Presentation on theme: "Net Present Value and Other Investment Criteria (Capital Budgeting)"— Presentation transcript:
1Net Present Value and Other Investment Criteria (Capital Budgeting) Chapter 8Net Present Value andOther Investment Criteria(Capital Budgeting)
2The Capital Budgeting Issue One of the most important issues in Corporate FinanceLaunch a new projectEnter a new marketDetermines the nature of the firm’s operations and products for years to comeFixed asset investments are generally long-lived and not easily reversed once madeFixed assets define the business of the firm
3Capital Budgeting *Net Present Value (NPV) Techniques used to analyze potential business ventures to decide which are worth undertaking:*Net Present Value (NPV)Preferred Approach*Internal Rate of Return (IRR)Payback PeriodAverage Accounting Return (AAR)Profitability Index (PI)
4Capital BudgetingGood Capital Budgeting criterion must tell us two things1. Is a particular project a good investment?2. If we have more than one good project, but we can only take one of them, which one should we take?We’ll see that: only the NPV criterion can always provide the correct answer to both questions
6Net Present Value The Basic Idea The goal of the financial manager is to create value for the stockholdersPotential investments must be examinedA widely used procedure for doing this is the “Net Present Value” approach
7Net Present Value The Basic Idea We create value by identifying an investment worth more in the marketplace than it costs us to acquireCapital Budgeting is about trying to determine whether a proposed investment or project will be worth more than it costs once it’s in place
8Net Present Value The Basic Idea The Net Present Value (NPV) – is the difference between an investment’s market value and its costsA way of assessing the profitability of a proposed investmentThe preferred approach in principle and typically in practiceGiven the goal of creating value for the stockholders:Capital budgeting is a search for investments with positive net present values
9Net Present Value Estimating Net Present Value Estimate the cost of the project or investmentEstimate the future cash flowsDiscount those cash flows to estimate the present value of the future cash flowsNPV = The Present Value of the Future Cash Flows less the initial cost of the project or investment.
10Net Present Value Net Present Value Rule If NPV is positive:Accept the project or investmentIncreases the total value of the stockThe greater the NPV, the greater the increase in the value of the stockIf NPV is negative:Reject the project or investmentDecreases the total value of the stockIf NPV is zero:Indifferent – between taking or not taking the project or investmentBreak-even propositionValue is neither created nor destroyed
11Net Present Value Example 8.1, Page 211 Suppose we are asked to decide whether or not a new consumer product should be launched.Based on projected sales and costs, we expect that the cash flows over the five-year life of the project will be: $2,000 in the first two years, $4,000 in the nest two, and $5,000 in the last year.It will cost about $10,000 to begin production.We use a 10% discount rate to evaluate new products.What should we do here?
12Net Present Value Example 8.1, Page 211 hp 12C Keystrokes Inst Manual Pg 70, 71,& 72Use Shift Keys: g – blue f – yellowCHS g CF = -10,000 Cost to begin projectg CFj = 2, st Yr Cash Flow Amtg CFj = 2,000 2nd Yr Cash Flow Amtg CFj = 4, rd Yr Cash Flow Amtg CFj = 4, th Yr Cash Flow Amtg CFj = 5, th Yr Cash Flow Amti = %f NPV = 2,313Based on the NPV Rule: since NPV is positive, we should take on, or “Accept” the project.Note: When NPV is negative “Reject” the project.
13Net Present Value Example: Not in Book You are going to choose between two investments. Both cost $80,000, but investment A pays $35,000 a year for 4 years while investment B pays $30,000 a year for 5 years. If your required return is 13%, which should you choose?Answer on following slide
14Net Present Value Example: Not in Book Answer to previous slide:NPV for Investment A = 24,106.50NPV for Investment B = 25,516.94Choose Investment B because it has a higher NPV.
15Net Present Value Example: Problem 10.b. – Page 233 Darby & Davis, LLC, has identified the following two mutually exclusive projects. If the required return is 11 %, what is the NPV for each of these projects? Which project will you choose if you apply the NPV decision rule?Year Cash Flow (A) Cash Flow (B), ,000, ,000, ,000, ,000, ,500NPV for Project (A) = $1,520.71NPV for Project (B) = $1,698.58Choose Project B it has the highest NPV
17The Internal Rate of Return Internal Rate of Return (IRR) – is simply the discount rate that makes the NPV of an investment zero.Put another way: It’s the rate of return at which the discounted future cash flows = the initial cash outlay“Internal” rate – only depends on the cash flows of a particular investment, not on rates offered elsewhereClosely related to NPVThe most important alternative to NPV
18The Internal Rate of Return IRR Rule:Accept: if the IRR exceeds the “required rate of return”Reject: if the IRR is below (less than) the “required rate of return”For Example: if your organization decides that it only wants to take on those projects with a return of 10% (10% is the required return), then you would:“Accept” all projects with an IRR greater than 10%“Reject” all projects with an IRR less than 10%.
19The Internal Rate of Return Example 8.3, Page 220 hp 12C Keystrokes Inst Manual Pg 70, 71,& 72Use Shift Keys: g – blue f – yellowCHS g CF0 = Up-Front Costg CFj = st Yr Cash Flowg CFj = nd Yr Cash Flowg CFj = rd Yr Cash Flowf IRR = 15%Conclusion:Since IRR = 15% and the required rate of return is 18%Reject: the IRR is below the “required rate of return”
20The Internal Rate of Return Problem 8, Page 233 hp 12C Keystrokes Instructions Pg 70, 71,& 72Use Shift Keys: g – blue f – yellowg CF0 = -2,400 Up-Front Costg CFj = st Yr Cash Flow Amountg CFj = nd Yr Cash Flow Amountg CFj = ,000 3rd Yr Cash Flow Amountf IRR = %
21The Internal Rate of Return Problems with IRR Non-conventional Cash Flows (Page 221):Multiple Answers (rates of return) – the possibility that more than one discount rate makes the NPV of an investment zeroWhen cash flows aren’t conventional, strange things start to happen with IRR:Some computers/calculators just report the first IRROthers report the smallest IRRWhat is the return?....becomes difficult to answerRead Page 221 and 222
22The Internal Rate of Return Problems with IRR Mutually Exclusive Investments – A situation where taking one investment prevents the taking of another (example: own a corner lot – can build a gas station or apartment bldg, but not both)The IRR can be misleading and may lead to incorrect decisionsThe project with the highest IRR may not produce the highest NPV due to:timing of the cash flowsand the required return rateTherefore, with “Mutually Exclusive Projects”, do not rank them based on their returns (IRR)When comparing investments to determine which is best – ALWAYS USE NPVWhich one is best? – the one with the largest NPV
23The Internal Rate of Return Redeeming Qualities of IRR IRR can be calculated w/o knowing the appropriate discount rate, NPV can’t.Easy to understand and communicate.
25The Payback Rule Defining the Rule Payback Period: is the amount of time required for an investment to generate cash flows to recover its initial cost.How many years do you have to wait until the accumulated cash flows from an investment equal or exceed the cost of the investment?
26The Payback Rule Defining the Rule Payback Rule: an investment is acceptable if its calculated payback period is less than some pre-specified number of years.Accept: if the payback period is less than or equal to the specified number of yearsReject: if the payback period is greater than the specified number of yearsExample 8.2, Page 213:Calculating Payback
27The Payback Rule Analyzing the Rule Severe shortcomings as compared to NPVNo discounting: the time value of money is ignoredProjects may be accepted that are worth less than they costConsiders no risk differencesCalculated the same way for both very risky and very safe projectsProblems with determining the exact cut-off periodCash flows after the payback period are ignoredBias toward short term investmentsProfitable long term investments may be rejected
28The Payback Rule Redeeming Qualities of the Rule Useful for relatively minor decisionsIn general: an investment that pays back rapidly and has benefits extending beyond the cutoff period probably has a positive NPV
29The Payback Rule Summary of the Rule A kind of “break-even” measureIn an accounting senseNot an economic sensebecause time value is ignoredIt determines how long it takes to recover the initial investment, not the impact an investment will have on the value of the stockDue to its simplicity, it’s a useful simple rule of thumb - as a screen for dealing with many minor investment decisions
31The Average Accounting Return Average Accounting Return (AAR): An investment’s average net income divided by its average book value:Average net incomeAverage book valueAAR Rule:Accept the project if its average accounting return exceeds a target average account returnReject: OtherwiseExample in book: Page 216 and 217Excel Spreadsheet
32The Average Accounting Return The AAR Rule has many problems:AAR is not a true rate of return. It ignores time value.It’s a ratio of two accounting numbers and not comparable to returns offered in the financial markets.Based on accounting net income and book values, instead of cash flows and market valuesDoesn’t indicate the effect on share price from taking the investmentHowever, it is easy to calculate and needed info is usually available
34The Profitability Index Profitability Index (PI) – Present Value of an investment’s future cash flows divided by its initial cost. Also called the Benefit-Cost RatioPI = PV / Initial CostIf a project costs $200 and the present value of its future cash flows is $220:PI = 220 / 200 = 1.10For every dollar invested $.10 in NPV resultsPI measures the value created per dollar investedOften proposed as a measure of performance for government or other not-for-profit investmentsWhen capital is scarce, it may make sense to allocate it to those projects with the highest PIs
35The Profitability Index PI > 1 for projects with a positive NPVPI < 1 for projects with a negative NPVRemember: Positive NPV means that the PV of the future cash flows is greater than the initial investmentPI may lead to incorrect decisions when considering mutually exclusive projectsThe PI Index cannot be used to rank mutually exclusive projectsAlways go with the project with the highest NPV!
36The Practice of Capital Budgeting While NPV is considered superior, its calculation involves only “estimated” future cash flows.The result can be very “soft”.For this reason firms typically use multiple criteria for evaluating a proposal
37Chapter 8 Suggested Homework Know Chapter theories, concepts and definitionsSuggested NPV Homework problems:Problem 8.1 – Page 229Problems 6, 9, and 10.b. – Page 233Problem 16.b & c – Page 235Problem 19.b & c and 22.b & c – Page 236Problem 23.b and c – Page 237