T9.1 Chapter Outline

Capital Budgeting / Investment AppraisalNet Present Value and Other Investment CriteriaChapter Organization9.1Net Present Value9.2The Payback Rule9.3The Average Accounting Return9.4The Internal Rate of Return9.5The Profitability Index9.6The Practice of Capital Budgeting9.7Summary and ConclusionsEvaluation TechniquesM ZAHID KHANFinancial Management & PolicyIntroduction / Capital BudgetingCapital budgeting is a long-term economics decision making. Each potential project's value should be estimated using a discounted cash flow (DCF) valuation, to find its net present value (NPV). This valuation requires estimating the size and timing of all the incremental cash flows from the project. The NPV is greatly affected by the discount rate, so selecting the proper ratesometimes called the hurdle rateis critical to making the right decision.

T9.1 Evaluation TechniqueM ZAHID KHANIntroduction / Capital Budgeting The hurdle rate is the Minimum acceptable rate of return on an investment. This should reflect the riskiness of the investment, typically measured by the volatility of cash flows, and must take into account the financing mix. Managers may use models such as the CAPM to estimate a discount rate appropriate for each particular project, and use the weighted average cost of capital (WACC) to reflect the financing mix selected. A common practice in choosing a discount rate for a project is to apply a WACC that applies to the entire firm, but a higher discount rate may be more appropriate when a project's risk is higher than the risk of the firm as a whole

T9.1 Evaluation TechniqueM ZAHID KHANIntroductionThe financial manager makes decisions regarding long-lived assets in the process referred to as capital budgeting. The capital budgeting decisions for a project requires analysis of:its future cash flows, the degree of uncertainty associated with these future cash flows, and the value of these future cash flows considering their uncertainty. T9.1 Evaluation TechniqueM ZAHID KHANConcept behind uncertaintyThe more uncertain a future cash flow, the less it is worth today. The degree of uncertainty, or risk, is reflected in a project's cost of capital. The cost of capital is what the firm must pay for the funds to finance its investment. The cost of capital may be an explicit cost (for example, the interest paid on debt) or an implicit cost (for example, the expected price appreciation of its shares of common stock).we focus on evaluating the future cash flows. Given estimates of incremental cash flows for a project and given a cost of capital that reflects the project's risk, we look at alternative techniques that are used to select projects.T9.1 Evaluation TechniqueM ZAHID KHANConcept behind uncertaintyFor now all we need to understand about a project's risk is that we can incorporate risk in either of two ways: (1) we can discount future cash flows using a higher discount rate, the greater the cash flow's risk, or (2) we can require a higher annual return on a project, the greater the risk of its cash flows.

T9.1 Evaluation TechniqueM ZAHID KHANEvaluation TechniquesWe look at six techniques that are commonly used by firms to evaluating investments in long-term assets:Payback period, Discounted payback period, Net present value, Profitability index, Internal rate of return, and Modified internal rate of return.We are interested in how well each technique discriminates among the different projects, steering us toward the projects that maximize owners' wealth.

T9.1 Evaluation TechniqueM ZAHID KHANAn evaluation technique should:Consider all the future incremental cash flows from the project; Consider the time value of money; Consider the uncertainty associated with future cash flows, and Have an objective criteria by which to select a project. Projects selected using a technique that satisfies all three criteria will, under most general conditions, maximize owners' wealth.

T9.1 Evaluation TechniqueM ZAHID KHANPayback PeriodThe payback period for a project is the time from the initial cash outflow to invest in it until the time when its cash inflows add up to the initial cash outflow. In other words, how long it takes to get your money back. The payback period is also referred to as the payoff period or the capital recovery period. If you invest $10,000 today and are promised $5,000 one year from today and $5,000 two years from today, the payback period is two years -- it takes two years to get your $10,000 investment back.

T9.1 Evaluation TechniqueM ZAHID KHANInitial outlay -$1,000 YearCash flow 1$200 2400 3600 Accumulated YearCash flow 1$200 2600 31,200Payback period = 2 2/3 yearsT9.4 Payback Rule IllustratedPayback Period Decision Rule:A shorter payback period is better than a longer payback period. Yet there is no clear-cut rule for how short is better. In addition to having no well-defined decision criteria, payback period analysis favors investments with "front-loaded" cash flows: an investment looks better in terms of the payback period the sooner its cash flows are received no matter what its later cash flows look like!

T9.1 Evaluation TechniqueM ZAHID KHANPayback Period Decision RulePayback should only be used as a coarse initial screen of investment projects. But it can be a useful indicator of some things. Since a dollar of cash flow in the early years is worth more than a dollar of cash flow in later years, the payback period method provides a simple, yet crude measure of the value of the investment.

T9.1 Evaluation TechniqueM ZAHID KHANPayback Period Decision RuleThe payback period also offers some indication on the risk of the investment. In industries where equipment becomes obsolete rapidly or where there are very competitive conditions, investments with earlier payback are more valuable. That's because cash flows farther into the future are more uncertain and therefore have lower present value. In the personal computer industry, for example, the fierce competition and rapidly changing technology requires investment in projects that have a payback of less than one year since there is no expectation of project benefits beyond one year.

T9.1 Evaluation TechniqueM ZAHID KHANPayback Period Decision RuleFurther, the payback period gives us a rough measure of the liquidity of the investment -- how soon we get cash flows from our investment. However, because the payback method doesn't tell us the particular payback period that maximizes wealth, we cannot use it as the primary screening device for investment in long-lived assetsT9.1 Evaluation TechniqueM ZAHID KHANDiscounted Payback PeriodThe discounted payback period is the time needed to pay back the original investment in terms of discounted future cash flows.Each cash flow is discounted back to the beginning of the investment at a rate that reflects both the time value of money and the uncertainty of the future cash flows. This rate is the cost of capital -- the return required by the suppliers of capital (creditors and owners) to compensate them for time value of money and the risk associated with the investment. The more uncertain the future cash flows, the greater the cost of capital.

T9.1 Evaluation TechniqueM ZAHID KHANThe Cost of Capital, The Required Rate of Return, and the Discount Rate:We discount an uncertain future cash flow to the present at some rate that reflects the degree of uncertainty associated with this future cash flow. The more uncertain, the less the cash flow is worth today -- this means that a higher discount rate is used to translate it into a value today.This discount rate is a rate that reflects the opportunity cost of funds. In the case of a corporation, we consider the opportunity cost of funds for the suppliers of capital (the creditors and owners). We refer to this opportunity cost as the cost of capital.

T9.1 Evaluation TechniqueM ZAHID KHANThe Cost of Capital, The Required Rate of Return, and the Discount Rate:The cost of capital comprises the required rate of return (RRR) (that is, the return suppliers of capital demand on their investment) and the cost of raising new capital if the firm cannot generate the needed capital internally (that is, from retaining earnings). The cost of capital and the required rate of return are the same concept but from different perspective. Therefore, we will use the terms interchangeably in our study of capital budgeting.

T9.1 Evaluation TechniqueM ZAHID KHANInitial outlay -$1,000R = 10% PV of Year Cash flow Cash flow 1$ 200$ 182 2400331 3700526 4300205 Accumulated Year discounted cash flow 1$ 182 2513 31,039 41,244Discounted payback period is just under 3 years T9.5 Discounted Payback Illustrated Cash Flow Accumulated Cash Flow Year Undiscounted Discounted Undiscounted Discounted 1$100$89$100$89 210079200168 310070300238 410062400300 510055500355T9.6 Ordinary and Discounted Payback (Table 9.3)Discounted Payback Decision Rule:

It appears that the shorter the payback period, the better, whether using discounted or non-discounted cash flows. But how short is better? We don't know. All we know is that an investment "breaks-even" in terms of discounted cash flows at the discounted payback period -- the point in time when the accumulated discounted cash flows equal the amount of the investment.

T9.1 Evaluation TechniqueM ZAHID KHANNet Present ValueThe net present value (NPV) is the present value of all expected cash flows.Net present value = Present value of all expected cash flows.The word "net" in this term indicates that all cash flows -- both positive and negative -- are considered. Often the change in operating cash flows are inflows and the investment cash flows are outflows. Therefore we tend to refer to the net present value as the difference between the present value of the cash inflows and the present value of the cash outflows.

T9.1 Evaluation TechniqueM ZAHID KHANNet Present ValueWe can represent the net present value using summation notation, where t indicates any particular period, CFt represents the cash flow at the end of period t, i represents the cost of capital, and N the number of periods comprising the economic life of the investment:

NPV = CF / (1+r)^tT9.1 Evaluation TechniqueM ZAHID KHANNet Present Value:If offered an investment that costs $5,000 today and promises to pay you $7,000 two years from today and if your opportunity cost for projects of similar risk is 10%, would you make this investment? To determine whether or not this is a good investment you need to compare your $5,000 investment with the $7,000 cash flow you expect in two years. Since you feels that a discount rate of 10% reflects the degree of uncertainty associated with the $7,000 expected in two years, today it is worth:Present value of $7,000 to be received in 2 years = $7,000/(1 + 0.10)2 = $5,785.12.

NPV ( The Present Value of an Investment Project net Cash Flows minus the Project initial Cash Flows). M ZAHID KHANNet Present ValueBy investing $5,000, today you are getting in return, a promise of a cash flow in the future that is worth $5,785.12 today. You increase your wealth by $785.12 when you make this investment. Another way of stating this is that the present value of the $7,000 cash inflow is $5,785.12, which is more than the $5,000, today's cash outflow to make the investment. When we subtract today's cash outflow to make an investment from the present value of the cash inflow from the investment, the difference is the increase or decrease in our wealth referred to as the net present value.

T9.1 Evaluation TechniqueM ZAHID KHANAssume you have the following information on Project X:Initial outlay -$1,100Required return = 10%Annual cash revenues and expenses are as follows: Year Revenues Expenses 1 $1,000 $500 2 2,000 1,000

Draw a time line and compute the NPV of project X.

T9.2 NPV IllustratedNet Present Value Decision Rule:If this means that and you...NPV > 0 - the investment is expected to increase shareholder wealth - should accept the project.NPV < 0 - the investment is expected to decrease shareholder wealth - should reject the project.NPV = 0 - the investment is expected not to change shareholder wealth - should be indifferent between accepting or rejecting the project

T9.1 Evaluation TechniqueM ZAHID KHANNet Present Value Decision Rule:Suppose , Investment A increases the value of the firm by $516,315 and B increases it by $552,620. If these are independent investments, both should be taken on because both increase the value of the firm. If A and B are mutually exclusive, such that the only choice is either A or B, then B is preferred since it has the greater NPV. Projects are said to be mutually exclusive if accepting one preclude the acceptance of the other.

T9.1 Evaluation TechniqueM ZAHID KHANNet Present Value Decision Rule:NPV and Further Considerations:The net present value technique considers:all expected future cash flows, the time value of money, and the risk of the future cash flows. One, NPV calculations result in a dollar amount, say $500 or $23,413, which is the incremental value to owners' wealth. However, investors and managers tend to think in terms of percentage returns, "Does this project return 10%? 15%?"

T9.1 Evaluation TechniqueM ZAHID KHANNet Present Value Decision Rule:

And two, to calculate NPV we need a cost of capital. This is not so easy. The concept behind the cost of capital is simple: It is compensation to the suppliers of capital for (a) the time value of money and (b) the risk they accept that the cash flows they expect to receive may not materialize as promised. Getting an estimate of how much compensation is needed is not so simple. That's because to estimate a cost of capital we have to make a judgment on the risk of a project and how much return is needed to compensate for that risk --

T9.1 Evaluation TechniqueM ZAHID KHANIrwin/McGraw-Hillcopyright 2002 McGraw-Hill Ryerson, Ltd.Internal Rate of ReturnAn investment's internal rate of return (IRR) is the discount rate that makes the present value of all expected future cash flows equal to zero.

T9.1 Evaluation TechniqueM ZAHID KHANInternal Rate of Return Decision Rule:The decision rule for the internal rate of return is to invest in a project if it provides a return greater than the cost of capital. The cost of capital, in the context of the IRR, is a hurdle rate -- the minimum acceptable rate of return. For independent projects and situations in which there is no capital rationing, thenIfthis means thatand you...IRR > cost of capital ----the investment is expected to increase shareholder wealth----should accept the project.IRR < cost of capital-----the investment is expected to decrease shareholder wealth---should reject the project.IRR = cost of capital----the investment is expected not to change shareholder wealth---should be indifferent between accepting or rejecting the project

T9.1 Evaluation TechniqueM ZAHID KHANInitial outlay = -$200 Year Cash flow 1$ 50 2100 3150Find the IRR such that NPV = 0 50 100 150 0 = -200 + + + (1+IRR)1 (1+IRR)2 (1+IRR)3 50 100 150 200 = + + (1+IRR)1 (1+IRR)2 (1+IRR)3T9.8 Internal Rate of Return IllustratedTrial and Error Discount ratesNPV 0%$100 5%68 10%41 15%18 20%-2IRR is just under 20% -- about 19.44%T9.8 Internal Rate of Return Illustrated (concluded)Year Cash flow 0 $275 1100 2100 3100 4100T9.9 Net Present Value ProfileDiscount rate2%6%10%14%18%12010080604020Net present value0 20 4022%IRRNow lets go back to the initial example - we assumed the following information on Project X:Initial outlay -$1,100Required return = 10%Annual cash benefits: YearCash flows 1 $ 500 2 1,000 Whats the Profitability Index (PI)?

T9.12 Profitability Index: The Present Value of an investment future cash flows divided by its initial cost. Also, benefit cost ratio.Previously we found that the NPV of Project X is equal to:

($454.55 + 826.45) - 1,100 = $1,281.00 - 1,100 = $181.00.

The PI = PV inflows/PV outlay = $1,281.00/1,100 = 1.1645.

This is a good project according to the PI rule. Can you explain why?Its a good project because the present value of the inflows exceeds the outlay. T9.12 Profitability Index Illustrated (concluded)The PI is obviously very similar to the NPV.However , Consider the project that cost 5$ has a 10$ present value and an investment that cost 100$ with a 150$ present value. The First of these investment has an NPV of 5$ and a PI of 2. The second has the NPV of 50$ and a PI of 1.50. If these project are Mutually Exclusive than the second one is preferred, even though is has lower PI. The ranking problem is very similar to the IRR ranking problem as we are more interested in the Profitability bottom line rather than the Ratio PI or Percent IRR.Profitability Index Illustrated (concluded)Advantages :Closely related to the NPV, generally leading to the identical decision.Easy to understand and communicate.May be useful when available funds are limited.

Drawback

May lead to incorrect decision making in comparison of Mutually exclusive Investment.Profitability Index (Advantage & Disadvantage )I. Discounted cash flow criteria A. Net present value (NPV). The NPV of an investment is the difference between its market value and its cost. The NPV rule is to take a project if its NPV is positive. NPV has no serious flaws; it is the preferred decision criterion.B. Internal rate of return (IRR). The IRR is the discount rate that makes the estimated NPV of an investment equal to zero. The IRR rule is to take a project when its IRR exceeds the required return. When project cash flows are not conventional, there may be no IRR or there may be more than one.C. Profitability index (PI). The PI, also called the benefit-cost ratio, is the ratio of present value to cost. The profitability index rule is to take an investment if the index exceeds 1.0. The PI measures the present value per dollar invested.

T9.13 Summary of Investment CriteriaII. Payback criteriaA. Payback period. The payback period is the length of time until the sum of an investments cash flows equals its cost. The payback period rule is to take a project if its payback period is less than some prespecified cutoff.B. Discounted payback period. The discounted payback period is the length of time until the sum of an investments discounted cash flows equals its cost. The discounted payback period rule is to take an investment if the discounted payback is less than some prespecified cutoff.III. Accounting criterionA. Average accounting return (AAR). The AAR is a measure of accounting profit relative to book value. The AAR rule is to take an investment if its AAR exceeds a benchmark. T9.13 Summary of Investment Criteria (concluded)1. Which of the capital budgeting techniques do account for both the time value of money and risk?

2. The change in firm value associated with investment in a project is measured by the projects _____________ .a. Payback periodb. Discounted payback periodc. Net present valued. Internal rate of return3. Why might one use several evaluation techniques to assess a given project?

T9.15 Chapter 9 Quick Quiz1. Which of the capital budgeting techniques do account for both the time value of money and risk? Discounted payback period, NPV, IRR, and PI2. The change in firm value associated with investment in a project is measured by the projects Net present value.

3. Why might one use several evaluation techniques to assess a given project?To measure different aspects of the project; e.g., the payback period measures liquidity, the NPV measures the change in firm value, and the IRR measures the rate of return on the initial outlay.T9.15 Chapter 9 Quick QuizOffshore Drilling Products, Inc. imposes a payback cutoff of 3 years for its international investment projects. If the company has the following two projects available, should they accept either of them? YearCash Flows ACash Flows B 0-$30,000-$45,000 1 15,000 5,000 2 10,000 10,000 3 10,000 20,000 4 5,000 250,000T9.16 Solution to Problem 9.3Project A: Payback period = 1 + 1 + ($30,000 - 25,000)/10,000 =2.50 yearsProject B: Payback period = 1 + 1 + 1 + ($45,000 - 35,000)/$250,000 = 3.04 yearsProject As payback period is 2.50 years and project Bs payback period is 3.04 years. Since the maximum acceptable payback period is 3 years, the firm should accept project A and reject project B.T9.16 Solution to Problem 9.3 (concluded)A firm evaluates all of its projects by applying the IRR rule. If the required return is 18 percent, should the firm accept the following project? YearCash Flow 0-$30,000 1 25,000 2 0 3 15,000T9.17 Solution to Problem 9.7To find the IRR, set the NPV equal to 0 and solve for the discount rate: NPV = 0 = -$30,000 + $25,000/(1 + IRR)1 + $0/(1 + IRR) 2 +$15,000/(1 + IRR)3At 18 percent, the computed NPV is ____.So the IRR must be (greater/less) than 18 percent. How did you know?T9.17 Solution of Problem 9.7 (concluded)To find the IRR, set the NPV equal to 0 and solve for the discount rate: NPV = 0 = -$30,000 + $25,000/(1 + IRR)1 + $0/(1 + IRR)2 +$15,000/(1 + IRR)3At 18 percent, the computed NPV is $316.So the IRR must be greater than 18 percent. We know this because the computed NPV is positive.By trial-and-error, we find that the IRR is 18.78 percent.T9.17 Solution of Problem 9.7 (concluded)THANK YOUEvaluation Techniques