week 7 chapter 9

7/28/2019 Week 7 Chapter 9

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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

7-1

Chapter Seven

Net Present Value and OtherInvestment Criteria


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7-2

7.1 Net Present Value

7.2 The Payback Rule

7.3 The Discounted Payback Rule

7.4 The Accounting Rate of Return

7.5 The Internal Rate of Return

7.6 The Present Value Index

7.7 The Practice of Capital Budgeting

7.8 Summary and Conclusions

Chapter Organisation


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7-3

Chapter Objectives

Discuss the various investment evaluationtechniques, including their advantages anddisadvantages.

Apply these techniques to the evaluation ofprojects.

Interpret the results of the application of thesetechniques in accordance with their respective

decision rules.

Understand the importance of net present value.


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7-4

Net Present Value (NPV)

Net present value is the difference between aninvestments market value (in todays dollars) and

its cost (also in todays dollars).

Net present value is a measure of how much valueis created by undertaking an investment.

Estimation of the future cash flows and thediscount rate are important in the calculation of theNPV.


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7-5

Net Present Value

Steps in calculating NPV:

The first step is to estimate the expected future

cash flows.

The second step is to estimate the required returnfor projects of this risk level.

The third step is to find the present value of the

cash flows and subtract the initial investment.


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7-6

NPV Illustrated

0 1 2

Initial outlay($1100)

Revenues $1000Expenses 500

Cash flow $500

Revenues $2000Expenses 1000

Cash flow $1000

$1100.00

+454.55

+826.45

+$181.00

1$500 x

1.10

1$1000 x

1.102

NPV


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7-7

NPV

An investment should be accepted if the NPV ispositive and rejected if it is negative.

NPV is a direct measure of how well theinvestment meets the goal of financialmanagementto increase owners wealth.

A positive NPV means that the investment isexpected to add value to the firm.


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7-8

Payback Period

The amount of time required for an investment to generatecash flows to recover its initial cost.

Estimate the cash flows.

Accumulate the future cash flows until they equal the initialinvestment.

The length of time for this to happen is the payback period.

An investment is acceptable if its calculated payback is lessthan some prescribed number of years.


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7-9

Payback Period Illustrated

Initial investment =$1000Year Cash flow

1 $200

2 400

3 600

AccumulatedYear Cash flow

1 $200

2 6003 1200

Payback period = 2 2/3 years


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7-10

Advantages of Payback Period

Easy to understand.

Adjusts for uncertainty of later cash flows.

Biased towards liquidity.


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7-11

Disadvantages of Payback Period

Time value of money and risk ignored.

Arbitrary determination of acceptable payback

period.

Ignores cash flows beyond the cut-off date.

Biased against long-term and new projects.


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7-12

Discounted Payback Period

The length of time required for an investments

discounted cash flows to equal its initial cost.

Takes into account the time value of money.

More difficult to calculate.

An investment is acceptable if its discountedpayback is less than some prescribed number ofyears.


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7-13

ExampleDiscounted Payback

Initial investment =

$1000R = 10%PV of

Year Cash flow Cash flow

1 $200 $182

2 400 331

3 700 526

4 300 205


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7-14

ExampleDiscounted Payback(continued)

Accumulated

Year discountedcash flow

1 $182

2 513

3 1039

4 1244

Discounted payback period isjust under three years


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7-15

Ordinary and Discounted Payback

Cash Flow Accumulated Cash Flow

Year Undiscounted Discounted Undiscounted Discounted

12345

$ 100100100100100

$ 8979706255

$ 100200300400500

$89168238300355

Initial investment =$300R = 12.5%

Ordinary payback? Discounted payback?


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7-16

Advantages and Disadvantages ofDiscounted Payback

Advantages

- Includes time value ofmoney

- Easy to understand

- Does not accept negativeestimated NPV investments

- Biased towards liquidity

Disadvantages

- May reject positive NPVinvestments

- Arbitrary determination ofacceptable payback period

- Ignores cash flows beyondthe cutoff date

- Biased against long-termand new products


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7-17

Accounting Rate of Return (ARR)

Measure of an investments profitability.

A project is accepted if ARR > target averageaccounting return.

book valueaverageprofitnetaverageARR


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7-18

ExampleARR

Year

1 2 3

Sales $440 $240 $160

Expenses 220 120 80

Gross profit 220 120 80

Depreciation 80 80 80

Taxable income 140 40 0

Taxes (25%) 35 10 0

Net profit $105 $30 $0

Assume initial investment = $240


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7-19

ExampleARR (continued)

$1202

$0$240

2

valueSalvageinvestmentInitialbook valueAverage

$45

3

$0$30$105profitnetAverage


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7-20

ExampleARR (continued)

37.5%

$120$45

book valueAverage

profitnetAverageARR


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7-21

Disadvantages of ARR

The measure is not a true reflection of return.

Time value is ignored.

Arbitrary determination of target average return.

Uses profit and book value instead of cash flowand market value.


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7-22

Advantages of ARR

Easy to calculate and understand.

Accounting information almost always available.


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7-23

Internal Rate of Return (IRR)

The discount rate that equates the present value ofthe future cash flows with the initial cost.

Generally found by trial and error.

A project is accepted if its IRR is > the requiredrate of return.

The IRR on an investment is the required returnthat results in a zero NPV when it is used as thediscount rate.


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7-24

ExampleIRR

Initial investment =$200

Year Cash flow

1 $ 50

2 100

3 150

n Find the IRR such that NPV = 0

50 100 1500 =200 + + +

(1+IRR)1 (1+IRR)2 (1+IRR)3

50

100 150

200 = + +(1+IRR)1 (1+IRR)2 (1+IRR)3


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7-25

ExampleIRR (continued)

Trial and Error

Discount rates NPV

0% $100

5% 68

10% 41

15% 18

20% 2

IRR is just under 20%about 19.44%


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7-26

NPV Profile

Year Cash flow

0 $2751 1002 1003 1004 100

Discount rate

2% 6% 10% 14% 18%

120

100

80

60

40

20

Net present value

0

20

40

22%

IRR


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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3e

Ross, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

7-27

Problems with IRR

More than one negative cash flow multiple ratesof return.

Project is not independent mutually exclusive

investments. Highest IRR does not indicate thebest project.

Advantages of IRR Popular in practice

Does not require a discount rate


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7-28

Multiple Rates of Return

Assume you are considering a project forwhich the cash flows are as follows:

Year Cash flows

0 $252

1 1431

2 3035

3 2850

4 1000


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7-29


n Whats the IRR? Find the rate at whichthe computed NPV = 0:

at 25.00%: NPV = 0

at 33.33%: NPV = 0

at 42.86%: NPV = 0

at 66.67%: NPV = 0

n Two questions:u 1. Whats going on here?

u 2. How many IRRs can there be?


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7-30


$0.06

$0.04

$0.02

$0.00

($0.02)

NPV

($0.04)

($0.06)

($0.08)

0.2 0.28 0.36 0.44 0.52 0.6 0.68

IRR = 25%

IRR = 33.33%

IRR = 42.86%

IRR = 66.67%

Discount rate


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7-31

IRR and Non-conventional CashFlows

When the cash flows change sign more than once,there is more than one IRR.

When you solve for IRR you are solving for the root

of an equation and when you cross thexaxis morethan once, there will be more than one return thatsolves the equation.

If you have more than one IRR, you cannot use

any of them to make your decision.


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7-32

IRR, NPV and Mutually-exclusiveProjects

Discount rate

2% 6% 10% 14% 18%

6040

20

0

20

40

Net present value

60

80

100

22%

IRRA IRRB

0

140

120100

80

160

Year

0 1 2 3 4

Project A: $350 50 100 150 200

Project B: $250 125 100 75 50

26%

Crossover Point

Present Value Index (PVI)


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7-33

Present Value Index (PVI)(Profitability Index)

Expresses a projects benefits relative to its initial

cost.

costInitialinflowsofPVPVI


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7-34

Present Value Index (PVI)

Expresses a projects benefits relative to its

initial cost.

Accept a project with a PVI > 1.0.

costInitialinflowsofPVPVI


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7-35

ExamplePVI

Assume you have the following information on Project X:

Initial investment =$1100 Required return = 10%

Annual cash revenues and expenses are as follows:

Year Revenues Expenses

1 $1000 $500

2 2000 1000


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7-36

ExamplePVI (continued)

1.16451001

1001181PVI

$181

10011.10

0001

1.10

500NPV

2


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7-37


1.1645

1001

1001181PVI

$181

10011.10

0001

1.10

500NP V

2

Net Present Value Index

= 181

1100

= 0.1645


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7-38


Is this a good project? If so, why?


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7-39


Is this a good project? If so, why?

This is a good project because the present value of

the inflows exceeds the outlay.

Each dollar invested generates $1.1645 in value or$0.1645 in NPV.


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7-40

Advantages and Disadvantages ofPVI (and NPVI)

Advantages

- Closely related toNPV, generally leadingto identical decisions.

- Easy to understand.

- May be useful whenavailable investmentfunds are limited.

Disadvantages

- May lead to incorrectdecisions in

comparisons ofmutually exclusiveinvestments.


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C f

Capital Budgeting in Practice

We should consider several investment criteriawhen making decisions.

NPV and IRR are the most commonly used primaryinvestment criteria.

Payback is a commonly used secondary

investment criteria.

week 7 chapter 9

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