CLA 1 Paper - Financial Management

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Ross_12e_PPT_Ch09.pptx

CHAPTER 9

NET PRESENT VALUE AND

OTHER INVESTMENT CRITERIA

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Show the reasons why the net present value criterion is the best way to evaluate proposed investments

Discuss the payback rule and some of its shortcomings

Discuss the discounted payback rule and some of its shortcomings

Explain accounting rates of return and some of the problems with them

Present the internal rate of return criterion and its strengths and weaknesses

Calculate the modified internal rate of return

Illustrate the profitability index and its relation to net present value

Key Concepts and Skills

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Net Present Value

The Payback Rule

The Discounted Payback

The Average Accounting Return

The Internal Rate of Return

The Profitability Index

The Practice of Capital Budgeting

Chapter Outline

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8.3

Lecture Tip: A logical prerequisite to the analysis of investment opportunities is the creation of investment opportunities. Unlike the field of investments, where the analyst more or less takes the investment opportunity set as a given, the field of 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 remind students of the importance of creativity in this area, as well as the importance of analytical techniques.

We need to ask ourselves the following questions when evaluating capital budgeting decision rules:

Does the decision rule adjust for the time value of money?

Does the decision rule adjust for risk?

Does the decision rule provide information on whether we are creating value for the firm?

Good Decision Criteria

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8.4

Section 9.1

Economics students will recognize that the practice of capital budgeting defines the firm’s investment opportunity schedule.

The difference between the market value of a project and its cost

How much value is created from undertaking an investment?

The first step is to estimate the expected future cash flows.

The second step is to estimate the required return for projects of this risk level.

The third step is to find the present value of the cash flows and subtract the initial investment.

Net Present Value

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8.5

Section 9.1 (A)

We learn how to estimate the cash flows and the required return in subsequent chapters.

The NPV measures the increase in firm value, which is also the increase in the value of what the shareholders own. Thus, making decisions with the NPV rule facilitates the achievement of our goal in Chapter 1 – making decisions that will maximize shareholder wealth.

Lecture Tip: Although this point may seem obvious, it is often helpful to stress the word “net” in net present value. It is not uncommon for some students to carelessly calculate the PV of a project’s future cash flows and fail to subtract out its cost (after all, this 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.

You are reviewing a new project and have estimated the following cash flows:

Year 0: CF = -165,000

Year 1: CF = 63,120; NI = 13,620

Year 2: CF = 70,800; NI = 3,300

Year 3: CF = 91,080; NI = 29,100

Average Book Value = 72,000

Your required return for assets of this risk level is 12%.

Project Example Information

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8.6

Section 9.1 (B)

This example will be used for each of the decision rules so that the students can compare the different rules and see that conflicts can arise. This illustrates the importance of recognizing which decision rules provide the best information for making decisions that will increase owner wealth.

If the NPV is positive, accept the project.

A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners.

Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal.

NPV – Decision Rule

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8.7

Section 9.1 (B)

Lecture 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.

Lecture Tip: In practice, financial managers are rarely presented with zero NPV projects for at least two reasons. First, in an abstract sense, zero is just another of the infinite number of values the NPV can take; as such, the likelihood of obtaining any particular number is small. Second, and more pragmatically, 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.

Using the formulas:

NPV = -165,000 + 63,120/(1.12) + 70,800/(1.12)2 + 91,080/(1.12)3 = 12,627.41

Using the calculator:

CF0 = -165,000; C01 = 63,120; F01 = 1; C02 = 70,800; F02 = 1; C03 = 91,080; F03 = 1; NPV; I = 12; CPT NPV = 12,627.41

Do we accept or reject the project?

Computing NPV for the Project

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8.8

Section 9.1 (B)

Again, the calculator used for the illustration is the TI BA-II plus. The basic procedure is the same; you start with the year 0 cash flow and then enter the cash flows in order. F01, F02, etc. are used to set the frequency of a cash flow occurrence. Many calculators only require you to use this function if the frequency is something other than 1.

Since we have a positive NPV, we should accept the project.

Does the NPV rule account for the time value of money?

Does the NPV rule account for the risk of the cash flows?

Does the NPV rule provide an indication about the increase in value?

Should we consider the NPV rule for our primary decision rule?

Decision Criteria Test – NPV

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8.9

Section 9.1 (B)

The answer to all of these questions is yes.

The risk of the cash flows is accounted for through the choice of the discount rate.

Lecture Tip: The new tax law contains a provision that allows firms, in some cases, to take bonus depreciation in year one up to 100 percent of the cost of the asset. This will, all else equal, increase the NPV of proposed projects.

Spreadsheets are an excellent way to compute NPVs, especially when you have to compute the cash flows as well.

Using the NPV function

The first component is the required return entered as a decimal.

The second component is the range of cash flows beginning with year 1.

Subtract the initial investment after computing the NPV.

Calculating NPVs with a Spreadsheet

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8.10

Section 9.1 (B)

Click on the Excel icon to go to an embedded Excel worksheet that has the cash flows along with the right and wrong way to compute NPV. Click on the cell with the solution to show the students the difference in the formulas.

How long does it take to get the initial cost back in a nominal sense?

Computation

Estimate the cash flows.

Subtract the future cash flows from the initial cost until the initial investment has been recovered.

Decision Rule – Accept if the payback period is less than some preset limit.

Payback Period

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Section 9.2 (A)

8.11

Assume we will accept the project if it pays back within two years.

Year 1: 165,000 – 63,120 = 101,880 still to recover

Year 2: 101,880 – 70,800 = 31,080 still to recover

Year 3: 31,080 – 91,080 = -60,000 project pays back in year 3

Do we accept or reject the project?

Computing Payback

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8.12

Section 9.2 (A)

The payback period is year 3 if you assume that the cash flows occur at the end of the year, as we do with all of the other decision rules.

If we assume that the cash flows occur evenly throughout the year, then the project pays back in 2.34 years.

Either way, the payback rule would say to reject the project.

Does the payback rule account for the time value of money?

Does the payback rule account for the risk of the cash flows?

Does the payback rule provide an indication about the increase in value?

Should we consider the payback rule for our primary decision rule?

Decision Criteria Test – Payback

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8.13

Section 9.2 (B)

The answer to all of these questions is no.

Lecture Tip: The payback period can be interpreted as a naïve form of discounting if we consider the class of investments with level cash flows over arbitrarily long lives. Since the present value of a perpetuity is the payment divided by the discount rate, a payback period cutoff can be seen to imply a certain discount rate. That is:

cost/annual cash flow = payback period cutoff cost = annual cash flow times payback period cutoff The PV of a perpetuity is: PV = annual cash flow / R. This illustrates the inverse relationship between the payback period cutoff and the discount rate.

Advantages

Easy to understand

Adjusts for uncertainty of later cash flows

Biased toward liquidity

Disadvantages

Ignores the time value of money

Requires an arbitrary cutoff point

Ignores cash flows beyond the cutoff date

Biased against long-term projects, such as research and development, and new projects

Advantages and Disadvantages of Payback

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8.14

Section 9.2 (D)

Teaching the payback rule seems to put one in a delicate situation – as the text indicates, the rule is flawed as an indicator of project desirability. Yet, past surveys suggest that practitioners often use it as a secondary decision measure. How can we explain this apparent discrepancy between theory and practice? 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 mutually exclusive projects are compared. Given two similar projects with different paybacks, the project with the shorter payback is often, but not always, the better project. Similarly, the bias toward liquidity may be justifiable in such industries as healthcare, where technology changes rapidly, requiring quick payback to make machines justifiable, or in international investments where the possibility of government seizure of assets exists.

Compute the present value of each cash flow and then determine how long it takes to pay back on a discounted basis.

Compare to a specified required period.

Decision Rule: Accept the project if it pays back on a discounted basis within the specified time.

Discounted Payback Period

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Section 9.3

8.15

Assume we will accept the project if it pays back on a discounted basis in 2 years.

Compute the PV for each cash flow and determine the payback period using discounted cash flows.

Year 1: 165,000 – 63,120/1.121 = 108,643

Year 2: 108,643 – 70,800/1.122 = 52,202

Year 3: 52,202 – 91,080/1.123 = -12,627 project pays back in year 3

Do we accept or reject the project?

Computing Discounted Payback

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8.16

Section 9.3

No – it doesn’t pay back on a discounted basis within the required 2-year period.

Does the discounted payback rule account for the time value of money?

Does the discounted payback rule account for the risk of the cash flows?

Does the discounted payback rule provide an indication about the increase in value?

Should we consider the discounted payback rule for our primary decision rule?

Decision Criteria Test – Discounted Payback

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8.17

Section 9.3

The answer to the first two questions is yes.

The answer to the third question is no because of the arbitrary cut-off date.

Since the rule does not indicate whether or not we are creating value for the firm, it should not be the primary decision rule.

Advantages

Includes time value of money

Easy to understand

Does not accept negative estimated NPV investments when all future cash flows are positive

Biased towards liquidity

Disadvantages

May reject positive NPV investments

Requires an arbitrary cutoff point

Ignores cash flows beyond the cutoff point

Biased against long-term projects, such as R&D and new products

Advantages and Disadvantages of Discounted Payback

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Section 9.3

8.18

There are many different definitions for average accounting return.

The one used in the book is:

Average net income / average book value

Note that the average book value depends on how the asset is depreciated.

Need to have a target cutoff rate

Decision Rule: Accept the project if the AAR is greater than a preset rate.

Average Accounting Return

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8.19

Section 9.4

The example in the book uses straight line depreciation to a zero salvage; that is why you can take the initial investment and divide by 2. If you use MACRS, you need to compute the BV in each period and take the average in the standard way.

Assume we require an average accounting return of 25%.

Average Net Income:

(13,620 + 3,300 + 29,100) / 3 = 15,340

AAR = 15,340 / 72,000 = .213 = 21.3%

Do we accept or reject the project?

Computing AAR

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8.20

Section 9.4

Students may ask where you came up with the 25%. Point out that 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.

This rule would indicate that we reject the project.

Does the AAR rule account for the time value of money?

Does the AAR rule account for the risk of the cash flows?

Does the AAR rule provide an indication about the increase in value?

Should we consider the AAR rule for our primary decision rule?

Decision Criteria Test – AAR

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8.21

Section 9.4

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. Thus, it is not surprising that most surveys indicate that few large firms employ the payback and/or AAR methods exclusively.

Advantages

Easy to calculate

Needed information will usually be available

Disadvantages

Not a true rate of return; time value of money is ignored

Uses an arbitrary benchmark cutoff rate

Based on accounting net income and book values, not cash flows and market values

Advantages and Disadvantages of AAR

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8.22

Section 9.4

Lecture 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.

This is the most important alternative to NPV.

It is often used in practice and is intuitively appealing.

It is based entirely on the estimated cash flows and is independent of interest rates found elsewhere.

Internal Rate of Return

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8.23

Section 9.5

The IRR rule is very important. Management, and individuals in general, often have a much better feel for percentage returns, and the value that is created, than they do for dollar increases. A dollar increase doesn’t appear to provide as much information if we don’t know what the initial expenditure was. Whether or not the additional information is relevant is another issue.

Definition: IRR is the return that makes the NPV = 0

Decision Rule: Accept the project if the IRR is greater than the required return.

IRR – Definition and Decision Rule

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Section 9.5

8.24

If you do not have a financial calculator, then this becomes a trial and error process.

Calculator

Enter the cash flows as you did with NPV.

Press IRR and then CPT.

IRR = 16.13% > 12% required return

Do we accept or reject the project?

Computing IRR

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8.25

Section 9.5

Many of the financial calculators will compute the IRR as soon as it is pressed; others require that you press compute.

NPV Profile for the Project

IRR = 16.13%

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8.26

Section 9.5

Note that the NPV profile is also a form of sensitivity analysis.

NPV 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14000000000000001 0.16 0.18 0.2 0.22 60000 50760 42121 34031 26446 19324 12627 6323 381 -5227 -10525 -15536 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14000000000000001 0.16 0.18 0.2 0.22 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14000000000000001 0.16 0.18 0.2 0.22 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14000000000000001 0.16 0.18 0.2 0.22

Discount Rate

NPV

Does the IRR rule account for the time value of money?

Does the IRR rule account for the risk of the cash flows?

Does the IRR rule provide an indication about the increase in value?

Should we consider the IRR rule for our primary decision criteria?

Decision Criteria Test - IRR

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8.27

Section 9.5

The answer to all of these questions is yes, although it is not always as 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 accounts for the risk of the cash flows because you compare it to the required return, which is determined by the risk of the project.

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 could consider the IRR rule as our primary decision criteria, but as we will see, it has some problems that the NPV does not have. That is why we end up choosing the NPV as our ultimate decision rule.

Knowing a return is intuitively appealing

It is a simple way to communicate the value of a project to someone who doesn’t know all the estimation details.

If the IRR is high enough, you may not need to estimate a required return, which is often a difficult task.

Advantages of IRR

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8.28

Section 9.5

You should point out, however, that if you get a very large IRR then you should go back and look at your cash flow estimates again. In competitive markets, extremely high IRRs should be rare. Also, since the IRR calculation assumes that you can reinvest future cash flows at the IRR, a high IRR may be unrealistic.

You start with the cash flows the same as you did for the NPV.

You use the IRR function.

You first enter your range of cash flows, beginning with the initial cash flow.

You can enter a guess, but it is not necessary.

The default format is a whole percent – you will normally want to increase the decimal places to at least two.

Calculating IRRs With A Spreadsheet

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8.29

Section 9.5

Click on the Excel icon to go to an embedded spreadsheet so that you can illustrate how to compute IRR on the spreadsheet.

Summary
Net Present Value Accept
Payback Period Reject
Discounted Payback Period Reject
Average Accounting Return Reject
Internal Rate of Return Accept

Summary of Decisions for the Project

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8.30

Section 9.5

So, what should we do?

We have two rules that indicate to accept and three that indicate to reject.

NPV and IRR will generally give us the same decision.

Exceptions:

Nonconventional cash flows – cash flow signs change more than once

Mutually exclusive projects

Initial investments are substantially different (issue of scale).

Timing of cash flows is substantially different.

NPV vs. IRR

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Section 9.5 (A)

8.31

When the cash flows change sign more than once, there is more than one IRR.

When you solve for IRR you are solving for the root of an equation, and when you cross the x-axis more than once, there will be more than one return that solves the equation.

If you have more than one IRR, which one do you use to make your decision?

IRR and Nonconventional Cash Flows

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8.32

Section 9.5 (A)

Lecture Tip: A good introduction to mutually exclusive projects and non-conventional cash flows is to provide examples that students can relate to. An excellent example of mutually exclusive projects is the choice of which college or university to attend. Many 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.

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.

Suppose an investment will cost $90,000 initially and will generate the following cash flows:

Year 1: 132,000

Year 2: 100,000

Year 3: -150,000

The required return is 15%.

Should we accept or reject the project?

Another Example: Nonconventional Cash Flows

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8.33

Section 9.5 (A)

NPV = – 90,000 + 132,000 / 1.15 + 100,000 / (1.15)2 – 150,000 / (1.15)3 = 1,769.54

Calculator: CF0 = -90,000; C01 = 132,000; F01 = 1; C02 = 100,000; F02 = 1; C03 = -150,000; F03 = 1; I = 15; CPT NPV = 1769.54

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.

Another type of nonconventional cash flow involves a “financing” project, where there is a positive cash flow followed by a series of negative cash flows. This is the opposite of an “investing” project. In this case, our decision rule reverses, and we accept a project if the IRR is less than the cost of capital, since we are borrowing at a lower rate.

NPV Profile

IRR = 10.11% and 42.66%

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8.34

Section 9.5 (A)

You should accept the project if the required return is between 10.11% and 42.66%.

NPV 0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55000000000000004 -8000 -3158.41 -52.59 1769.54 2638.89 2800 2435.14 1681.15 641.4 -605.6 -2000 -3496.02 0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55000000000000004 0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55000000000000004 0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55000000000000004

Discount Rate

NPV

The NPV is positive at a required return of 15%, so you should Accept.

If you use the financial calculator, you would get an IRR of 10.11% which would tell you to Reject.

You need to recognize that there are non-conventional cash flows and look at the NPV profile.

Summary of Decision Rules

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Section 9.5 (A)

8.35

Mutually exclusive projects

If you choose one, you can’t choose the other.

Example: You can choose to attend graduate school at either Harvard or Stanford, but not both.

Intuitively, you would use the following decision rules:

NPV – choose the project with the higher NPV

IRR – choose the project with the higher IRR

IRR and Mutually Exclusive Projects

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Section 9.5 (A)

8.36

Period Project A Project B
0 -500 -400
1 325 325
2 325 200
IRR 19.43% 22.17%
NPV 64.05 60.74

Example With Mutually Exclusive Projects

The required return for both projects is 10%.

Which project should you accept and why?

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8.37

Section 9.5 (A)

As long as we do not have limited capital, we should choose project A. Students will often argue that you should choose B because then you can invest the additional $100 in another good project, say C. The point is that if we do not have limited capital, we can invest in A and C and still be better off.

If we have limited capital, then we will need to examine what combinations of projects with A provide the highest NPV and what combinations of projects with B provide the highest NPV. You then go with the set that will create the most value. If you have limited capital and a large number of mutually exclusive projects, then you will want to set up a computer program to determine the best combination of projects within the budget constraints. The important point is that we DO NOT use IRR to choose between projects regardless of whether or not we have limited capital.

Embedded in the analysis, we may want to calculate the NPV of the incremental project, i.e., the additional CF represented by project A above project B. The IRR of this CF stream is the crossover point and provides the return on the incremental investment.

NPV Profiles

IRR for A = 19.43%

IRR for B = 22.17%

Crossover Point = 11.8%

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8.38

Section 9.5 (A)

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%, then you should choose B.

A 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14000000000000001 0.16 0.18 0.2 0.22 0.24 150 131.01 112.98 95.85 79.56 64.05 49.27 35.159999999999997 21.7 8.83 -3.47 -15.25 -26.53 B 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14000000000000001 0.16 0.18 0.2 0.22 0.24 125 110.86 97.41 84.6 72.39 60.74 49.62 38.979999999999997 28.8 19.059999999999999 9.7200000000000006 0.77 -7.83

Discount Rate

NPV

NPV directly measures the increase in value to the firm.

Whenever there is a conflict between NPV and another decision rule, you should always use NPV.

IRR is unreliable in the following situations:

Nonconventional cash flows

Mutually exclusive projects

Conflicts Between NPV and IRR

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9-‹#›

Section 9.5 (A)

8.39

Calculate the net present value of all cash outflows using the borrowing rate.

Calculate the net future value of all cash inflows using the investing rate.

Find the rate of return that equates these values.

Benefits: single answer and specific rates for borrowing and reinvestment

Modified IRR

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8.40

Section 9.5 (C)

Measures the benefit per unit cost, based on the time value of money.

A profitability index of 1.1 implies that for every $1 of investment, we create an additional $0.10 in value.

This measure can be very useful in situations in which we have limited capital.

Profitability Index

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9-‹#›

Section 9.6

8.41

Advantages

Closely related to NPV, generally leading to identical decisions

Easy to understand and communicate

May be useful when available investment funds are limited

Disadvantages

May lead to incorrect decisions in comparisons of mutually exclusive investments

Advantages and Disadvantages of Profitability Index

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9-‹#›

Section 9.6

8.42

We should consider several investment criteria when making decisions.

NPV and IRR are the most commonly used primary investment criteria.

Payback is a commonly used secondary investment criteria.

Capital Budgeting In Practice

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8.43

Section 9.7

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 criterion may be because short paybacks allow firms to have funds sooner to invest in other projects without going to the capital markets.

Why are smaller firms more likely to use payback as a primary decision criterion?

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;

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. 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.

Net present value

Difference between market value and cost

Take the project if the NPV is positive.

Has no serious problems

Preferred decision criterion

Internal rate of return

Discount rate that makes NPV = 0

Take the project if the IRR is greater than the required return.

Same decision as NPV with conventional cash flows

IRR is unreliable with nonconventional cash flows or mutually exclusive projects.

Profitability Index

Benefit-cost ratio

Take investment if PI > 1

Cannot be used to rank mutually exclusive projects

May be used to rank projects in the presence of capital rationing

Summary – DCF Criteria

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8.44

Section 9.8

For IRR, we assume a conventional investment project. For a financing project, we accept if the IRR is less than the “required” rate.

Payback period

Length of time until initial investment is recovered

Take the project if it pays back within some specified period.

Doesn’t account for time value of money, and there is an arbitrary cutoff period

Discounted payback period

Length of time until initial investment is recovered on a discounted basis

Take the project if it pays back in some specified period.

There is an arbitrary cutoff period.

Summary – Payback Criteria

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9-‹#›

Section 9.8

8.45

Average Accounting Return

Measure of accounting profit relative to book value

Similar to return on assets measure

Take the investment if the AAR exceeds some specified return level.

Serious problems and should not be used

Summary – Accounting Criterion

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9-‹#›

Section 9.8

8.46

Consider an investment that costs $100,000 and has a cash inflow of $25,000 every year for 5 years. The required return is 9%, and required payback is 4 years.

What is the payback period?

What is the discounted payback period?

What is the NPV?

What is the IRR?

Should we accept the project?

What decision rule should be the primary decision method?

When is the IRR rule unreliable?

Quick Quiz

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9-‹#›

8.47

Section 9.8

Payback period = 4 years

The project does not pay back on a discounted basis.

NPV = -2,758.72

IRR = 7.93%

An ABC poll in the spring of 2004 found that one-third of students age 12 – 17 admitted to cheating and the percentage increased as the students got older and felt more grade pressure. If a book entitled “How to Cheat: A User’s Guide” would generate a positive NPV, would it be proper for a publishing company to offer the new book?

Should a firm exceed the minimum legal limits of government imposed environmental regulations and be responsible for the environment, even if this responsibility leads to a wealth reduction for the firm? Is environmental damage merely a cost of doing business?

Should municipalities offer monetary incentives to induce firms to relocate to their areas?

Ethics Issues

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8.48

Case 1:

Assume the publishing company has a cost of capital of 8% and estimates it could sell 10,000 volumes by the end of year one 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 one net would be $60,000. From a capital budgeting standpoint, is it financially wise to buy the publication rights? What is the NPV of this investment? The year 0 cash flow is -20,000, year 1 is 60,000, and years 2 and 3 are 30,000 each. Given a cost of capital of 8%, the NPV is just over $85,000. It looks good, right? Now ask the class if the publishing of this book would encourage cheating and if the publishing company would want to be associated with this text and its message. Some students may feel that one should accept these profitable investment opportunities, while others might prefer that the publication of this profitable text be rejected due to the behavior it could encourage. Although the example is simplistic, this type of issue is not uncommon and serves as a starting point for a discussion of the value of “reputational capital.”

Case 2:

Assume that to comply with the Air Quality Control Act of 1989, a company must install three smoke stack scrubber units to its ventilation stacks at an installed cost of $355,000 per unit. An estimated $100,000 per unit in fines could be saved each year over the five-year life of the ventilation stacks. The cost of capital is 14% for the firm. The analysis of the investment results in a NPV of -$35,076. Could investment in a healthier working environment result in lower long-term costs in the form of lower future health costs? If so, might this decision result in an increase in shareholder wealth? Notice that if the answer to this second question is yes, it suggests that our original analysis omitted some side benefits to the project.

An investment project has the following cash flows: CF0 = -1,000,000; C01 – C08 = 200,000 each

If the required rate of return is 12%, what decision should be made using NPV?

How would the IRR decision rule be used for this project, and what decision would be reached?

How are the above two decisions related?

Comprehensive Problem

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8.49

Section 9.8

NPV = -$6,472; reject the project since it would lower the value of the firm.

IRR = 11.81%, so reject the project since it would tie up investable funds in a project that will provide insufficient return.

The NPV and IRR decision rules will provide the same decision for all independent projects with conventional/normal cash flow patterns. If a project adds value to the firm (i.e., has a positive NPV), then it must be expected to provide a return above that which is required. Both of those justifications are good for shareholders.

End of Chapter

CHAPTER 9

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9-‹#›

Sheet1

Year 0 1 2 3
Cash Flows -165000 63120 70800 91080
Required Return 0.12
NPV - WRONG $11,274.48
NPV - RIGHT $12,627.41

Sheet2

Sheet3

Sheet1

Year 0 1 2 3
Cash Flows -165000 63120 70800 91080
Required Return 0.12
NPV - WRONG $11,274.48
NPV - RIGHT $12,627.41
IRR 16% 16.13%
Default Format

Sheet2

Sheet3