Week 7 Chapter 9

Chapter Seven
Net Present Value and Other Investment Criteria
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright
7-1
Chapter Organisation
7.1 Net Present Value 7.2 The Payback Rule 7.3 The Discounted Payback Rule 7.4 The Accounting Rate of Return 7.5 The Internal Rate of Return 7.6 The Present Value Index 7.7 The Practice of Capital Budgeting 7.8 Summary and Conclusions
7-2
Chapter Objectives
Discuss the various investment evaluation
techniques, including their advantages and disadvantages.

Apply these techniques to the evaluation of
projects.
Interpret the results of the application of these
techniques in accordance with their respective decision rules.

Understand the importance of net present value.
7-3
Net Present Value (NPV)

Net present value is the difference between an
investments market value (in todays dollars) and its cost (also in todays dollars).
Net present value is a measure of how much value
is created by undertaking an investment.

Estimation of the future cash flows and the
discount rate are important in the calculation of the NPV.

7-4
Net Present Value

Steps in calculating NPV:
The first step is to estimate the expected future
cash flows. The second step is to estimate the required return for projects of this risk level. The third step is to find the present value of the cash flows and subtract the initial investment.
7-5
NPV Illustrated
0 Initial outlay ($1100) Revenues Expenses Cash flow $1100.00 $500 x +454.55 1 1.10 $1000 x 1 $1000 500 $500 Revenues Expenses 2 $2000 1000
Cash flow $1000
1
1.102
+826.45
+$181.00 NPV
7-6
NPV
An investment should be accepted if the NPV is
positive and rejected if it is negative.

NPV is a direct measure of how well the
investment meets the goal of financial managementto increase owners wealth.

A positive NPV means that the investment is
expected to add value to the firm.

7-7
Payback Period
The amount of time required for an investment to generate cash flows to recover its initial cost. Estimate the cash flows. Accumulate the future cash flows until they equal the initial investment. The length of time for this to happen is the payback period.
An investment is acceptable if its calculated payback is less than some prescribed number of years.
7-8
Payback Period Illustrated

Initial investment = $1000 Year 1 2 3 Cash flow $200 400 600 Accumulated Cash flow $200 600 1200
Year
1 2 3
Payback period = 2 2/3 years

7-9
Advantages of Payback Period
Easy to understand. Adjusts for uncertainty of later cash flows. Biased towards liquidity.
7-10
Disadvantages of Payback Period

Time value of money and risk ignored. Arbitrary determination of acceptable payback
period.
Ignores cash flows beyond the cut-off date.
Biased against long-term and new projects.
7-11
Discounted Payback Period

The length of time required for an investments
discounted cash flows to equal its initial cost.

Takes into account the time value of money. More difficult to calculate. An investment is acceptable if its discounted
payback is less than some prescribed number of years.

7-12
ExampleDiscounted Payback
Initial investment = $1000 R = 10% PV of Year Cash flow Cash flow 1 $200 $182
2 3 4 400 700 300 331 526 205
7-13
ExampleDiscounted Payback (continued)

Accumulated discounted cash flow $182 513 1039 1244
Year 1 2 3 4
Discounted payback period is just under three years

7-14
Ordinary and Discounted Payback

Initial investment = $300 R = 12.5% Cash Flow
Year Undiscounted
Accumulated Cash Flow

Discounted Undiscounted Discounted
1 2 3 4 5
$ 100 100 100 100 100
$ 89 79 70 62 55
$ 100 200 300 400 500
$89 168 238 300 355
Ordinary payback? Discounted payback?

7-15
Advantages and Disadvantages of Discounted Payback
Advantages
Disadvantages May reject positive NPV investments Arbitrary determination of acceptable payback period Ignores cash flows beyond the cutoff date Biased against long-term and new products
- Includes time value of money - Easy to understand - Does not accept negative estimated NPV investments - Biased towards liquidity
7-16
Accounting Rate of Return (ARR)

Measure of an investments profitability.
average net profit ARR average book value

A project is accepted if ARR > target average
accounting return.
7-17
ExampleARR
Year 1 Sales Expenses Gross profit Depreciation Taxable income Taxes (25%) Net profit $440 220 220 80 140 35 $105 2 $240 120 120 80 40 10 $30 3 $160 80 80 80 0 0 $0
Assume initial investment = $240

7-18
ExampleARR (continued)
$105 $30 $0 Average net profit 3 $45 Average book value Initial investment Salvage value 2 $240 $0 2 $120
7-19
ExampleARR (continued)
Average net profit Average book value $45 $120 37.5%
ARR
7-20
Disadvantages of ARR
The measure is not a true reflection of return. Time value is ignored.
Arbitrary determination of target average return.

Uses profit and book value instead of cash flow
and market value.
7-21
Advantages of ARR
Easy to calculate and understand. Accounting information almost always available.
7-22
Internal Rate of Return (IRR)

The discount rate that equates the present value of
the future cash flows with the initial cost.

Generally found by trial and error.
A project is accepted if its IRR is > the required
rate of return.
The IRR on an investment is the required return
that results in a zero NPV when it is used as the discount rate.

7-23
ExampleIRR
Initial investment = $200
Year
1 2 3
Cash flow
$ 50 100 150
n Find the IRR such that NPV = 0
0 = 200 +
50 (1+IRR)1 + +
100 (1+IRR)2 + +
150 (1+IRR)3
50 200 = (1+IRR)1
100 (1+IRR)2
150 (1+IRR)3
7-24
ExampleIRR (continued)
Trial and Error Discount rates 0% 5% NPV $100 68
10% 15%
20%
41 18
2
IRR is just under 20%about 19.44%

7-25
NPV Profile
Net present value 120 100 80 60 40 20 0 20 40 2% 6% 10% 14% 18% IRR 22% Discount rate Year 0 1 2 3 4 Cash flow $275 100 100 100 100
7-26
Problems with IRR

More than one negative cash flow multiple rates
of return.
Project is not independent mutually exclusive
investments. Highest IRR does not indicate the best project.
Advantages of IRR
Popular in practice
Does not require a discount rate
7-27
Multiple Rates of Return

Assume you are considering a project for which the cash flows are as follows:
Year
0 1 2 3 4
Cash flows
$252 1431 3035 2850 1000
7-28

n Whats the IRR? Find the rate at which
the computed NPV = 0:

at 25.00%: at 33.33%: at 42.86%: at 66.67%: NPV = NPV = NPV = NPV = 0 0 0 0
n Two questions:
u
u
1. Whats going on here? 2. How many IRRs can there be?

7-29

NPV $0.06 $0.04 IRR = 25%
$0.02
$0.00
($0.02)
IRR = 33.33%
IRR = 66.67% IRR = 42.86%
($0.04)
($0.06)
($0.08) 0.2 0.28 0.36 0.44 0.52 Discount rate 0.6 0.68
7-30
IRR and Non-conventional Cash Flows

When the cash flows change sign more than once,
there is more than one IRR. When you solve for IRR you are solving for the root of an equation and when you cross the x axis more than once, there will be more than one return that solves the equation. If you have more than one IRR, you cannot use any of them to make your decision.
7-31
IRR, NPV and Mutually-exclusive Projects

Net present value 160 140 120 100 80 60 40 20 0 20 40 60 80 100 0 2% 6% 10% 14% IRR A
Year 0 Project A: Project B: $350 $250 1 50 125 2 100 100 3 150 75 4 200 50
Crossover Point
Discount rate 18% IRRB 22% 26%
7-32
Present Value Index (PVI)

(Profitability Index)
Expresses a projects benefits relative to its initial
cost.
PV of inflows PVI Initial cost
7-33
Present Value Index (PVI)

Expresses a projects benefits relative to its
initial cost.
PV of inflows PVI Initial cost

Accept a project with a PVI > 1.0.
7-34
ExamplePVI
Assume you have the following information on Project X: Initial investment = $1100 Required return = 10%
Annual cash revenues and expenses are as follows: Year 1 2 Revenues $1000 2000 Expenses $500 1000
7-35
ExamplePVI (continued)
500 1 000 NPV 1100 1.10 1.102 $181 181 1100 PVI 1100 1.1645
7-36
500 1 000 NPV 1100 2 1.10 1.10 Net Present Value Index $181 = 181 181 1100 PVI 1100 1.1645
1100 = 0.1645
7-37
Is this a good project? If so, why?
7-38
Is this a good project? If so, why?
This is a good project because the present value of
the inflows exceeds the outlay.

Each dollar invested generates $1.1645 in value or
$0.1645 in NPV.
7-39
Advantages and Disadvantages of PVI (and NPVI)

Advantages
-
Disadvantages
-
Closely related to NPV, generally leading to identical decisions.
- Easy to understand. - May be useful when available investment funds are limited.
May lead to incorrect decisions in comparisons of mutually exclusive investments.
7-40
Capital Budgeting in Practice

We should consider several investment criteria
when making decisions.

NPV and IRR are the most commonly used primary
investment criteria.
Payback is a commonly used secondary
investment criteria.
7-41

Week 7 Chapter 9

Enviado por

Dados do documento

Direitos autorais

Formatos disponíveis

Compartilhar este documento

Compartilhar ou incorporar documento

Opções de compartilhamento

Você considera este documento útil?

Este conteúdo é inapropriado?

Direitos autorais:

Formatos disponíveis

Week 7 Chapter 9

Enviado por

Direitos autorais:

Formatos disponíveis

Chapter Seven

Net Present Value and Other Investment Criteria

techniques, including their advantages and disadvantages.

techniques in accordance with their respective decision rules.

Net Present Value (NPV)

is created by undertaking an investment.

discount rate are important in the calculation of the NPV.

Net Present Value

Cash flow $1000

positive and rejected if it is negative.

investment meets the goal of financial managementto increase owners wealth.

expected to add value to the firm.

Payback Period Illustrated

Payback period = 2 2/3 years

Advantages of Payback Period

Disadvantages of Payback Period

Biased against long-term and new projects.

Discounted Payback Period

discounted cash flows to equal its initial cost.

payback is less than some prescribed number of years.

ExampleDiscounted Payback (continued)

Discounted payback period is just under three years

Ordinary and Discounted Payback

Accumulated Cash Flow

$ 100 100 100 100 100

$ 100 200 300 400 500

$89 168 238 300 355

Ordinary payback? Discounted payback?

Advantages and Disadvantages of Discounted Payback

Accounting Rate of Return (ARR)

average net profit ARR average book value

Assume initial investment = $240

Arbitrary determination of target average return.

and market value.

Internal Rate of Return (IRR)

the future cash flows with the initial cost.

A project is accepted if its IRR is > the required

that results in a zero NPV when it is used as the discount rate.

n Find the IRR such that NPV = 0

IRR is just under 20%about 19.44%

Problems with IRR

investments. Highest IRR does not indicate the best project.

Does not require a discount rate

Multiple Rates of Return

Multiple Rates of Return

the computed NPV = 0:

1. Whats going on here? 2. How many IRRs can there be?

Multiple Rates of Return

IRR = 66.67% IRR = 42.86%

IRR and Non-conventional Cash Flows

IRR, NPV and Mutually-exclusive Projects

Discount rate 18% IRRB 22% 26%

Present Value Index (PVI)

Expresses a projects benefits relative to its initial

PV of inflows PVI Initial cost

Present Value Index (PVI)

PV of inflows PVI Initial cost

Is this a good project? If so, why?

the inflows exceeds the outlay.

Advantages and Disadvantages of PVI (and NPVI)

Closely related to NPV, generally leading to identical decisions.

May lead to incorrect decisions in comparisons of mutually exclusive investments.

Capital Budgeting in Practice

when making decisions.