of this rule. There is no good theory for determining what the return should be. We generally just use some rule of thumb.
Slide 8.22 Decision Criteria Test—AAR
The answer to all of these questions is NO. In fact, this rule is even worse than the payback rule in that it doesn’t even use cash flows for the analysis. It uses net income and book value.
Tip: An alternative view of the AAR is that it is the micro-level analogue to the ROA discussed in a previous chapter. As you remember, firm ROA is normally computed as Firm net income / Firm total assets. And, it is not uncommon to employ values averaged over several quarters or years in order to smooth out this measure. Some analysts ask, “If the ROA is appropriate for the firm, why is it less appropriate for a project?” Perhaps the best answer is that whether you compute the measure for the firm or for a project, you need to recognize the limitations—it doesn’t account for risk or the time value of money, and it is based on accounting, rather than market, data.
Slide 8.23 Advantages and Disadvantages of AAR
Clearly, AAR’s main drawback is that it uses accounting data rather than cash flows and is, therefore, not comparable to any other true “return” figures.
Real-World Tip: Surveys indicate that few large firms employ the payback period and/or the AAR methods exclusively; rather, these techniques are used in conjunction with one or more of the DCF techniques. On the other hand, anecdotal evidence suggests that many smaller firms rely more heavily on non-DCF approaches. Reasons for this include (1) small firms don’t have direct access to the capital markets and, therefore, find it more difficult to estimate discount rates based on funds cost; (2) the AAR is the project-level equivalent to the ROA measure used for analyzing firm profitability; and (3) some small-firm decision makers may be less aware of DCF approaches than their large-firm counterparts.
Slide 8.24 Internal Rate of Return
Internal rate of return (IRR)—the rate that makes the present value of the future cash flows equal to the initial cost or investment. In other words, the discount rate that gives a project a $0 NPV.
The IRR rule is very important. Management and individuals in general, often have a much better feel for percent returns and the value that is created than they do for dollar increases. A dollar increase doesn’t seem to provide as much information if we don’t know what the initial expenditure was.
Slide 8.25 IRR—Definition and Decision Rule
Tip: Remember that the goal of IRR is not to find zero NPV projects, but rather to find a range of discount rates for which the project is acceptable.
Slide 8.26 NPV versus IRR
Shows both the NPV and IRR formulas for comparison.
Slide 8.27 Computing IRR for the Project
Without a financial calculator or Excel, computing IRR (like YTM for a bond) is a trial-and-error process. In fact, the YTM of a bond is its IRR.
Many financial calculators compute the IRR as soon as the key is pressed; others (like the TI BAII+) require that you press compute.
Slide 8.28 Computing IRR for the Project—TI BAII+
The TU BAII+ uses the Cash Flow worksheet to compute IRR. Cash flows are entered in the same manner as for NPV. When the final CF has been entered, press the IRR key. “IRR” will display on the screen. Press compute .
Slide 8.29 Computing IRR for the Project—Excel
Excel also has an IRR function, BUT, unlike the NPV function, the cash flow range for IRR INCLUDES cash flow zero. (next slide)
Slide 8.30 Computing IRR for the Project—Excel (Excel link)
Click on the Excel link to pull up the spreadsheet displayed on the slide.
The row and column headings are shown to emphasize that the function requires the range to include cash flow 0.
Slide 8.31 NPV Profile for the Project
Tip: Notice that the NPV profile is also a form of sensitivity analysis—the slope of the NPV profile indicates how much a project’s estimated NPV is affected by a change in the discount rate used to compute it.
Slide 8.32 Decision Criteria Test—IRR
The answer to all of these questions is YES, although it is not always obvious.
· The IRR rule accounts for time value because it is finding the rate of return that equates all of the cash flows on a time value basis.
· The IRR rule provides an indication of value because we will always increase value if we can earn a return greater than our required return.
· We should not consider the IRR rule as our primary decision rule. It has some problems that NPV does not have, thus NPV is our ultimate decision rule.
Slide 8.33 Advantages of IRR
If you get a very large IRR, you should go back and look at your cash flow estimation again. In competitive markets, extremely high IRRs should be rare.
Slide 8.34 Disadvantages of IRR
These are some rather serious flaws in the IRR method, which are discussed on the following slides.
Slide 8.35 Summary of Decisions for the Project
So, what should we do? We have two rules that indicate to accept and two that indicate to reject. Easy—NPV prevails.
Slide 8.36 NPV versus IRR
If a project’s cash flows are conventional (costs are paid early and benefits are received over the life), and if the project is independent, then NPV and IRR will give the same accept or reject signal, which was the case with our Sample Project.
There are situations where NPV and IRR will give conflicting answers.
Slide 8.37 IRR and Nonconventional Cash Flows
Nonconventional cash flows means the sign of the cash flows changes more than once or the cash inflow comes first and outflows come later. If this occurs, you will have multiple internal rates of return. This is problematic for the IRR rule; however, the NPV rule still works correctly.
Nonconventional cash flows and multiple IRRs occur when there is a net cost to shutting down a project. The most common examples deal with collecting natural resources. After the resource has been harvested, there is generally a cost associated with restoring the environment.
Slide 8.38 Multiple IRRs
Explains why nonconventional cash flows result in multiple IRRs.
The IRR formula is a polynomial of degree n, which implies n roots.
Descartes’ Rule of Signs says that for every sign change, a real root will exist.
Conventional cash flow streams have one sign change (CF0 = negative, CF1–N = positive) and result in one real root—the IRR.
With more than one sign change, we get more than one real root (the rest are imaginary).
Slide 8.39 Nonconventional Cash Flows
The example problem on this slide is solved on the next slide. Note that CF0 = –90,000 and CF3 = –150,000—two sign changes.
Slide 8.40 Nonconventional Cash Flows (Excel link)
Summary of Decision Rules
The steps to compute NPV are not shown because we have covered them previously.
If you compute the IRR on the calculator, you get 10.11% because it is the first one that you come to. So, if you just blindly use the calculator without recognizing the uneven cash flows, NPV would say to accept and IRR would say to reject.
Slide 8.41 NPV Profile
You should accept the project if the required return is between 10.11% and 42.66%.
This provides a good visual of the 2 IRRs.
Slide 8.42 Independent versus Mutually Exclusive Projects
Tip: A good introduction to mutually exclusive projects is to provide examples that others can relate to. An excellent example of mutually exclusive projects is the choice of which college or university to attend. Most students apply and are accepted to more than one college, yet they cannot attend more than one at a time. Consequently, they have to decide between mutually exclusive projects.
Slide 8.43 Reinvestment Rate Assumption
If a project analysis results in a high IRR, the reinvestment rate assumption tends to inflate that result because it assumes that cash flows from the project are reinvested at that high rate—which is attractive but not reasonable.
Slide 8.44 Example of Mutually Exclusive Projects
This is a simple example of two mutually exclusive projects that result in conflicting signals from NPV and IRR.
The important point is that we DO NOT use IRR to choose between projects.
Slide 8.45 NPV Profiles
If the required return is less than the crossover point of 11.8%, then you should choose A. If the required return is greater than the crossover point of 11.8%, and doesn’t exceed B’s IRR of 22.17%, then you should choose B.
Slide 8.46 Two Reasons NPV Profiles Cross
The situations that result in crossing NPV profiles are:
· Scale differences
· Timing differences
Slide 8.47 Conflicts between NPV and IRR
Emphasizing that NPV is the dominant decision criteria and the situations where IRR is unreliable.
Slide 8.48 Modified Internal Rate of Return (MIRR)
Executives clearly prefer IRR yet it has shortcomings. MIRR, or Modified Internal Rate of Return, controls for these problems.
There are three methods of computing MIRR, each demonstrated on the next three slides.
Slide 8.49 MIRR Method 1—Discounting Approach (Excel link)
Slide 8.50 MIRR Method 2—Reinvestment Approach (Excel link)
Slide 8.51 MIRR Method 3—Combination Approach (Excel link)
Slide 8.52 MIRR in Excel (Excel link)
Excel’s embedded MIRR function uses Method 3 shown on slide 8.51.
Two rates of interest are used:
· A financing rate is used to discount cash outflow.
· A reinvestment rate is used to compound cash inflows.
For our example, the same rate will be used for both.
Slide 8.53 MIRR- First, find PV and TV
Manually calculating MIRR is somewhat confusing. Much like valuing a nonconstant growth stock, seeing the timeline can help you understand the process.
Step 1 is to find the PV of cash outflows and the Terminal Value (TV) of cash inflows.
Slide 8.54 MIRR—Second, Find the Discount Rate That Equates PV and TV
Once the values in step 1 are computed, use the standard TVM functions to find the rate that grows the PV to TV in n periods. This is illustrated on the next slide.
Slide 8.55 MIRR—Second, Find the Discount Rate That Equates PV and TV
Formula, Calculator, and Excel solutions.
In Excel, you can use the basic RATE function or the specialized MIRR function.
Note that the TI BAII+ professional calculator has the MIRR function built-in.
Slide 8.56 MIRR versus IRR
Summarizes why MIRR is a better choice than IRR if a rate of return metric is preferred. MIRR is used by major firms, including Federal Express, in their project analysis.
Slide 8.57 Profitability Index
Profitability index—present value of the future cash flows divided by the initial investment (both numerator and denominator are positive).
This definition assumes no negative cash flows after year zero. Technically, PI = PV of inflows / PV of outflows; thus a nonconventional project’s PI will have a PV in both the numerator and the denominator. If a project has a positive NPV, then the PI will be greater than 1.
Slide 8.58 Profitability Index
Formula for PI
Slide 8.59 Advantages and Disadvantages of Profitability Index
Because the profitability index is closely related to NPV, it does generally lead to identical signals. However, project scale can lead to incorrect choices with mutually exclusive projects as is shown on the next slide.
Tip: The profitability index is often used when a firm faces capital rationing. The basic idea is to compute the PI for all independent projects and choose those projects that have the highest PI until you run out of funds. If a high PI project uses the majority of funds, then you should see if skipping it and taking the next highest set of PI projects results in a higher overall NPV (some trial-and-error may be required).
Slide 8.60 Profitability Index—Example of Conflict with NPV
Due to the difference in scale, the PI of project A is greater than that of B, yet clearly B is a better choice because it will increase firm value five times as much in dollars as project A.
Slide 8.61 Capital Budgeting in Practice
It is common among large firms to employ a discounted cash flow technique such as IRR or NPV along with payback period or average accounting return. It is suggested that this is one way to resolve the considerable uncertainty over future events that surrounds the estimation of NPV.
Even though payback and AAR should not be used to make the final decision, we should consider the project very carefully if they suggest rejection. There may be more risk than we have considered, or we may want to pay additional attention to our cash flow estimations. Sensitivity and scenario analysis can be used to help us evaluate our cash flows.
The fact that payback is commonly used as a secondary criteria may be because short paybacks allow firms to have funds sooner to invest in other projects without going to the capital markets
Slide 8.62 Summary of Methods
Recaps the five methods covered in the chapter—what each measures and the metric used.
While NPV is the dominant decision criteria, there are reasons to calculate all five because each provides indications concerning the value and/or risk of a proposed project.
Tip: While uncertainty about inputs and interpretation of the outputs help explain why multiple criteria are used to judge capital investment projects in practice, another reason is managerial performance assessment. When managers are judged and rewarded primarily on the basis of periodic accounting figures, there is an incentive to evaluate projects with methods such as payback or average accounting return. On the other hand, when compensation is tied to firm value, it makes more sense to use NPV as the primary decision tool.
The following five slides give a brief review of each of the methods and its advantages and drawbacks:
Slide 8.63 NPV Summary
Slide 8.64 IRR Summary
Slide 8.65 Payback Summary
Slide 8.66 AAR Summary
Slide 8.67 Profitability Index Summary
Slide 8.68 Quick Quiz
Problem solution on next slide.
Slide 8.69 Quick Quiz Solution (Excel link)
Slide 8.70 Chapter 8 END
Extended Ethics Note: Financial Incentives
The use of various financial incentives to induce firms to locate in a given municipality raises some interesting issues in the capital budgeting area. From the viewpoint of the firm’s analysts, how do you estimate the impact of such incentives? A reduction in the initial outlay? Increases in future cash inflows? And what discount rate should be assigned to these tax reductions? Are these promises riskless?
And what about the municipal officials who offer such incentives? Stated reasons are typically related to “employment growth” or “increased economic activity.” But, from a capital budgeting standpoint, have you ever seen a fully developed cash flow analysis of the stated benefits relative to the costs?
Consider this example from a Federal Reserve publication:
“Alabama offered Mercedes-Benz a package valued at more than the cost of the plant itself. To lure the $300 million plant, with about 1,500 jobs, the state promised to buy the site for $30 million, and lease it to Mercedes for $100. Surrounding communities will contribute an additional $5 million each, and the University of Alabama will offer German language and culture classes to the children of plant employees. On top of this, the state will provide a package of tax breaks valued at more than $300 million, which will, among other things, allow the plant to be paid for with money that would have been paid to the state.”
Several incentives described above directly affect the costs and benefits of the proposed project and would be accounted for in the capital budgeting analysis performed by Mercedes. However, the state officials should perform their own capital budgeting analysis—they too are incurring economic costs in the hope for future benefits. But at least one aspect is different: When a corporation makes a poor investment, shareholders suffer; when a state makes poor decisions, all of the residents of the state suffer. Thus, the ethics of the capital budgeting decision come into play more clearly in the latter case.
Extended Ethics Note: Financially Sound versus Ethically Sound
Because a project is financially sound, it must be ethically sound, right? Well … the question of ethical appropriateness is less frequently discussed in the context of capital budgeting than is financial appropriateness.
Consider the following simple example. The American Association of Colleges and Universities estimates that 10% of all college students cheat at some point during their postsecondary education careers. You might pose the ethical question of whether it would be proper for a publishing company to offer a new book, “How to Cheat: A User’s Guide.” The company has a cost of capital of 8% and estimates it could sell 10,000 volumes by the end of year 1 and 5,000 volumes in each of the following two years. The immediate printing costs for the 20,000 volumes would be $20,000. The book would sell for $7.50 per copy and net the company a profit of $6 per copy after royalties, marketing costs, and taxes. Year 1 net would be $60,000.
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