Net Present Value and Other Investment Criteria CHAPTER 9 Net Present Value and Other Investment Criteria

Net Present Value The difference between the market value of a project and its cost Estimating NPV: (DCF) The first step is to estimate the expected future cash flows. The second step is to estimate the required return for projects of this risk level. The third step is to find the present value of the cash flows and subtract the initial investment.

NPV – Decision Rule If the NPV is positive, accept the project A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners. Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal.

Payback Period The amount of time required for an investment to generate cash flows sufficient to recover its initial cost. An investment is accepted if its calculated period is less than some prespecified number of years

Example E D C B A Year -50$ -200$ -100 $ 100 40 30 1 -50,000,000 20 2 100 40 30 1 -50,000,000 20 2 -200 10 50 3 200 130 60 4

Analyzing the rule Does the payback rule account for the time value of money? Does the payback rule account for the risk of the cash flows? Does the payback rule provide an indication about the increase in value? Should we consider the payback rule for our primary decision rule?

Example short Long Year -250$ 100 1 200 2 3 4

Advantages and Disadvantages of Payback Ignores the time value of money Requires an arbitrary cutoff point Ignores cash flows beyond the cutoff date Biased against long-term projects, such as research and development, and new projects Advantages Easy to understand Adjusts for uncertainty of later cash flows Biased toward liquidity

Discounted Payback Period The length of time required for an investment’s discounted cash flows to equal its initial cost. An investment is acceptable if its discounted payback is less than some prespecified number of years

Example Accumulated cash flow Cash flow discounted undiscounted year 89 100 89$ 100$ 1 168 200 79 2 238 300 70 3 400 62 4 355 500 55 5

Decision Criteria Test – Discounted Payback Does the discounted payback rule account for the time value of money? Does the discounted payback rule account for the risk of the cash flows? Does the discounted payback rule provide an indication about the increase in value? Should we consider the discounted payback rule for our primary decision rule?

Advantages and Disadvantages of Discounted Payback Includes time value of money Easy to understand Does not accept negative estimated NPV investments when all future cash flows are positive Biased towards liquidity Disadvantages May reject positive NPV investments Requires an arbitrary cutoff point Ignores cash flows beyond the cutoff point Biased against long-term projects, such as R&D and new products

Ex 8 Page 293 Cash flow year -34,000$ 16,000 1 18,000 2 15,000 3 Suppose the firm uses the NPV decision rule. At a required return of 11 percent, should the firm accept the project? What of the required return was 30 percent?

Ex 11 Page 294 What is the NPV at a discount rate of zero percent? Cash flow year -19,500$ 9,800 1 10,300 2 8,600 3 What is the NPV at a discount rate of zero percent?

Ex 1 Page 292 What is the payback period for the following set of cash flows? Cash flow year -6,400$ 1,600 1 1,900 2 2,300 3 1,400 4

Ex 2 Page 293 An investment project provides cash inflows of 765$ per year for eight years. What is the project payback period if the initial cost is 2,400$?

Ex 4 Page 293 An investment project has annual cash inflows of 4,200$ , 5,300$ , 6,100$ and 7,400$, and a discount rate of 14 percent. What is the discounted payback period for these cash flows if the initial cost is 13,000?

Average Accounting Return An investment’s average net income divided by its average book value A project is acceptable if its average accounting return exceeds a target average accounting return

Example Suppose we are deciding whether to open a store in anew shopping mall. The required investment in improvements is 500,000$. The store would have a five-year life. The required investment would be 100 percent depreciated. The tax rate is 25 percent. Net income for the five years as follow: NI year 100,000 1 150,000 2 50,000 3 4 -50,000 5

Decision Criteria Test - AAR Does the AAR rule account for the time value of money? Does the AAR rule account for the risk of the cash flows? Does the AAR rule provide an indication about the increase in value? Should we consider the AAR rule for our primary decision rule?

Advantages and Disadvantages of AAR Not a true rate of return; time value of money is ignored Based on accounting net income and book values, not cash flows and market values Advantages Easy to calculate Needed information will usually be available

Internal Rate of Return The discounted rate that makes the NPV of an investment zero This is the most important alternative to NPV An investment is acceptable if the IRR exceeds the required return

Decision Criteria Test - IRR Does the IRR rule account for the time value of money? Does the IRR rule account for the risk of the cash flows? Does the IRR rule provide an indication about the increase in value? Should we consider the IRR rule for our primary decision criteria?

Advantages and Disadvantages of IRR Advantageous Closely related to NPV leading to identical decisions Easy to understand and communicate

Conflicts Between NPV and IRR NPV directly measures the increase in value to the firm Whenever there is a conflict between NPV and another decision rule, you should always use NPV

Ex 7 Page 293 A firm evaluates all of its projects by applying the IRR. If the required return is 16 percent, should the firm accept the following project? CF year $-34,000 16,000 1 18,000 2 15,000 3

Ex 9 Page 293 A project that provides annual cash flows of 28,500$ for nine years costs 138,000$ today. Is this a good project if the required rate of return is 20 percent? At what discount rate would you be indifferent between accepting the project and rejecting it?

Profitability Index The present value of an investment’s future value cash flows divided by its initial cost. This measure can be very useful in situations in which we have limited capital

Advantages of Profitability Index Closely related to NPV, generally leading to identical decisions Easy to understand and communicate May be useful when available investment funds are limited

Ex 15 Page 294 What is the profitability index for the following set of cash flows if the relevant discount rate is 22 percent? CF year -14,000$ 7,300 1 6,900 2 5,700 3

Capital Budgeting In Practice We should consider several investment criteria when making decisions NPV and IRR are the most commonly used primary investment criteria Payback is a commonly used secondary investment criteria

Comprehensive Problem An investment project has the following cash flows: CF0 = -1,000,000; C01 – C08 = 200,000 each If the required rate of return is 12%, what decision should be made using NPV? How would the IRR decision rule be used for this project, and what decision would be reached?