1. 0 Corporate Finance Ross  Westerfield  Jaffe Seventh Edition 6 Chapter Six Some Alternative Investment Rules

2. 1 Chapter Outline 6.1 Why Use Net Present Value? 6.2 The Payback Period Rule 6.3 The Discounted Payback Period Rule 6.4 The Average Accounting Return 6.5 The Internal Rate of Return 6.6 Problems with the IRR Approach 6.7 The Profitability Index

3. 2 6.1 Why Use Net Present Value? Accepting positive NPV projects benefits shareholders. The discount rate on a risky project is the return that one can expect to earn on a financial asset of comparable risk. This discount rate is often referred to as an opportunity cost.

4. 3 The Net Present Value (NPV) Rule Net Present Value (NPV) = -Initial Investment +Total PV of future CF ’ s Estimating NPV: –1. Estimate future cash flows: how much? and when? –2. Estimate discount rate –3. Estimate initial costs Minimum Acceptance Criteria: Accept if NPV > 0 Ranking Criteria: Choose the highest NPV

5. 4 Good Attributes of the NPV Rule 1. Uses cash flows 2. Uses ALL cash flows of the project 3. Discounts ALL cash flows properly Reinvestment assumption: the NPV rule assumes that all cash flows can be reinvested at the discount rate.

6. 5 6.2 The Payback Period RulePayback Period How long does it take the project to “ pay back ” its initial investment? Payback Period = number of years to recover initial costs Minimum Acceptance Criteria: –set by management Ranking Criteria: –set by management

7. 6 The Payback Period Rule (continued) Disadvantages: –Ignores the time value of money –Ignores cash flows after the payback period –Requires an arbitrary acceptance criteria Advantages: –Easy to understand –Biased toward liquidity

8. 7 The payback rule is often used by: large and sophisticated companies when making relatively small decisions, or firms with very good investment opportunities but no available cash (small, privately held firms with good growth prospects but limited access to the capital markets).

9. 8 6.3 The Discounted Payback Period Rule How long does it take the project to “ pay back ” its initial investment taking the time value of money into account? Two other problems with the payback method still exist.

10. 9 6.4 The Average Accounting Return RuleAverage Accounting Return Ranking Criteria and Minimum Acceptance Criteria set by management Disadvantages: –Ignores the time value of money –Uses an arbitrary benchmark cutoff rate –Based on book values, not cash flows and market values Advantages: –The accounting information is usually available –Easy to calculate

11. 10 6.5 The Internal Rate of Return (IRR) Rule IRR: the discount that sets NPV to zero Minimum Acceptance Criteria: –Accept if the IRR exceeds the required return. Ranking Criteria: –Select alternative with the highest IRR Reinvestment assumption: –All future cash flows assumed reinvested at the IRR. Disadvantages: –Does not distinguish between investing and borrowing. –IRR may not exist or there may be multiple IRR –Problems with mutually exclusive investments Advantages: –Easy to understand and communicate

12. 11 The Internal Rate of Return: Example Consider the following project: 0123 $50$100$150 -$200 The internal rate of return for this project is 19.44%

13. 12 6.6 Problems with the IRR Approach Are We Borrowing or Lending? Multiple IRRs. The Scale Problem. The Timing Problem.

14. 13 Definition of Independent and Mutually Exclusive Projects –Independent project: one whose acceptance or rejection is independent of the acceptance or rejection of other projects. –Mutually exclusively investments: you can accept A or B, or reject both of them, but you can not accept both of them.

15. 14 –The Scale Problem We can handle any mutually exclusive example in one of three ways: –Compare the NPVs of the two choices. –Compare the incremental NPV from making the large- budget picture. –Compare the incremental IRR to the discount rate. We must not compare the IRRs of the two projects.

16. 15 The Timing Problem The NPV of investment B is higher with low discount rates, and the NPV of investment A of investment is higher with high discount rates. We also can select the better project with one of three different methods, but we should not compare the IRRs of the two projects. When working with mutually exclusive projects, we should simply use either an incremental IRR or an NPV approach.

17. 16 6.7 The Profitability Index (PI) Rule Minimum Acceptance Criteria: –Accept if PI > 1 Ranking Criteria: –Select alternative with highest PI Disadvantages: –Problems with mutually exclusive investments Advantages: –May be useful when available investment funds are limited –Easy to understand and communicate –Correct decision when evaluating independent projects

18. 17 We consider three possibilities: –Independent Projects Accept an independent project if PI>1. Reject if PI<1. –Mutually Exclusive Projects The PI may lead to a wrong selection, because, like IRR, it ignores differences of scale for mutually exclusive projects. However, the flaw can be corrected using incremental analysis. –Capital Rationing When a firm does not have enough capital to fund all positive NPV projects, they can use PI to make decisions. The PI cannot handle capital rationing over multiple time periods.

19. 18 6.8 The Practice of Capital Budgeting Varies by industry: –Some firms use payback, others use accounting rate of return. The most frequently used technique for large corporations is IRR or NPV.

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