l2 alternative investment rules basics 1pp

7/23/2019 L2 Alternative Investment Rules Basics 1pp

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Brief Overview of AlternativeInvestment Rules

January 12, 2016

Based on Berk et al, Chapter 8.

Optional reading: McKinsey on Finance: "IRR: Acautionary tale.


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Objectives

1. Define internal rate of return andpayback period rules for choosinginvestment projects.

2.

Describe decision rules for each of the

tools in objective 1 and for the NPV rule,for both stand-alone and mutuallyexclusive projects.

3. Discuss pros and cons of each of the tworules in objective 1.

4.

Optional Appendix provides examples ofseveral other rules.


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The Net Present Value (NPV) Rule

! Net Present Value (NPV) = Total PV of future

CFs - Initial Investment

! Estimating NPV:

Estimate future cash flows: how much? and when?Estimate discount rate

Estimate initial costs

! Minimum Acceptance Criteria: Accept if NPV > 0

!

Ranking Criteria: Choose the highest NPV


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Why Use Net Present Value?

!Accepting positive NPV projects benefitsshareholders.

! NPV uses cash flows

!NPV uses

allthe cash flows of the project

! NPV discounts the cash flows properly

! Cons: fixed supply of a resource thus not allpositive NPV projects may be undertaken (e.g.,limited warehouse space). See Ch. 8.5; we willnot discuss this.


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The Internal Rate of Return (IRR) Rule

IRR: the discount that sets NPV to zero

Minimum Acceptance Criteria:Accept if the IRR exceeds the required return.

Ranking Criteria:Select alternative with the highest IRR

! Reinvestment assumption:All future cash flows assumed reinvested at the IRR.

!Advantages:Easy to understand and communicate

! Note: Often used by consultancies


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The Internal Rate of Return: Example

Consider the following project:

0 1 2 3

$50 $100 $150

-$200

The internal rate of return for this project is 19.44%

NPV = 0! 0 = "200+$50

(1+ IRR)+

$100

(1+ IRR)2 +

$150

(1+ IRR)3


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Pitfalls of the IRR Approach

Usually named: Multiple/Non-existent IRRs.This problem is overemphasized. The issue may arise when

expected cash flows alternate between positive and negative,

but it does not when there is only one negative expected cash

flow (cost). (Descartes Rule of Signs implies exactly one IRRin this case.)

Are we Investing of Financing?

The Scale Problem (problems with mutually exclusive

projects)The Timing Problem (again, with mutually exclusive projects)


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Investing vs Financing

This is not aproblem, but need to be careful:

If investing (i.e., pay initial cost and then

positive expected cash flows) "want theproject with the highest IRR

If financing (i.e., borrowing: receive initial

payment and then pay back to the lender/investor)"want the project with the lowest

IRR.


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Mutually Exclusive vs. Independent Projects

! Mutually Exclusive Projects: only ONE of severalpotential projects can be chosen, e.g., acquiringan accounting system.

RANK all alternatives and select the best one.

! Independent Projects: accepting or rejecting one

project does not affect the decision of the otherprojects.

Must exceed a MINIMUM acceptance criteria.


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The Scale Problem

Would you rather make 100% or 50% on

your investments?

What if the 100% return is on a $1investment while the 50% return is on a

$1,000 investment?

This problem arises only when projects are

mutually exclusive.


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The Timing Problem

0 1 2 3

$10,000 $1,000 $1,000

-$10,000

Project A

IRR=16.04%

0 1 23

$1,000 $1,000 $12,000

-$10,000

Project B

IRR=12.94%

The preferred project in this case may depend on the discount

rate/rate of return, not the IRR. Q: When are you consuming?


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The Timing Problem (Contd)

At home: compute the NPV for each of the

two projects on the previous slide for the

following interest rates:

R= 0%, R=10%, and R=15%.


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The Payback Period Rule

! How long does it take the project to paybackits initial investment?

! Payback Period = number of years to recover

initial costs! Minimum Acceptance Criteria:

set by management

! Ranking Criteria:

set by management


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The Payback Period Rule (contd)

!

Disadvantages:

Ignores the time value of money (to counter this,discounted payback period rule is introduced).

Ignores cash flows after the payback period

Biased against long-term projects

Requires an arbitrary acceptance criteria

A project accepted based on the payback criteriamay not have a positive NPV

!

Advantages:

Easy to understand

Biased toward liquidity


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The Discounted Payback Period Rule

! Idea: how long does it take the project topay backits initial investment taking thetime value of money into account?

! First discount the cash flows, then ask how it

takes for the discounted cash flows to equalthe initial investment.

! By the time you have discounted the cashflows, you might as well calculate the NPV.

!

We will not use this rule in the course, but theAppendix to this set of slides provides anexample of its usage.


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The Practice of Capital Budgeting

! Varies by industry:

Some firms use payback, others use

accounting rate of return.

!

Discounted cash flow techniques (such asIRR or NPV ) are the most frequently used by

large industrial corporations.

! (We stop here in lecture; the remainder of the

slides are optional for the course.)


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Appendix: Other Rules

!

The Appendix provides examples of three otherrules. We are not covering these in class, andknowledge of these is not required in the course.

! Examples:

Discounted Pay-back Rule

The Average Accounting Return Rule

The Profitability Index (PI) Rule

Incremental IRR Rule (See 8.4., for a pair of

mutually exclusive projects).


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Assume you have the following information on

Project X:

! Initial outlay -$1,000

!Required return = 10%

Annual that cash flows and their PVs are as follows:

Year Cash flow PV of Cash flow

1 $ 200 $ 182

2 400 331

3 700 526

4 300 205

The Discounted Payback Period Rule: Example


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Year Accumulated discounted CF

1 $ 182

2 513

3 1,039

4 1,244

The Discounted Payback Period Rule:

Example (continued)

Discounted payback period is just under 3 years


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The Average Accounting Return Rule

! Ranking Criteria and Minimum AcceptanceCriteria set by management

! Disadvantages: Ignores the time value of money

Uses an arbitrary benchmark cutoff rate

Based on book values, not cash flows and market

values

!Advantages:The accounting information is usually available

Easy to calculate

InvestmentofValueBookAverageIncomeNetAverageAAR =


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The Profitability Index (PI) Rule

! Ranking Criteria:Select alternative with highest PI

!

Advantages:May be useful when available investment funds are limited

Easy to understand and communicate

! Disadvantages:

Problems with multiple resource constraints

PI =ValueCreated

Resource consumed=

NPV

Resource consumed

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