Presentation on theme: "Net Present Value and Other Investment Criteria"— Presentation transcript:
1 Net Present Value and Other Investment Criteria CHAPTER 9Net Present Value and Other Investment Criteria
2 Net Present ValueThe difference between the market value of a project and its costEstimating NPV: (DCF)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.
3 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.
4 Payback PeriodThe amount of time required for an investment to generate cash flows sufficient to recover its initial cost.An investment is accepted if its calculated period is less than some prespecified number of years
5 Example E D C B A Year -50$ -200$ -100 $ 100 40 30 1 -50,000,000 20 2 10040301-50,000,000202-20010503200130604
6 Analyzing the ruleDoes the payback rule account for the time value of money?Does the payback rule account for the risk of the cash flows?Does the payback rule provide an indication about the increase in value?Should we consider the payback rule for our primary decision rule?
8 Advantages and Disadvantages of Payback Ignores 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 projectsAdvantagesEasy to understandAdjusts for uncertainty of latercash flowsBiased toward liquidity
9 Discounted Payback Period The length of time required for an investment’s discounted cash flows to equal its initial cost.An investment is acceptable if its discounted payback is less than some prespecified number of years
10 Example Accumulated cash flow Cash flow discounted undiscounted year 8910089$100$1168200792238300703400624355500555
11 Decision Criteria Test – Discounted Payback Does the discounted payback rule account for the time value of money?Does the discounted payback rule account for the risk of the cash flows?Does the discounted payback rule provide an indication about the increase in value?Should we consider the discounted payback rule for our primary decision rule?
12 Advantages and Disadvantages of Discounted Payback Includes time value of moneyEasy to understandDoes not accept negativeestimated NPV investmentswhen all future cash flows are positiveBiased towards liquidityDisadvantagesMay reject positive NPV investmentsRequires an arbitrary cutoff pointIgnores cash flows beyond the cutoff pointBiased against long-term projects, such as R&D and new products
13 Ex 8 Page 293Cash flowyear-34,000$16,000118,000215,0003Suppose the firm uses the NPV decision rule. At a required return of 11 percent, should the firm accept the project? What of the required return was 30 percent?
14 Ex 11 Page 294 What is the NPV at a discount rate of zero percent? Cash flowyear-19,500$9,800110,30028,6003What is the NPV at a discount rate of zero percent?
15 Ex 1 Page 292What is the payback period for the following set of cash flows?Cash flowyear-6,400$1,60011,90022,30031,4004
16 Ex 2 Page 293An investment project provides cash inflows of 765$ per year for eight years. What is the project payback period if the initial cost is 2,400$?
17 Ex 4 Page 293An investment project has annual cash inflows of 4,200$ , 5,300$ , 6,100$ and 7,400$, and a discount rate of 14 percent. What is the discounted payback period for these cash flows if the initial cost is 13,000?
18 Average Accounting Return An investment’s average net income divided by its average book valueA project is acceptable if its average accounting return exceeds a target average accounting return
19 ExampleSuppose we are deciding whether to open a store in anew shopping mall. The required investment in improvements is 500,000$. The store would have a five-year life. The required investment would be 100 percent depreciated. The tax rate is 25 percent. Net income for the five years as follow:NIyear100,0001150,000250,00034-50,0005
20 Decision Criteria Test - AAR Does the AAR rule account for the time value of money?Does the AAR rule account for the risk of the cash flows?Does the AAR rule provide an indication about the increase in value?Should we consider the AAR rule for our primary decision rule?
21 Advantages and Disadvantages of AAR Not a true rate of return; time value of money is ignoredBased on accounting net income and book values, not cash flows and market valuesAdvantagesEasy to calculateNeeded informationwill usually be available
22 Internal Rate of Return The discounted rate that makes the NPV of an investment zeroThis is the most important alternative to NPVAn investment is acceptable if the IRR exceeds the required return
23 Decision Criteria Test - IRR Does the IRR rule account for the time value of money?Does the IRR rule account for the risk of the cash flows?Does the IRR rule provide an indication about the increase in value?Should we consider the IRR rule for our primary decision criteria?
24 Advantages and Disadvantages of IRR AdvantageousClosely related to NPV leading to identical decisionsEasy to understand and communicate
25 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 NPV
26 Ex 7 Page 293A firm evaluates all of its projects by applying the IRR. If the required return is 16 percent, should the firm accept the following project?CFyear$-34,00016,000118,000215,0003
27 Ex 9 Page 293A project that provides annual cash flows of 28,500$ for nine years costs 138,000$ today. Is this a good project if the required rate of return is 20 percent? At what discount rate would you be indifferent between accepting the project and rejecting it?
28 Profitability IndexThe present value of an investment’s future value cash flows divided by its initial cost.This measure can be very useful in situations in which we have limited capital
29 Advantages of Profitability Index Closely related to NPV, generally leading to identical decisionsEasy to understand and communicateMay be useful when available investment funds are limited
30 Ex 15 Page 294What is the profitability index for the following set of cash flows if the relevant discount rate is 22 percent?CFyear-14,000$7,30016,90025,7003
31 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 criteria
32 Comprehensive Problem An investment project has the following cash flows: CF0 = -1,000,000; C01 – C08 = 200,000 eachIf the required rate of return is 12%, what decision should be made using NPV?How would the IRR decision rule be used for this project, and what decision would be reached?