Net Present Value and

1
Chapter 8

• Net Present Value and
• Other Investment Criteria
• (Capital Budgeting)

2
The Capital Budgeting Issue

• The Capital Budgeting Issue
• One of the most important issues in Corporate
  Finance
• Launch a new project
• Enter a new market
• Determines the nature of the firms operations
  and products for years to come
• Fixed asset investments are generally long-lived
  and not easily reversed once made
• Fixed assets define the business of the firm

3
Capital Budgeting

• Techniques used to analyze potential business
  ventures to decide which are worth undertaking
• Net Present Value (NPV)
• Preferred Approach
• Internal Rate of Return (IRR)
• Payback Period
• Average Accounting Return (AAR)
• Profitability Index (PI)

4
Capital Budgeting

• Good Capital Budgeting criterion must tell us two
  things
• 1. Is a particular project a good investment?
• 2. If we have more than one good project, but we
  can only take one of them, which one should we
  take?
• Well see that only the NPV criterion can
  always provide the correct answer to both
  questions

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Net Present Value (NPV)
6
Net Present ValueThe Basic Idea

• The goal of the financial manager is to create
  value for the stockholders
• Potential investments must be examined
• A widely used procedure for doing this is the
  Net Present Value approach

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Net Present ValueThe Basic Idea

• We create value by identifying an investment
  worth more in the marketplace than it costs us to
  acquire
• Capital Budgeting is about trying to determine
  whether a proposed investment or project will be
  worth more than it costs once its in place

8
Net Present ValueThe Basic Idea

• The Net Present Value (NPV) is the difference
  between an investments market value and its
  costs
• A way of assessing the profitability of a
  proposed investment
• The preferred approach in principle and typically
  in practice
• Given the goal of creating value for the
  stockholders
• Capital budgeting is a search for investments
  with positive net present values

9
Net Present ValueEstimating Net Present Value

• Estimate the cost of the project or investment
• Estimate the future cash flows
• Discount those cash flows to estimate the present
  value of the future cash flows
• NPV The Present Value of the Future Cash Flows
  less the initial cost of the project or
  investment.

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Net Present ValueNet Present Value Rule

• If NPV is positive
• Accept the project or investment
• Increases the total value of the stock
• The greater the NPV, the greater the increase in
  the value of the stock
• If NPV is negative
• Reject the project or investment
• Decreases the total value of the stock
• If NPV is zero
• Indifferent between taking or not taking the
  project or investment
• Break-even proposition
• Value is neither created nor destroyed

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Net Present Value Example 8.1, Page 211

• Suppose we are asked to decide whether or not a
  new consumer product should be launched.
• Based on projected sales and costs, we expect
  that the cash flows over the five-year life of
  the project will be 2,000 in the first two
  years, 4,000 in the nest two, and 5,000 in the
  last year.
• It will cost about 10,000 to begin production.
  
• We use a 10 discount rate to evaluate new
  products.
• What should we do here?

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Net Present ValueExample 8.1, Page 211

• hp 12C Keystrokes Inst Manual Pg 70, 71, 72
• Use Shift Keys g blue f yellow
• CHS g CF0 -10,000 Cost to begin project
• g CFj 2,000 1st Yr Cash Flow Amt
• g CFj 2,000 2nd Yr Cash Flow Amt
• g CFj 4,000 3rd Yr Cash Flow
  Amt
• g CFj 4,000 4th Yr Cash Flow
  Amt
• g CFj 5,000 5th Yr Cash Flow
  Amt
• i 10
• f NPV 2,313
• Based on the NPV Rule since NPV is positive, we
  should take on, or Accept the project.
• Note When NPV is negative ? Reject the
  project.

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Net Present ValueExample Not in Book

• You are going to choose between two investments.
  Both cost 80,000, but investment A pays 35,000
  a year for 4 years while investment B pays
  30,000 a year for 5 years. If your required
  return is 13, which should you choose?
• Answer on following slide

14
Net Present ValueExample Not in Book

• Answer to previous slide
• NPV for Investment A 24,106.50
• NPV for Investment B 25,516.94
• Choose Investment B because it has a higher NPV.

15
Net Present ValueExample Problem 10.b. Page
233

• Darby Davis, LLC, has identified the following
  two mutually exclusive projects. If the required
  return is 11 , what is the NPV for each of these
  projects? Which project will you choose if you
  apply the NPV decision rule?
• Year Cash Flow (A) Cash Flow (B)
• 0 -17,000 -17,000
• 1 8,000 2,000
• 2 7,000 5,000
• 3 5,000 9,000
• 4 3,000 9,500
• NPV for Project (A) 1,520.71
• NPV for Project (B) 1,698.58
• Choose Project B ? it has the highest NPV

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Internal Rate of Return(IRR)
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The Internal Rate of Return

• Internal Rate of Return (IRR) is simply the
  discount rate that makes the NPV of an investment
  zero.
• Put another way Its the rate of return at
  which the discounted future cash flows the
  initial cash outlay
• Internal rate only depends on the cash flows
  of a particular investment, not on rates offered
  elsewhere
• Closely related to NPV
• The most important alternative to NPV

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The Internal Rate of Return

• IRR Rule
• Accept if the IRR exceeds the required rate of
  return
• Reject if the IRR is below (less than) the
  required rate of return
• For Example if your organization decides that
  it only wants to take on those projects with a
  return of 10 (10 is the required return), then
  you would
• Accept all projects with an IRR greater than
  10
• Reject all projects with an IRR less than 10.
  

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The Internal Rate of Return Example 8.3, Page 220

• hp 12C Keystrokes Inst Manual Pg 70, 71, 72
• Use Shift Keys g blue f yellow
• CHS g CF0 -435.44 Up-Front Cost
• g CFj 100 1st Yr Cash Flow
• g CFj 200 2nd Yr Cash Flow
• g CFj 300 3rd Yr Cash Flow
• f IRR 15
• Conclusion
• Since IRR 15 and the required rate of return
  is 18
• Reject the IRR is below the required rate of
  return

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The Internal Rate of ReturnProblem 8, Page 233

• hp 12C Keystrokes Instructions Pg 70, 71, 72
• Use Shift Keys g blue f yellow
• g CF0 -2,400 Up-Front Cost
• g CFj 640 1st Yr Cash Flow Amount
• g CFj 800 2nd Yr Cash Flow Amount
• g CFj 2,000 3rd Yr Cash Flow Amount
• f IRR 16.58

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The Internal Rate of ReturnProblems with IRR

• Non-conventional Cash Flows (Page 221)
• Multiple Answers (rates of return) the
  possibility that more than one discount rate
  makes the NPV of an investment zero
• When cash flows arent conventional, strange
  things start to happen with IRR
• Some computers/calculators just report the first
  IRR
• Others report the smallest IRR
• What is the return?....becomes difficult to
  answer
• Read Page 221 and 222

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The Internal Rate of ReturnProblems with IRR

• Mutually Exclusive Investments A situation
  where taking one investment prevents the taking
  of another (example own a corner lot can
  build a gas station or apartment bldg, but not
  both)
• The IRR can be misleading and may lead to
  incorrect decisions
• The project with the highest IRR may not produce
  the highest NPV due to
• timing of the cash flows
• and the required return rate
• Therefore, with Mutually Exclusive Projects, do
  not rank them based on their returns (IRR)
• When comparing investments to determine which is
  best ALWAYS USE NPV
• Which one is best? the one with the largest NPV

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The Internal Rate of ReturnRedeeming Qualities
of IRR

• IRR can be calculated w/o knowing the appropriate
  discount rate, NPV cant.
• Easy to understand and communicate.

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The Payback Rule
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The Payback RuleDefining the Rule

• Payback Period is the amount of time required
  for an investment to generate cash flows to
  recover its initial cost.
• How many years do you have to wait until the
  accumulated cash flows from an investment equal
  or exceed the cost of the investment?

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The Payback RuleDefining the Rule

• Payback Rule an investment is acceptable if its
  calculated payback period is less than some
  pre-specified number of years.
• Accept if the payback period is less than or
  equal to the specified number of years
• Reject if the payback period is greater than
  the specified number of years
• Example 8.2, Page 213
• Calculating Payback

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The Payback RuleAnalyzing the Rule

• Severe shortcomings as compared to NPV
• No discounting the time value of money is
  ignored
• Projects may be accepted that are worth less than
  they cost
• Considers no risk differences
• Calculated the same way for both very risky and
  very safe projects
• Problems with determining the exact cut-off
  period
• Cash flows after the payback period are ignored
• Bias toward short term investments
• Profitable long term investments may be rejected

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The Payback RuleRedeeming Qualities of the Rule

• Useful for relatively minor decisions
• In general an investment that pays back rapidly
  and has benefits extending beyond the cutoff
  period probably has a positive NPV

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The Payback RuleSummary of the Rule

• A kind of break-even measure
• In an accounting sense
• Not an economic sense
• because time value is ignored
• It determines how long it takes to recover the
  initial investment, not the impact an investment
  will have on the value of the stock
• Due to its simplicity, its a useful simple rule
  of thumb - as a screen for dealing with many
  minor investment decisions

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Average Accounting Return
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The Average Accounting Return

• Average Accounting Return (AAR) An investments
  average net income divided by its average book
  value
• Average net income
• Average book value
• AAR Rule
• Accept the project if its average accounting
  return exceeds a target average account return
• Reject Otherwise
• Example in book Page 216 and 217
• Excel Spreadsheet

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The Average Accounting Return

• The AAR Rule has many problems
• AAR is not a true rate of return. It ignores time
  value.
• Its a ratio of two accounting numbers and not
  comparable to returns offered in the financial
  markets.
• Based on accounting net income and book values,
  instead of cash flows and market values
• Doesnt indicate the effect on share price from
  taking the investment
• However, it is easy to calculate and needed info
  is usually available

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The Profitability Index
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The Profitability Index

• Profitability Index (PI) Present Value of an
  investments future cash flows divided by its
  initial cost. Also called the Benefit-Cost Ratio
• PI PV / Initial Cost
• If a project costs 200 and the present value of
  its future cash flows is 220
• PI PV / Initial Cost
• PI 220 / 200 1.10
• For every dollar invested .10 in NPV results
• PI measures the value created per dollar invested
• Often proposed as a measure of performance for
  government or other not-for-profit investments
• When capital is scarce, it may make sense to
  allocate it to those projects with the highest PIs

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The Profitability Index

• PI gt 1 for projects with a positive NPV
• PI lt 1 for projects with a negative NPV
• Remember Positive NPV means that the PV of the
  future cash flows is greater than the initial
  investment
• PI may lead to incorrect decisions when
  considering mutually exclusive projects
• The PI Index cannot be used to rank mutually
  exclusive projects
• Always go with the project with the highest NPV!

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The Practice ofCapital Budgeting

• While NPV is considered superior, its calculation
  involves only estimated future cash flows.
• The result can be very soft.
• For this reason firms typically use multiple
  criteria for evaluating a proposal

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Chapter 8Suggested Homework

• Know Chapter theories, concepts and definitions
• Suggested NPV Homework problems
• Problem 8.1 Page 229
• Problems 6, 9, and 10.b. Page 233
• Problem 16.b c Page 235
• Problem 19.b c and 22.b c Page 236
• Problem 23.b and c Page 237

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Chapter 8Suggested Homework

• Suggested IRR Homework problems
• Problem 5 - Page 232-3
• Problem 8, 10a - Page 233
• Problem 16a - Page 235
• Problem 23a - Page 236-7
• Problem 25a - Page 237

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Chapter 8Suggested Homework

• Suggested Payback Rule Homework problems
• Problems 1 - Page 232
• Suggested Average Accounting Return Homework
  problems
• Problem 4, Page 232
• Suggested Profitability Index Homework
• Problem 13, Page 234