Evaluating Investment Projects

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Chapter 8

• Evaluating Investment Projects

Shapiro and Balbirer Modern Corporate Finance
A Multidisciplinary Approach to Value
Creation Graphics by Peeradej Supmonchai
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Learning Objectives

• Describe capital budgeting as a management
  process and its integration into a companys
  strategic plans.
• List ways in which projects can be categorized.
• Calculate a projects NPV and IRR and use these
  measures to make investment decisions.
• Explain the similarities and differences between
  the net present value (NPV) and internal rate of
  return (IRR) method, and discuss why NPV is the
  preferred criterion for making investment
  decisions.

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Learning Objectives (Cont.)

• Indicate the problems in using non-discounted
  cash flow techniques such as payback and
  accounting rate of return to make capital
  budgeting decisions.
• Describe the use of capital budgeting techniques
  in practice and explain why managers use other
  methods than NPV to make investment decisions.
• Indicate how the equivalent annual cost method
  can be used to evaluate projects with different
  economic lives.

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Capital Budgeting as a Management Process

• Development of a strategic plan
• Generation of potential investment opportunities
• Estimation of a projects cash flows
• Acceptance or rejection
• Project post-audit

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Classification of Investment Projects

• Size
• Type of Benefit Expected
• By Degree of Dependence

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Classification by Benefit Type

• Cost Reduction
• Expansion Project
• New Product Introduction
• Mandated Projects

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Classification by Degree of Dependence

• Independent Projects
• Mutually Exclusive Projects
• Contingent Projects

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Net Present Value (NPV) Decision Criterion

• Calculate the present value of the expected cash
  flows from an investment using an appropriate
  discount rate. Subtract from this the present
  value of the initial net cash outlay for the
  project to get the NPV. If the NPV is positive,
  accept the project. If it is negative, reject it.
  If two projects are mutually exclusive, choose
  the one with the highest NPV.

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Mathematical Representation of NPV

• Where
• St the cash flow in time period t
• I0 the initial investment outlay in time
  zero
• k the required rate of return on the
  project
• N the projects economic life in periods

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Calculating A Projects IRR-An Example

• Quickie Enterprises is considering the
  construction of a microprocessor plant costing
  400 million. Cash flows will increase by 10
  million a year from 100 million in the first
  year to 140 million in five years. At the end
  of 5 years, the plant will be obsolete and have
  no value. Whats the plants NPV if Quickies
  required rate of return is 12 ?

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Calculating A Projects NPV- An Example

• Quickie Enterprises Microprocessor Plant
• Cash Flows in million
• Year Cash Flow PVIF_at_12 Present Value
• 0 -400 1.0000 -400.00
• 1 100 0.8929 89.29
• 2 110 0.7972 87.69
• 3 120 0.7118 85.41
• 4 130 0.6355 82.62
• 5 140 0.5674 79.44
• NPV 24.45

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Internal Rate of Return (IRR) Decision Criterion

• The IRR is the discount (or interest) rate that
  equates the present value of the cash flows with
  the initial investment. If a projects IRR
  exceeds the required rate of return accept it
  otherwise reject it. If two projects are mutually
  exclusive, choose the investment with the highest
  IRR.

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Mathematical Representation of IRR

• Where
• St the cash flow in time period t
• I0 the initial investment outlay in time
  zero
• N the projects economic life in periods

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Calculating A Projects IRR- An Example

• Quickie Enterprises Microprocessor Plant
• Cash Flows in million
• 100 110 120
  130 140
• 400
• (1IRR) (1IRR)2 (1IRR )3 (1IRR )4
  (1IRR )5
• IRR 14.30

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Similarities between NPV and IRR

• Both are DCF techniques that focus on the amount
  and timing of a projects cash flows.
• Both can accommodate differences in risk by
  adjusting the projects required rate of return.
• Both give the same accept-reject decision for
  independent projects.

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Differences between NPV and IRR

• NPV is an absolute measure of project worth IRR
  measures the return per dollar invested.
• NPV assumes the cash flows are reinvested at the
  required rate of return IRR assumes the cash
  flows are reinvested at the IRR.
• The NPV is unique for a given required rate of
  return with an unconventional cash flow pattern,
  there may be multiple IRRs.

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NPV Profile

• The NPV profile is the relationship between the
  NPV of a project and the discount rate used to
  calculate that NPV. Since the IRR is the discount
  rate that makes a projects NPV zero, the NPV
  profile also identifies a projects IRR.

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Graphical Illustration of the NPV Profile
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Payback Period

• Length of time it take a projects cash flows to
  recover its initial investment.
• Projects whose paybacks are shorter than some
  maximum cutoff period are accepted those with
  longer paybacks are rejected.
• Under the payback method, projects with shorter
  payback periods are preferred to longer ones.

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Limitations of the Payback Method

• Ignores the time value of money.
• Does not consider cash flows beyond the payback
  period.
• No connection between the maximum acceptable
  payback period and shareholder required rates of
  return.

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Accounting Rate of Return (ARR)

• The accounting rate of return (ARR) is the ratio
  of the average after-tax profits to the average
  book value of the investment.

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Limitations of the ARR

• Ignores the time value of money
• Based on accounting profits, not cash flow
• Difficult to establish target rates of return

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Capital Budgeting in Practice

• Most large firms use either IRR and/or NPV for
  making decisions
• IRR appears to be more popular than NPV
• Payback is used heavily as a secondary method