Presentation on theme: "Good Decision Criteria"— Presentation transcript:
0 Net Present Value and Other Investment Criteria 9Net Present Value and Other Investment CriteriaRevised by DBH, January 2006
1 Good Decision Criteria We need to ask ourselves the following questions when evaluating capital budgeting decision rulesDoes the decision rule adjust for the time value of money?Does the decision rule adjust for risk?Does the decision rule provide information on whether we are creating value for the firm?
2 Project Example Information You are looking at a new project and you have estimated the following cash flows:Year 0: CF = -165,000Year 1: CF = 63,120; NI = 13,620Year 2: CF = 70,800; NI = 3,300Year 3: CF = 91,080; NI = 29,100Average Book Value = 72,000Your required return for assets of this risk is 12%.This example will be used for each of the decision rules so that the students can compare the different rules and see that conflicts can arise. This illustrates the importance of recognizing which decision rules provide the best information for making decisions that will increase owner wealth.
3 Payback PeriodHow long does it take to get the initial cost back in a nominal sense?ComputationEstimate the cash flowsSubtract the future cash flows from the initial cost until the initial investment has been recoveredDecision Rule – Accept if the payback period is less than some preset limit
4 Computing Payback For The Project Assume we will accept the project if it pays back within two years.Year 1: 165,000 – 63,120 = 101,880 still to recoverYear 2: 101,880 – 70,800 = 31,080 still to recoverYear 3: 31,080 – 91,080 = -60,000 project pays back in year 3Do we accept or reject the project?The payback period is year 3 if you assume that the cash flows occur at the end of the year as we do with all of the other decision rules.If we assume that the cash flows occur evenly throughout the year, then the project pays back in 2.34 years.Either way, the payback rule would say to reject the project.
5 Decision Criteria Test - Payback Does the payback rule account for the time value of money? (No)Does the payback rule account for the risk of the cash flows? (No)Does the payback rule provide an indication about the increase in value? (No)Should we consider the payback rule for our primary decision rule? (No)The answer to all of these questions is no.
6 Advantages and Disadvantages of Payback Easy to understandAdjusts for uncertainty of later cash flowsBiased towards liquidityDisadvantagesIgnores the time value of moneyRequires an arbitrary cutoff pointIgnores cash flows beyond the cutoff dateBiased against long-term projects, such as research and development, and new projects
7 AAR and Discounted Payback Discounted payback is a variation on the payback rule that does allow for the time value of money, but still requires an arbitrary cutoff.Average Accounting Return (AAR) doesn’t even measure cash flows, but only whether average accounting income from the project = a set percentage of returnNeither effectively measures whether a long-term investment has added value to the firm. For sake of time, we will ignore these methods.
8 Net Present ValueThe difference between the market value of a project and its costHow much value is created from undertaking an investment?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.We learn how to estimate the cash flows in chapter 9.We learn how to estimate the required return in chapter 12.
9 NPV – Decision Rule If the NPV is positive, accept the project A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners.Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal.
10 Computing NPV for the Project Using the formulas:NPV = 63,120/(1.12) + 70,800/(1.12)2 + 91,080/(1.12)3 – 165,000 = 12,627.42Many financial calculators also have templates for calculating NPVEasiest to calculate using a computerized spreadsheet (See Excel, next slide):Do we accept or reject the project?Again, the calculator used for the illustration is the TI- BA-II plus. The basic procedure is the same, you start with the year 0 cash flow and then enter the cash flows in order. F01, F02, etc. are used to set the frequency of a cash flow occurrence. Many of the calculators only require you to use that if the frequency is something other than 1.Since we have a positive NPV, we should accept the project.
11 NPV using ExcelSince NPV is positive at 12%, we should accept the investment.
12 Decision Criteria Test - NPV Does the NPV rule account for the time value of money? (Yes)Does the NPV rule account for the risk of the cash flows? (Yes)Does the NPV rule provide an indication about the increase in value? (Yes)Should we consider the NPV rule for our primary decision rule? (Yes)The answer to all of these questions is yesThe risk of the cash flows is accounted for through the choice of the discount rate.
13 Internal Rate of Return This is the most important alternative to NPVIt is often used in practice and is intuitively appealingIt is based entirely on the estimated cash flows and is independent of interest rates found elsewhereThe IRR rule is very important. Management, and individuals in general, often have a much better feel for percentage returns and the value that is created, than they do for dollar increases. A dollar increase doesn’t appear to provide as much information if we don’t know what the initial expenditure was. Whether or not the additional information is relevant is another issue.
14 IRR – Definition and Decision Rule Definition: IRR is the return that makes the NPV = 0Decision Rule: Accept the project if the IRR is greater than the required return
15 Computing IRR For The Project If you do not have a financial calculator, then this becomes a trial and error processAgain many financial calculators have templates for estimating IRRBut IRR is most easily estimated using a spreadsheet (See Excel, next slide)Do we accept or reject the project?Many of the financial calculators will compute the IRR as soon as it is pressed; others require that you press compute.
16 IRR using ExcelDBH suggestion: Use the required return as the “guess” rate requested by the Excel function (in this case 12%) Since 16.13% > 12% we would accept the project.
17 Decision Criteria Test - IRR Does the IRR rule account for the time value of money? (Yes)Does the IRR rule account for the risk of the cash flows? (Yes)Does the IRR rule provide an indication about the increase in value? (Yes, by %)Should we consider the IRR rule for our primary decision criteria? (Not primary, see following slides)The answer to all of these questions is yes, although it is not always as obvious.The IRR rule accounts for time value because it is finding the rate of return that equates all of the cash flows on a time value basis.The IRR rule accounts for the risk of the cash flows because you compare it to the required return, which is determined by the risk of the project.The IRR rule provides an indication of value because we will always increase value if we can earn a return greater than our required return.We should consider the IRR rule as our primary decision criteria, but as we will see, it has some problems that the NPV does not have. That is why we end up choosing the NPV as our ultimate decision rule.
18 Advantages of IRR Knowing a return is intuitively appealing It is a simple way to communicate the value of a project to someone who doesn’t know all the estimation detailsIf the IRR is high enough, you may not need to estimate a required return, which is often a difficult taskYou should point out, however, that if you get a very large IRR that you should go back and look at your cash flow estimation again. In competitive markets, extremely high IRRs should be rare.Also, since the IRR calculation assumes that you can reinvest future cash flows at the IRR, a high IRR may be unrealistic.
19 Summary of Decisions For The Project Net Present ValueAcceptPayback PeriodRejectDiscounted Payback PeriodAverage Accounting ReturnInternal Rate of ReturnSo what should we do – we have two rules that indicate to accept and three that indicate to reject.
20 NPV Vs. IRR NPV and IRR will generally give us the same decision ExceptionsNon-conventional cash flows – cash flow signs change more than onceMutually exclusive projectsInitial investments are substantially differentTiming of cash flows is substantially different
21 IRR and Non-conventional Cash Flows When the cash flows change sign more than once, there is more than one IRRWhen 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 equationIf multiple IRR’s are calculated, none are then reliable.
22 Another Example – Non-conventional Cash Flows Suppose an investment will cost $90,000 initially and will generate the following cash flows:Year 1: 132,000Year 2: 100,000Year 3: -150,000The required return is 15%.Should we accept or reject the project?NPV = 132,000 / ,000 / (1.15)2 – 150,000 / (1.15)3 – 90,000 = 1,769.54Calculator: CF0 = -90,000; C01 = 132,000; F01 = 1; C02 = 100,000; F02 = 1; C03 = -150,000; F03 = 1; I = 15; CPT NPV =If you compute the IRR on the calculator, you get 10.11% because it is the first one that you come to.So, if you just blindly use the calculator without recognizing the uneven cash flows, NPV would say to accept and IRR would say to reject.
24 Summary of Decision Rules The NPV is positive at a required return of 15%, so you should AcceptIf you use the financial calculator or spreadsheet, you would get an IRR of 10.11% which would tell you to RejectYou need to recognize when there are non-conventional cash flows and look at the NPV profile
25 IRR and Mutually Exclusive Projects If you choose one, you can’t choose the otherExample: You can choose to attend graduate school at either Harvard or Stanford, but not bothIntuitively you would use the following decision rules:NPV – choose the project with the higher NPVIRR – choose the project with the higher IRR
26 Example With Mutually Exclusive Projects PeriodProject AProject B-500-40013252200IRR19.43%22.17%NPV64.0560.74The required return for both projects is 10%.Which project should you accept and why?As long as we do not have limited capital, we should choose project A. Students will often argue that you should choose B because then you can invest the additional $100 in another good project, say C. The point is that if we do not have limited capital, we can invest in A and C and still be better off.If we have limited capital, then we will need to examine what combinations of projects with A provide the highest NPV and what combinations of projects with B provide the highest NPV. You then go with the set that will create the most value. If you have limited capital and a large number of mutually exclusive projects, then you will want to set up a computer program to determine the best combination of projects within the budget constraints.The important point is that we DO NOT use IRR to choose between projects regardless of whether or not we have limited capital.Project A has a smaller IRR but it is a larger project, thus generating greater value to the firmIRR can’t measure that, but NPV can.
27 Conflicts Between NPV and IRR NPV directly measures the increase in value to the firmWhenever there is a conflict between NPV and another decision rule, you should always use NPVIRR is unreliable in the following situationsNon-conventional cash flowsMutually exclusive projects
28 Profitability IndexMeasures the benefit per unit cost, based on the time value of moneyA profitability index of 1.1 implies that for every $1 of investment, we create an additional $0.10 in valueThis measure can be very useful in situations in which we have limited capital
29 Advantages and Disadvantages of Profitability Index Closely related to NPV, generally leading to identical decisionsEasy to understand and communicateMay be useful when available investment funds are limitedDisadvantagesMay lead to incorrect decisions in comparisons of mutually exclusive investments
30 Capital Budgeting In Practice We should consider several investment criteria when making decisionsNPV and IRR are the most commonly used primary investment criteriaPayback is a commonly used secondary investment criteriaEven though payback and AAR should not be used to make the final decision, we should consider the project very carefully if they suggest rejection. There may be more risk than we have considered or we may want to pay additional attention to our cash flow estimations. Sensitivity and scenario analysis can be used to help us evaluate our cash flows.The fact that payback is commonly used as a secondary criteria may be because short paybacks allow firms to have funds sooner to invest in other projects without going to the capital markets
31 Summary – Discounted Cash Flow Criteria Net present valueDifference between market value and costTake the project if the NPV is positiveHas no serious problemsPreferred decision criterionInternal rate of returnDiscount rate that makes NPV = 0Take the project if the IRR is greater than the required returnSame decision as NPV with conventional cash flowsIRR is unreliable with non-conventional cash flows or mutually exclusive projectsProfitability IndexBenefit-cost ratioTake investment if PI > 1Cannot be used to rank mutually exclusive projectsMay be used to rank projects in the presence of capital rationing
32 Summary – Payback Criteria Payback periodLength of time until initial investment is recoveredTake the project if it pays back in some specified periodDoesn’t account for time value of money and there is an arbitrary cutoff periodDiscounted payback periodLength of time until initial investment is recovered on a discounted basisThere is an arbitrary cutoff period
33 Quick QuizConsider an investment that costs $100,000 and has a cash inflow of $25,000 every year for 5 years. The required return is 9% and required payback is 4 years.What is the payback period? (4 yrs)What is the NPV? (-2,758.72)What is the IRR? ( 7.93%)Should we accept the project? (No)What decision rule should be the primary decision method?When is the IRR rule unreliable?Payback period = 4 yearsThe project does not pay back on a discounted basis.NPV =IRR = 7.93%
34 Quiz using Excel Year 0 -$100,000 Year 1 $25,000 Year 2 Year 3 Year 4 IRR7.93%NPV at 9%$97,241.28-Original Inv.NPV($2,758.72)Reject project!
35 Class CasePause here to work in-class NPV / IRR case for Wally’s Widget Works: