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T9.1 Chapter Outline Chapter 9 Net Present Value and Other Investment Criteria Chapter Organization 9.1Net Present Value 9.2The Payback Rule 9.3The Average Accounting Return 9.4The Internal Rate of Return 9.5The Profitability Index 9.6The Practice of Capital Budgeting 9.7Summary and Conclusions CLICK MOUSE OR HIT SPACEBAR TO ADVANCE Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd.

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 2 Capital Budgeting In Chapter 1 we defined capital budgeting as ‘the process of planning and managing a firm’s investment in fixed assets’ ...probably the most or at least one of the most important issues in corporate finance. Identifying investment opportunities which offer more value to the firm than their cost - the value of the future cash flows need to be greater than the investment required estimating the size, timing and risk of future cash flows is the most challenging aspect of capital budgeting

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 3 Investment Criteria NPV - Net Present Value the difference between an investment’s market value and its cost Payback - the length of time it takes to recover the initial investment Discounted Payback the length of time required for an investment’s discounted cash flows to equal its initial cost Average Accounting Return - AAR an investment’s average net income divided by its average book value Internal Rate of Return the discount rate that makes the NPV of an investment equal to zero

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 4 Investment Critieria cont’d The Profitability Index- “PI’ ‘The present value of an investment’s future cash flows divided by its initial cost - also known as the benefit/cost ratio

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 5 T9.2 NPV Illustrated Estimate future cash flows, calculate the PV of these cash flows and then compare to cost of project to arrive at NPV Assume you have the following information on Project X: Initial outlay -$1,100Required return = 10% Annual cash revenues and expenses are as follows: Year Revenues Expenses 1 $1,000 $500 2 2,000 1,000 Draw a time line and compute the NPV of project X.

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 6 T9.2 NPV Illustrated (concluded) 0 1 2 Initial outlay ($1,100) Revenues$1,000 Expenses500 Cash flow$500 Revenues$2,000 Expenses1,000 Cash flow$1,000 – $1,100.00 +454.55 +826.45 +$181.00 1 $500 x 1.10 1 $1,000 x 1.10 2 NPV

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 7 T9.3 Underpinnings of the NPV Rule The foundation of the NPV approach: A “firm” is created when securityholders supply the funds to acquire assets that will be used to produce and sell a good or a service; The market value of the firm is based on the present value of the cash flows it is expected to generate; Additional investments are “good” if the present value of the incremental expected cash flows exceeds their cost; Thus, “good” projects are those which increase firm value - or, put another way, good projects are those projects that have positive NPVs! Conclusion - Invest only in projects with positive NPV’s.

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 8 Payback Rule ‘length of time it takes to recover the initial investment’ how long does the investment take before I recover my initial investment? - a break-even in an accounting sense but not in an economic sense The Payback ‘Rule’ - an investment is considered acceptabe if the payback is less than some prespecified time frame shortcomings of the payback rule vs the NPV ignores time value of money - simply adds up future cash flows ignores risk differences - payback is calculated the same way for projects that are risky and ‘safe’ projects determining the cut-off - what should the payback be?? Ignores the cash flows beyond the payback cut-off

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 9 T9.4 Payback Rule Illustrated Initial outlay -$1,000 YearCash flow 1$200 2400 3600 Accumulated YearCash flow 1$200 2600 31,200 Payback period = 2 2/3 years

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 10 Discounted Payback The same basic concept in how long does it take to recover the original investment but in this case the future cash flows are discounted. ‘the length of time it takes for an investment’s discounted cash flows to equal its initial cost.’ break-even in an economic sense What are its shortcomings? Cash flows beyond the cut-off point are ignored the cut-off point still has to be arbitrarily established

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 11 T9.5 Discounted Payback Illustrated Initial outlay -$1,000 R = 10% PV of Year Cash flow Cash flow 1$ 200$ 182 2400331 3700526 4300205 Accumulated Year discounted cash flow 1$ 182 2513 31,039 41,244 Discounted payback period is just under 3 years

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 12 T9.6 Ordinary and Discounted Payback (Table 9.3) Cash Flow Accumulated Cash Flow Year Undiscounted Discounted Undiscounted Discounted 1$100$89$100$89 210079200168 310070300238 410062400300 510055500355

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 13 Average Accounting Return ‘An investment’s average net income divided by its average book value’ or ‘Some measure of average accounting profit/some measure of average accounting value’ ....’a project is acceptable if its average accounting return exceeds a target average accounting return Advantages easy to calculate readily available accounting information What are its shortcomings? Ignores time value of money - the average return does not differentiate between near term returns vs. Returns in the distant future focuses on net income and book value instead of cash flow and market value

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 14 T9.7 Average Accounting Return Illustrated Average net income: Year 1 2 3 Sales$440$240$160 Costs22012080 Gross profit22012080 Depreciation808080 Earnings before taxes140400 Taxes (25%)35100 Net income$105$30$0 Average net income = ($105 + 30 + 0)/3 = $45

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 15 T9.7 Average Accounting Return Illustrated (concluded) Average book value: Initial investment = $240 Average investment = ($240 + 0)/2 = $120 Average accounting return (AAR): Average net income $45 AAR = = = 37.5% Average book value $120

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 16 Internal Rate of Return or ‘IRR’ ‘the discount rate that makes the NPV of an investment equal to zero’ - sometimes called the discounted cash flow or ‘DCF return’ The IRR ‘rule’ suggest that an investment is acceptable if the IRR exceeds the required return. A viable alternative to the NPV model Used extensively in practice - provides a return figure when analyzing investments as opposed to a $ figure more difficult to calculate - requires trial and error

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 17 Internal Rate of Return What are the shortcomings of the IRR approach? Non -conventional cash flows make the calculation much more difficult Mutually exclusive Investments - meaning we can accept one project but not another that is under consideration

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 18 T9.8 Internal Rate of Return Illustrated Initial outlay = -$200 Year Cash flow 1$ 50 2100 3150 Find the IRR such that NPV = 0 50 100 150 0 = -200 + + + (1+IRR) 1 (1+IRR) 2 (1+IRR) 3 50 100 150 200 = + + (1+IRR) 1 (1+IRR) 2 (1+IRR) 3

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 19 T9.8 Internal Rate of Return Illustrated (concluded) Trial and Error Discount ratesNPV 0%$100 5%68 10%41 15%18 20%-2 IRR is just under 20% -- about 19.44%

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 20 Year Cash flow 0– $275 1100 2100 3100 4100 T9.9 Net Present Value Profile Discount rate 2% 6% 10% 14% 18% 120 100 80 60 40 20 Net present value 0 – 20 – 40 22% IRR

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 21 Assume you are considering a project for which the cash flows are as follows: Year Cash flows 0 -$252 1 1,431 2 -3,035 3 2,850 4 -1,000 T9.10 Multiple Rates of Return

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 22 T9.10 Multiple Rates of Return (continued) What’s the IRR? Find the rate at which the computed NPV = 0: at 25.00%:NPV = _______ at 33.33%:NPV = _______ at 42.86%:NPV = _______ at 66.67%:NPV = _______

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 23 T9.10 Multiple Rates of Return (continued) What’s the IRR? Find the rate at which the computed NPV = 0: at 25.00%:NPV = 0 at 33.33%:NPV = 0 at 42.86%:NPV = 0 at 66.67%:NPV = 0 Two questions: 1.What’s going on here? 2.How many IRRs can there be?

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 24 T9.10 Multiple Rates of Return (concluded) $0.06 $0.04 $0.02 $0.00 ($0.02) NPV ($0.04) ($0.06) ($0.08) 0.20.280.360.440.520.60.68 IRR = 1/4 IRR = 1/3 IRR = 3/7 IRR = 2/3 Discount rate

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 25 T9.11 IRR, NPV, and Mutually Exclusive Projects Discount rate 2% 6% 10% 14%18% 60 40 20 0 – 20 – 40 Net present value – 60 – 80 – 100 22% IRR A IRR B 0 140 120 100 80 160 Year 0 1 2 3 4 Project A:– $35050100150200 Project B:– $2501251007550 26% Crossover Point

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 26 Profitability Index - ‘PI’ ‘The present value of an investment’s future cash flows divided by its initial cost’ measures ‘bang for the buck’ or the value created per dollar invested Shortcomings does not recognize total market value added (as does the NPV approach) - thus when comparing mutually exclusive investments it can lead to incorrect decisions

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 27 T9.12 Profitability Index Illustrated Now let’s go back to the initial example - we assumed the following information on Project X: Initial outlay -$1,100Required return = 10% Annual cash benefits: YearCash flows 1 $ 500 2 1,000 What’s the Profitability Index (PI)?

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 28 T9.12 Profitability Index Illustrated (concluded) Previously we found that the NPV of Project X is equal to: ($454.55 + 826.45) - 1,100 = $1,281.00 - 1,100 = $181.00. The PI = PV inflows/PV outlay = $1,281.00/1,100 = 1.1645. This is a good project according to the PI rule. Can you explain why? It’s a good project because the present value of the inflows exceeds the outlay.

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 29 T9.13 Summary of Investment Criteria I. Discounted cash flow criteria A. Net present value (NPV). The NPV of an investment is the difference between its market value and its cost. The NPV rule is to take a project if its NPV is positive. NPV has no serious flaws; it is the preferred decision criterion. B. Internal rate of return (IRR). The IRR is the discount rate that makes the estimated NPV of an investment equal to zero. The IRR rule is to take a project when its IRR exceeds the required return. When project cash flows are not conventional, there may be no IRR or there may be more than one. C. Profitability index (PI). The PI, also called the benefit-cost ratio, is the ratio of present value to cost. The profitability index rule is to take an investment if the index exceeds 1.0. The PI measures the present value per dollar invested.

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 30 T9.13 Summary of Investment Criteria (concluded) II. Payback criteria A. Payback period. The payback period is the length of time until the sum of an investment’s cash flows equals its cost. The payback period rule is to take a project if its payback period is less than some prespecified cutoff. B. Discounted payback period. The discounted payback period is the length of time until the sum of an investment’s discounted cash flows equals its cost. The discounted payback period rule is to take an investment if the discounted payback is less than some prespecified cutoff. III. Accounting criterion A. Average accounting return (AAR). The AAR is a measure of accounting profit relative to book value. The AAR rule is to take an investment if its AAR exceeds a benchmark.

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 31 T9.14 The Practice of Capital Budgeting

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 32 T9.15 Chapter 9 Quick Quiz 1. Which of the capital budgeting techniques do account for both the time value of money and risk? 2. The change in firm value associated with investment in a project is measured by the project’s _____________. a. Payback period b. Discounted payback period c. Net present value d. Internal rate of return 3. Why might one use several evaluation techniques to assess a given project?

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 33 T9.15 Chapter 9 Quick Quiz 1. Which of the capital budgeting techniques do account for both the time value of money and risk? Discounted payback period, NPV, IRR, and PI 2. The change in firm value associated with investment in a project is measured by the project’s Net present value. 3. Why might one use several evaluation techniques to assess a given project? To measure different aspects of the project; e.g., the payback period measures liquidity, the NPV measures the change in firm value, and the IRR measures the rate of return on the initial outlay.

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 34 T9.16 Solution to Problem 9.3 Offshore Drilling Products, Inc. imposes a payback cutoff of 3 years for its international investment projects. If the company has the following two projects available, should they accept either of them? YearCash Flows ACash Flows B 0-$30,000-$45,000 1 15,000 5,000 2 10,000 10,000 3 10,000 20,000 4 5,000 250,000

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 35 T9.16 Solution to Problem 9.3 (concluded) Project A: Payback period = 1 + 1 + ($30,000 - 25,000)/10,000 =2.50 years Project B: Payback period = 1 + 1 + 1 + ($45,000 - 35,000)/$250,000 = 3.04 years Project A’s payback period is 2.50 years and project B’s payback period is 3.04 years. Since the maximum acceptable payback period is 3 years, the firm should accept project A and reject project B.

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 36 T9.17 Solution to Problem 9.7 A firm evaluates all of its projects by applying the IRR rule. If the required return is 18 percent, should the firm accept the following project? YearCash Flow 0-$30,000 1 25,000 2 0 3 15,000

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 37 T9.17 Solution of Problem 9.7 (concluded) To find the IRR, set the NPV equal to 0 and solve for the discount rate: NPV = 0 = -$30,000 + $25,000/(1 + IRR) 1 + $0/(1 + IRR) 2 +$15,000/(1 + IRR) 3 At 18 percent, the computed NPV is ____. So the IRR must be (greater/less) than 18 percent. How did you know?

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Irwin/McGraw-Hillcopyright © 2002 McGraw-Hill Ryerson, Ltd Slide 38 T9.17 Solution of Problem 9.7 (concluded) To find the IRR, set the NPV equal to 0 and solve for the discount rate: NPV = 0 = -$30,000 + $25,000/(1 + IRR) 1 + $0/(1 + IRR) 2 +$15,000/(1 + IRR) 3 At 18 percent, the computed NPV is $316. So the IRR must be greater than 18 percent. We know this because the computed NPV is positive. By trial-and-error, we find that the IRR is 18.78 percent.

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