Chapter 6 Capital Budgeting Techniques

Net Present Value (NPV) Net Present Value (NPV). Net Present Value is found by subtracting the present value of the after-tax outflows from the present value of the after-tax inflows.

If NPV > 0, accept the project If NPV < 0, reject the project Net Present Value (NPV) Net Present Value (NPV). Net Present Value is found by subtracting the present value of the after-tax outflows from the present value of the after-tax inflows. Decision Criteria If NPV > 0, accept the project If NPV < 0, reject the project If NPV = 0, indifferent

Net Present Value (NPV)

Net Present Value (NPV) Using the Bennett Company data from Table 9.1, assume the firm has a 10% cost of capital. Based on the given cash flows and cost of capital (required return), the NPV can be calculated as shown in Figure 9.2

Net Present Value (NPV)

Internal Rate of Return (IRR) The Internal Rate of Return (IRR) is the discount rate that will equate the present value of the outflows with the present value of the inflows. The IRR is the project’s intrinsic rate of return.

Capital Budgeting (NPV) Advantages: Cash flows rather than profits are analyzed Recognizes the time value of money Acceptance criterion is consistent with the goal of maximizing value Disadvantage: Detailed, accurate long-term forecasts are required to evaluate a project’s acceptance

If IRR > k, accept the project If IRR < k, reject the project Internal Rate of Return (IRR) The Internal Rate of Return (IRR) is the discount rate that will equate the present value of the outflows with the present value of the inflows. The IRR is the project’s intrinsic rate of return. Decision Criteria If IRR > k, accept the project If IRR < k, reject the project If IRR = k, indifferent

The Internal Rate of Return (IRR)

Capital Budgeting (IRR) Advantages: Cash flows rather than profits are analyzed Recognizes the time value of money Acceptance criterion is consistent with the goal of maximizing value Disadvantages: Detailed, accurate long-term forecasts are required to evaluate a project’s acceptance Difficult to solve for IRR without a financial calculator or spreadsheet

NPV versus IRR When NPV>0, a project is acceptable because the firm will earn a return greater than its required rate of return (k) if it invests in the project. When IRR>k, a project is acceptable because the firm will earn a return greater than its required rate of return (k) if it invests in the project. When NPV>0, IRR>k for a project—that is, if a project is acceptable using NPV, it is also acceptable using IRR

Net Present Value Profiles

IRR and Mutually Exclusive Projects If you choose one, you can’t choose the other Example: You can choose to attend graduate school next year at either Harvard or Stanford, but not both Intuitively you would use the following decision rules: NPV – choose the project with the higher NPV IRR – choose the project with the higher IRR

Example With Mutually Exclusive Projects Period Project A Project B -500 -400 1 325 2 200 IRR 19.43% 22.17% NPV 64.05 60.74 The required return for both projects is 10%. Which project should you accept and why?

NPV profiles

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 IRR is unreliable in the following situations Non-conventional cash flows Mutually exclusive projects