© 2003 The McGraw-Hill Companies, Inc. All rights reserved. Net Present Value and Other Investment Criteria Chapter Nine

9.1 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Chapter Outline n Net Present Value n The Payback Rule n The Discounted Payback n The Average Accounting Return n The Internal Rate of Return n The Profitability Index n The Practice of Capital Budgeting

9.2 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. What Makes a Good Decision Criteria? n Questions for evaluating a decision criteria n Does the decision rule adjust for the time value of money? n Does the decision rule adjust for risk? n Does the decision rule provide information on whether we are creating value for the firm?

9.3 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example: Project Information n You are investigating a new project and you have estimated the following cash flows: n Year 0:Cash Flow = -165,000 n Year 1: Cash Flow = 63,120; Net Income = 13,620 n Year 2: Cash Flow = 70,800; Net Income = 3,300 n Year 3: Cash Flow = 91,080; Net Income = 29,100 n Average Book Value = 72,000 n Your required return for assets of this risk is 12%. n Should we undertake this project? n If we do undertake this project, what impact will it have on shareholder wealth?

9.4 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Net Present Value 9.1 n Net present value is the difference between the market value of a project and its cost n It is the addition to shareholder wealth from undertaking the investment n How much value is created from undertaking an investment? The answer is a three step process: n Step #1: Estimate the expected future cash flows. n Step #2: Estimate the required return for projects of this risk level. n Step #3: Find the present value of the cash flows and subtract the initial investment.

9.5 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. NPV – Decision Rule n If the NPV is positive, accept the project n A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners. n Since our goal is to increase the wealth of the shareholder, NPV is a direct measure of how well this project will meet our goal.

9.6 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Computing NPV for the Project n Using the formulas: n NPV = – 165, ,120/(1.12) + 70,800/(1.12) ,080/(1.12) 3 = 12, n Using the calculator: n -165,000CF j n 63,120CF j n 70,800 CF j n 91,080CF j n 12 I; n 2nd NPV 12, n Do we accept or reject the project?

9.7 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Payback Period 9.2 n Payback Period - Tells us how long it takes to get the initial investment back n Computation n Estimate the cash flows n Subtract the future cash flows from the initial cost until the initial investment has been recovered n Decision Rule – Accept if the payback period is less than some time period

9.8 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Computing Payback For The Project n Assume we will accept the project if it pays back within two years. $165,000 is the initial investment. n Year 1: $165,000 – $63,120 = $101,880 still to recover n Year 2: $101,880 – $70,800 = $31,080 still to recover n Year 3: $31,080 – $91,080 = -$60,000 n Project pays back in year 3 n Therefore reject the project

9.9 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Computing Payback For The Project (cont.) n PP = ∑ CFN / CF Where CFN = cash flow needed in any given year to recover initial investment CF = cash flow in any giver year Example PP = (63,120/63,120) + (70,800/70,800) + (31,080/91,080) = = 2.34 years

9.10 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Advantages and Disadvantages of Payback n Advantages n Easy to understand n Biased towards liquidity n Disadvantages n Ignores the time value of money n Requires an arbitrary cutoff point n Ignores cash flows beyond the cutoff date n Biased against long-term projects, such as research and development, and new projects

9.11 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Discounted Payback Period n Compute the present value of each cash flow and then determine how long it takes to payback on a discounted basis n Compare to a specified required payback period n Decision Rule - Accept the project if it pays back on a discounted basis within the specified time

9.12 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Computing Discounted Payback for the Project n Assume we will accept the project if it pays back on a discounted basis in 2 years. n Compute the PV for each cash flow and determine the payback period using discounted cash flows n Year 1: $165,000 – 63,120/ = $108,643 n Year 2: $108,643 – 70,800/ = $52,202 n Year 3: $52,202 – 91,080/ = -$12,627 project pays back in year 3 n Therefore reject the project

9.13 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Advantages and Disadvantages of Discounted Payback n Advantages n Includes time value of money n Easy to understand n Biased towards liquidity n Disadvantages n May reject positive NPV investments n Requires an arbitrary cutoff point n Ignores cash flows beyond the cutoff date n Biased against long-term projects, such as R&D, and new projects

9.14 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Average Accounting Return 9.3 n There are many different definitions for average accounting return n The one used in the book is: n Average net income / Average book value n Note that the average book value depends on how the asset is depreciated. n Need to have a target cutoff rate n Decision Rule: Accept the project if the AAR is greater than a preset rate.

9.15 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Computing AAR For The Project n Assume we require an average accounting return of 25% n Average Net Income: n (13, , ,100) / 3 = 15,340 n AAR = 15,340 / 72,000 =.213 = 21.3% n Therefore reject the project

9.16 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Advantages and Disadvantages of AAR n Advantages n Easy to calculate n Needed information is usually available n Disadvantages n Not a true rate of return; time value of money is ignored n Uses an arbitrary benchmark cutoff rate n Based on accounting net income and book values, not cash flows and market values

9.17 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Internal Rate of Return 9.4 n This is the most important alternative to NPV n It is often used in practice and is intuitively appealing n It is based entirely on the estimated cash flows and is independent of interest rates found elsewhere

9.18 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. IRR – Definition and Decision Rule n Definition: IRR is the rate of return that makes the NPV = 0 n Decision Rule: Accept the project if the IRR is greater than the required return

9.19 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Computing IRR For The Project n Assume that 12% is the hurdle rate (or required rate of return) n (If you do not have a financial calculator, then this becomes a trial and error process) n Using the calculator: n -165,000CF j n 63,120CF j n 70,800 CF j n 91,080CF j n 2nd IRR 16.13% n Therefore we accept the project

9.20 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. NPV Profile For The Project IRR = 16.13%

9.21 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Advantages of IRR n Knowing a return is intuitively appealing n It is a simple way to communicate the value of a project to someone who doesn’t know all the estimation details n If the IRR is high enough, you may not need to estimate a required return, which is often a difficult task n Generally leads to the same answers as the NPV method

9.22 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Disadvantages of IRR n NPV and IRR will generally give us the same decision n Exceptions: n May result in multiple answers or no answer with non- conventional cash flows n According to Descartes Rule, there will be one IRR for each change in sign of the cash flows n May lead to incorrect decisions when comparing mutually exclusive investments

9.23 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. IRR and Non-conventional Cash Flows n When the cash flows change sign more than once, there is more than one IRR n When you solve for the IRR, you are solving for the root of an equation. When you cross the x-axis more than once, there will be more than one return that solves the equation n If you have more than one IRR, which one do you use to make your decision?

9.24 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example – Non-conventional Cash Flows n Suppose an investment will cost $90,000 initially and will generate the following cash flows: n Year 1: 132,000 n Year 2: 100,000 n Year 3: -150,000 n The required return is 15%. n Should we accept or reject the project?

9.25 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. NPV Profile IRR = 10.11% and 42.66%

9.26 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Summary of Decision Rules n The NPV is positive at a required return of 15%, so you should Accept n If you use the financial calculator, you would get an IRR of 10.11% which would tell you to Reject n You need to recognize that there are non-conventional cash flows and look at the NPV profile

9.27 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. IRR and Mutually Exclusive Projects n Mutually exclusive projects n If you choose one, you can’t choose the other n Example: You can choose to attend graduate school next year at either Harvard or Stanford, but not both n Intuitively you would use the following decision rules: n NPV – choose the project with the higher NPV n IRR – choose the project with the higher IRR

9.28 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example With Mutually Exclusive Projects PeriodProject AProject B IRR19.43%22.17% NPV The required return for both projects is 10%. Which project should you accept and why?

9.29 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. NPV Profiles IRR for A = 19.43% IRR for B = 22.17% Crossover Point = 11.8%

9.30 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Conflicts Between NPV and IRR n NPV directly measures the increase in value to the firm n Whenever there is a conflict between NPV and another decision rule, you should always use NPV n IRR is unreliable in the following situations n Non-conventional cash flows n Mutually exclusive projects

9.31 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Profitability Index 9.5 n Measures the benefit per unit of cost, based on the time value of money n A profitability index of 1.1 implies that for every $1 of investment, we create an additional $0.10 in value n This measure can be very useful in situations where we have limited capital

9.32 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Advantages and Disadvantages of Profitability Index n Advantages n Closely related to NPV, generally leading to identical decisions n Easy to understand and communicate n May be useful when available investment funds are limited n Disadvantages n May lead to incorrect decisions in comparisons of mutually exclusive investments

9.33 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Capital Budgeting In Practice 9.6 n We should consider several investment criteria when making decisions n NPV and IRR are the most commonly used primary investment criteria n Payback is a commonly used secondary investment criteria

9.34 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Summary 9.7 n Net present value n Difference between market value and cost n Accept the project if the NPV is positive n Has no serious problems n Preferred decision criterion n Internal rate of return n Discount rate that makes NPV = 0 n Accept the project if the IRR is greater than required return n Same decision as NPV with conventional cash flows n IRR is unreliable with non-conventional cash flows or mutually exclusive projects n Profitability Index n Benefit-cost ratio n Accept investment if PI > 1 n Cannot be used to rank mutually exclusive projects n May be use to rank projects in the presence of capital rationing

9.35 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Summary continued n Payback period n Length of time until initial investment is recovered n Accept the project if it pays back in some specified period n Doesn’t account for time value of money and there is an arbitrary cutoff period n Discounted payback period n Length of time until initial investment is recovered on a discounted basis n Accept the project if it pays back in some specified period n There is an arbitrary cutoff period n Average Accounting Return n Measure of accounting profit relative to book value n Similar to return on assets measure n Accept the investment if the AAR exceeds some specified return level n Serious problems and should not be used