1. Chapter 5 Principles of Corporate Finance Eighth Edition Why Net Present Value Leads to Better Investment Decisions Than Other Criteria Slides by Matthew Will Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

2. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 2 McGraw-Hill/Irwin Topics Covered  A Review of The Basics –NPV and its Competitors  The Payback Period –The Book Rate of Return  Internal Rate of Return  Capital Rationing

3. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 3 McGraw-Hill/Irwin NPV and Cash Transfers  Every possible method for evaluating projects impacts the flow of cash about the company as follows. Cash Investment opportunity (real asset) FirmShareholder Investment opportunities (financial assets) InvestAlternative: pay dividend to shareholders Shareholders invest for themselves

4. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 4 McGraw-Hill/Irwin CFO Decision Tools Survey Data on CFO Use of Investment Evaluation Techniques SOURCE: Graham and Harvey, “The Theory and Practice of Finance: Evidence from the Field,” Journal of Financial Economics 61 (2001), pp. 187-243.

5. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 5 McGraw-Hill/Irwin Net Present Value (NPV)  NPV = The difference between an investment’s market value (=present value) and its cost  An investment should be accepted if the NPV is positive, and rejected otherwise

6. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 6 McGraw-Hill/Irwin NPV Example  Your company is worth three million, 1 million in cash and 2 million in other assets  There are 500.000 shares outstanding, the expected return on these stock is 12 %  You are offered an investment costing one million and offering cash flows of 300.000 per year for five years.  Should you accept the offer?

7. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 7 McGraw-Hill/Irwin NPV Example cont.  PV = 300.000(1/0.12 – 1/0.12(1.12) 5 ) = 1.081.432  NPV = -1.000.000 + 1.081,432 = 81,432  Accept because NPV > 0  Rationale: –Share price will increase by 16 cents: from 6,00 euros to 6,16 euros  What if required return were 17%? –NPV = -40.196 –Share price would decrease by 8 cents

8. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 8 McGraw-Hill/Irwin Book Rate of Return Book Rate of Return - Average income divided by average book value over project life. Also called accounting rate of return. Managers rarely use this measurement to make decisions. The components reflect tax and accounting figures, not market values or cash flows.

9. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 9 McGraw-Hill/Irwin Payback  The payback period of a project is the number of years it takes before the cumulative forecasted cash flow equals the initial outlay.  The payback rule says only accept projects that “payback” in the desired time frame.  This method is flawed, primarily because it ignores later year cash flows and the the present value of future cash flows.

10. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 10 McGraw-Hill/Irwin Payback Example Examine the three projects and note the mistake we would make if we insisted on only taking projects with a payback period of 2 years or less.

11. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 11 McGraw-Hill/Irwin Payback Example Examine the three projects and note the mistake we would make if we insisted on only taking projects with a payback period of 2 years or less.

12. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 12 McGraw-Hill/Irwin Internal Rate of Return  The discount rate that makes NPV zero  Accept the project, if Internal Rate of Return is greater than the Required return, IRR > r

13. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 13 McGraw-Hill/Irwin Internal Rate of Return Example You can purchase a turbo powered machine tool gadget for $4,000. The investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment?

14. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 14 McGraw-Hill/Irwin Internal Rate of Return Example You can purchase a turbo powered machine tool gadget for $4,000. The investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment?

15. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 15 McGraw-Hill/Irwin Internal Rate of Return IRR=28%

16. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 16 McGraw-Hill/Irwin Internal Rate of Return Pitfall 1 - Lending or Borrowing?  With some cash flows (as noted below) the NPV of the project increases s the discount rate increases.  This is contrary to the normal relationship between NPV and discount rates.

17. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 17 McGraw-Hill/Irwin Internal Rate of Return Pitfall 2 - Multiple Rates of Return  Certain cash flows can generate NPV=0 at two different discount rates.  The following cash flow generates NPV=$A 3.3 million at both IRR% of (-44%) and +11.6%. Cash Flows (millions of Australian dollars)

18. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 18 McGraw-Hill/Irwin Internal Rate of Return Pitfall 2 - Multiple Rates of Return  Certain cash flows can generate NPV=0 at two different discount rates.  The following cash flow generates NPV=$A 3.3 million at both IRR% of (-44%) and +11.6%. 600 NPV 300 0 -30 -600 Discount Rate IRR=11.6% IRR=-44%

19. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 19 McGraw-Hill/Irwin Internal Rate of Return Pitfall 2 - Multiple Rates of Return  It is possible to have no IRR and a positive NPV –(NPV is positive at all discount rates)

20. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 20 McGraw-Hill/Irwin Internal Rate of Return Pitfall 3 - Mutually Exclusive Projects  IRR sometimes ignores the magnitude of the project.  The following two projects illustrate that problem.

21. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 21 McGraw-Hill/Irwin Internal Rate of Return Pitfall 3 - Mutually Exclusive Projects

22. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 22 McGraw-Hill/Irwin Internal Rate of Return Pitfall 4 - Term Structure Assumption  We assume that discount rates are stable during the term of the project.  This assumption implies that all funds are reinvested at the IRR.  This is a false assumption.

23. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 23 McGraw-Hill/Irwin Profitability Index  When resources are limited, the profitability index (PI) provides a tool for selecting among various project combinations and alternatives  A set of limited resources and projects can yield various combinations.  The highest weighted average PI can indicate which projects to select.

24. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 24 McGraw-Hill/Irwin Profitability Index Cash Flows ($ millions) Suppose you only have 10 to invest. Choose (A) or (B and C)?

25. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 25 McGraw-Hill/Irwin Profitability Index Cash Flows ($ millions)

26. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 26 McGraw-Hill/Irwin Web Resources www.invest-faq.com/articles/analy-int-rate-return.html www.rebuild.org/lawson/irr.asp www.hud.gov/offices/cpd/affordablehousing/training/ener gy/cost/payback.cfm www.unix.mcs.anl.gov/otc/Guide/faq/linear-programming- faq.html www.faqs.org/faqs/linear-programming-faq/ Click to access web sites Internet connection required