1. Net Present Value and Other Investment Criteria Chapter 9

2. Prof. Oh, Spring 12Ch9-1 Corporate Finance Key Concepts  Net Present Value (NPV) Rule  Internal Rate of Return (IRR) Rule  Profitability Index (PI) Rule  Payback Rule  Average Accounting Return (AAR) Rule

3. Prof. Oh, Spring 12Ch9-2 Corporate Finance The Net Present Value (NPV)  Net Present Value  = After-tax cash flow at time t  = Discount rate reflecting the project’s risk  I = Initial investment costs

4. Prof. Oh, Spring 12Ch9-3 Corporate Finance NPV – Decision Rule  If the NPV is positive, accept the project  If NPV < 0, then reject it.  A positive NPV means that the project is expected to add value to the firm

5. Prof. Oh, Spring 12Ch9-4 Corporate Finance Computing NPV for the Project  A pharmaceutical company is going to invest $100 million for developing a new drug. The drug is expected to generate $20 million after-tax cash flow for 15 years from now on. If the required return on the project is 10%, what is the NPV of the project? What if the required return goes up to 20%?

6. Prof. Oh, Spring 12Ch9-5 Corporate Finance NPV Solution = 10% p.a. = 20% p.a.

7. Prof. Oh, Spring 12Ch9-6 Corporate Finance Internal Rate of Return (IRR)  IRR is the return that makes NPV equal to 0  IRR Rule: Accept the project if the IRR is greater than the required return  If IRR <, then reject it.

8. Prof. Oh, Spring 12Ch9-7 Corporate Finance IRR Example  In case of the previous pharmaceutical company, the IRR is  Trial and error or financial calculator will give you IRR = 18.4%.  If Rp < 18.4%, then accept it

9. Prof. Oh, Spring 12Ch9-8 Corporate Finance NPV Vs. IRR  NPV and IRR will generally give us the same decision  Exceptions Non-conventional cash flows – cash flow signs change more than once Mutually exclusive projects – If you choose one project, you can’t have the other.

10. Prof. Oh, Spring 12Ch9-9 Corporate Finance Non-conventional Cash Flows  Suppose an investment will cost $90,000 initially and will generate the following cash flows: Year 1: 132,000 Year 2: 100,000 Year 3: -150,000  The required return is 15%.  Should we accept or reject the project?

11. Prof. Oh, Spring 12Ch9-10 Corporate Finance NPV Profile IRR = 10.11% and 42.66%

12. Prof. Oh, Spring 12Ch9-11 Corporate Finance Mutually Exclusive Projects PeriodProject AProject B 0-500-400 1325 2 200 IRR19.43%22.17% NPV64.0560.74 The required return for both projects is 10%. Which project should you accept and why?

13. Prof. Oh, Spring 12Ch9-12 Corporate Finance NPV Profiles IRR for A = 19.43% IRR for B = 22.17% Crossover Point = 11.8%

14. Prof. Oh, Spring 12Ch9-13 Corporate Finance 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

15. Prof. Oh, Spring 12Ch9-14 Corporate Finance Profitability Index  PI = (I + NPV)/I = 1 + NPV/I  A profitability index of 1.1 implies that for every $1 of investment, we create an additional $0.10 in value  This measure can be very useful in situations where we have limited capital

16. Prof. Oh, Spring 12Ch9-15 Corporate Finance Profitability Index Example  What do you choose among the following projects when you have $6,000 as a budget?

17. Prof. Oh, Spring 12Ch9-16 Corporate Finance Payback Period  This is the time it takes to get the initial cost back  Decision Rule – Accept if the payback period is less than some preset limit  Problems Ignore time value of money Ignore cash flows occurring after the payback period Arbitrary preset limit

18. Prof. Oh, Spring 12Ch9-17 Corporate Finance Average Accounting Return  Average net income / average book value  Decision Rule: Accept the project if the AAR is greater than a preset cutoff rate.  Problems Accounting numbers can be cooked Ignore time value of money Do not consider risk, investment cost

19. Prof. Oh, Spring 12Ch9-18 Corporate Finance 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

20. Prof. Oh, Spring 12Ch9-19 Corporate Finance

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