Chapter Six Some Alternative Investment Rules

1
Chapter Six - Some Alternative Investment Rules

• Why use Net Present Value?
• Ex Suppose Alpha Corp. is considering a new
  project
• Initial expenditure 500,000
• Cash flows of 200,000 a year forever
• Discount rate 10
• Should the company accept the project?
• NPV ???
• What does a positive NPV mean?

2
Value of the firm and NPV

• By choosing the project, the firms value will
  increase by 1,500,000
• NPV measures change in value over and above all
  costs
• Hence positive NPV project benefit stockholders

3
Alternative 1 - Payback rule Choose the project
with the shortest payback period

• Payback period
• EX(p135) Consider a project with the following
  cash flows
• Time 0 -50,000
• Time 1 30,000
• Time 2 20,000
• Time 3 10,000
• Payback period 2 years

4
Problems with payback

• EX(p136) Consider the following projects
• A B C
• Time 0 -100,000 -100,000 -100,000
• Time 1 20,000 50,000 50,000
• Time 2 30,000 30,000 30,000
• Time 3 50,000 20,000 20,000
• Time 4 60,000 60,000 600,000
• The payback rule All projects are equal

5

• Are they all really equally good projects?
• ???

6
Discounted Payback

• The payback period is computed taking into
  account the discounted cash flows
• Ex If the discount rate is 10, the payback for
  A would be 3 years and about 4 months
• Problem Payments after payback period are ignored

7
Alternative 2 - Average Accounting Return(AAR)

• AAR Average net income
• Average investment
• Accept the project if the AAR exceeds target
  return for the firm

8
Alternative 3 - Internal Rate of Return IRR

• IRR is the rate that equates the present value of
  cash outflows to the present value of cash
  inflows from the project
• Ex (p141) Consider the following project
• Time 0 -100
• Time 1 110
• To solve for IRR, set 100 110/(1IRR)
• -100 110 / (1IRR) 0
• IRR 10
• Rule Accept the project if IRR gt Discount rate

9

• Example Joes Bowling Alley is considering
  whether to relacquer the lanes which will
  generate additional business. The projects cash
  flows are as follows
• Year Cash flows
• 0 -9,000
• 1 4,000
• 2 5,000
• 3 3,000
• What is the IRR for the relacquering project? If
  the yields of riskless zero-coupon bonds maturing
  in years 1,2 and 3 are 8,5 and 6 respectively,
  should the project be accepted?

10
Problems with IRR

• Investing or financing
• Ex (p144) Cash flows
• Time 0 Time1
• 100 -130
• IRR 30
• Accept if the discount rate lt 30
• Assume that the discount rate is 10
• IRR Rule Accept NPV -18.18
• With a discount rate lt 30, NPV of this project
  is negative and vice versa

11
Multiple rates of return

• Could have projects with multiple IRRs
• Which is the right IRR?
• Ex (p145) Cash flows from a project
• Time 0 -100
• Time 1 230
• Time 2 -132
• IRR 10 or 20
• If the discount rate is 15, what does the IRR
  rule say?

12
The Scale problem

• Ex (p148) Two projects (equal risk)
• 1 2
• Time 0 -10 million -25 million
• Time 1 40 million 65 million
• IRR of 1 ??
• IRR of 2 ??
• NPV of 1 _at_ 25 ??
• NPV of 2 _at_ 25 ??

13
Timing problem

• Ex (p149) Consider the following projects
• A B
• Time 0 -10,000 -10,000
• Time 1 10,000 1,000
• Time 2 1,000 1,000
• Time 3 1,000 12,000
• IRR 16.04 12.94
• NPV _at_ 0 2,000 4,000
• NPV _at_ 10 669 751
• NPV _at_ 15 109 -484

14

• Profitability Index
  (PI)
• gt PI PV of cash flows after initial
  investment
• Initial Investment
• gt Ex (p152) Consider the following projects
• A
  B
• Time 0 -20
  -10
• Time 1 70
  15
• Time 2 10
  40
• PI _at_ 12 17.47/20 3.53
  45.38/10 4.53
• Accept if PI gt 1 - Consistent with positive
  NPV

15

• Questions from text
• 6.2
• 6.7 - 6.14