Investment Decision Rules 04/30/07 Ch. 10 and Ch. 12

Investment decision revisited Acceptable projects are those that yield a return greater than the minimum acceptable hurdle rate with adjustments for project riskiness. We know now how to calculate the acceptable hurdle rate (cost of capital), and relevant project cash flows. The final step in the process is to evaluate the project. This entails understanding and applying the appropriate investment decision tools. We must also understand their benefits and drawbacks.

Accounting income-based investment decision rules Return on Capital This measures the return to all capital providers (equity and debt) For a given year, this return can be measured as: ROC = EBIT(1-t) / (avg. BV of total investment + total working capital investment) where average BV is calculated as the (ending BV + beginning BV) / 2 Decision rule: If ROC > cost of capital, then project is acceptable Note: You can assess the collective quality of a firm’s investments by measuring ROC as: ROC = EBIT(1-t) / (BV of equity + BV of debt)

Problems with accounting return approaches Changing depreciation methods may result in different decisions Ignores the time value of money For projects without a significant investment, these measures have less meaning

Payback period The payback on a project is a measure of how quickly the cash flows generated by the project cover the initial investment. Decision rule: Projects are considered acceptable if the payback period is shorter than some arbitrarily determined period by the firm.

Problems with the payback period method It ignores the time value of money. It ignores all cash flows after the arbitrary cut off date.

Discounted cash flow measures of return Net Present Value (NPV): Sum of the present values of all cash flows on the project, including the initial investment, with the cash flows being discounted at the appropriate hurdle rate (cost of capital, if cash flow is cash flow to the firm, and cost of equity, if cash flow is to equity investors) Decision Rule: Accept if NPV > 0

Discounted cash flow measures of return Attractive properties of NPV NPVs are additive value of the firm is the NPV of all projects adopted by the firm The additional value to the firm of divestitures and acquisitions can be calculated as Price – expected NPV Intermediate CFs are reinvested at the hurdle rate NPV calculations allow for changes in interest rates and hurdle rates

Discounted cash flow measures of return Why is NPV not used exclusively? Managers are more comfortable talking about percentage returns than absolute returns Capital rationing, the inability of firms to invest in all positive NPV projects, necessitates managers choosing the projects that add most value to the firm

Discounted cash flow measures of return Internal Rate of Return (IRR): The internal rate of return is the discount rate that sets the net present value equal to zero. It is the percentage rate of return, based upon incremental time-weighted cash flows. Decision Rule: Accept if IRR > hurdle rate Where the hurdle rate is the cost of capital if cash flow is cash flow to the firm, and cost of equity if cash flow is to equity investors

Discounted cash flow measures of return The multiple IRR problem The number of IRRs equals the number of sign changes in cash flows Therefore, if the sign of cash flows changes more than once during the life of the project, multiple IRRs will result

Discounted cash flow measures of return NPV and IRR generally result in the same decision about projects. However, when the projects are mutually exclusive, differences can arise Differences in scale Capital rationing may be a factor Difference in reinvestment rate assumption

Capital rationing and choosing a rule If a business has limited access to capital and has a stream of surplus value projects, it is much more likely to use IRR as its decision rule. Small, high-growth companies and private businesses are much more likely to use IRR. If a business has substantial funds on hand, access to capital and limited surplus value projects, it is much more likely to use NPV as its decision rule. As firms go public and grow, they are much more likely to gain from using NPV.

NPV, IRR and the reinvestment rate assumption The NPV rule assumes that intermediate cash flows on the project get reinvested at the hurdle rate (which is based upon what projects of comparable risk should earn). The IRR rule assumes that intermediate cash flows on the project get reinvested at the IRR. Conclusion: When the IRR is high (the project is creating significant surplus value) and the project life is long, the IRR will overstate the true return on the project.

Modified IRR The modified IRR (MIRR) calculates a project’s rate of return assuming that intermediate cash flows get reinvested at the hurdle rate. The MIRR is calculated as follows: Calculate the terminal value, which is the future value of cash flows after initial investment compounded at the hurdle rate Calculate the MIRR assuming the terminal value equals the future value and initial investment equals the present value Decision Rule: Accept if MIRR > hurdle rate

Mutually exclusive projectswith different lives In our discussions of ranking mutually exclusive projects, we assumed that the projects being considered had equal lives. We now expand our analyses to incorporate differences in project lives.

Ranking mutually exclusive projects with different lives The net present values of mutually exclusive projects with different lives cannot be compared, since there is a bias towards longer-life projects. To do the ranking, we have to either replicate the projects till they have the same life or; convert the net present values into equivalent annuities where

Capital rationing Capital rationing occurs when a firm is unable to invest in projects that earn returns greater than hurdle rates. Sources of capital rationing: Firm’s lack of credibility with financial markets Underpricing of securities Costs (flotation) of external financing These sources are typically more severe for smaller firms and for firms seeking equity financing.

An alternative to IRR with capital rationing The problem with the NPV rule, when there is capital rationing, is that it is a dollar value. It measures success in absolute terms. The NPV can be converted into a relative measure by dividing by the investment required in the project. This is called the profitability index (PI). Decision rule: If PI > 1, the project is acceptable.

A summary of decision-making in capital budgeting For independent projects, NPV is the best method of evaluation as it provides an indication of how much wealth the project will add to the firm. The MIRR and PI methods will also provide you with the correct decision. The IRR method will too, as long as cash flows are conventional. For mutually exclusive projects without capital rationing constraints, NPV is the best method for ranking projects. The PI method will also provide you with the same rankings. The IRR method rankings will be biased towards projects with larger early cash flows. The MIRR method may not rank the project that generates the most wealth for the firm first. For mutually exclusive projects with capital rationing constraints, the MIRR method tends to work the best. The value tends to be more meaningful than the PI method value, which also will provide accurate rankings in this case.

What firms actually use.. Decision Rule% of Firms using as primary decision rule in IRR53.6%49.0%47.0% Accounting Return25.0%8.0%8.1% NPV9.8%21.0%23.3% PI2.7%3.0%6.0% Payback Period8.9%19.0%15.0%

Chapter 10 and 12 sections NOT covered Chapter 10 Return on Equity Cash Flow Returns on Equity and Capital Chapter 12 Projects with Equal Lives Calculating Breakeven The Replacement Decision: A Special Case of Mutually Exclusive Projects Side Costs of Projects and all sections thereafter