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Chapter 6 --Alternate Measures of Capital Investment Desirability u Goals for this chapter: u Know how to calculate the following measures of investment desirability: u Net present value u Profitability index Modified profitability index u Internal rate of return Modified internal rate of return u Payback periodPresent value payback u Strengths and weaknesses of various methods u Know the reasons for multiple measures and when each would be appropriately used in reality

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Calculating a Net Present Value u Steps to calculate the net present value: u Step 1 -- Lay out the years and cash flows u Step 2 -- Discount back to present with the NPV function u Step 3 -- Net the result of step 2 with the initial outlay

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Calculating a Profitability Index u Steps to calculate the profitability index: u Step 1 -- Calculate the net present value u Step 2 -- Use the formula in the book to calculate the PI u PI = 1 + NPV/ Initial outlay (always positive)

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What Does the Profitability Index Measure? u The wealth created per dollar of initial outlay u The margin of safety or margin for error

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When Would You Use the Profitability Index? u As a very crude short cut when your firm is facing capital rationing u Capital rationing may exist when the firm is not large enough or profitable enough to raise money in the capital markets u This is not uncommon for small, new or rapidly growing businesses u You must still watch for size differentials u Might use this when you cannot see all your projects at one time (which is often the case)

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The Modified Profitability Index u Steps to calculate the Modified Profitability Index: u Calculate the NPV u Start at the rightmost negative number u Discount the amount in step 2 back one year by dividing by the 1+ the interest rate u Net step three with that year’s cash flow u If negative, continue steps 3 and 4 u If positive, stop, this is a self financing project and MPI = PI u When arriving at 0 you have the additional investment u Add the additional investment to the initial outlay to get the initial commitment u Use the formula MPI = 1 + NPV / Initial commitment (always positive)

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Strengths of the Modified Profitability Index u Strengths of the modified profitability index over the profitability index u It tells you the up front initial commitment needed to finish the project u You can use this to: u Ask the regulators for rate hikes or commitments u Raise the appropriate amount of money up front rather than at many points in the future. (negative signal and costly)

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Calculating the Internal Rate of Return u Steps to calculate the internal rate of return: u Lay out the years and cash flows u Discount back to present with u the IRR function on the calculator as described in earlier chapters u Must use the goal seek tool (under the tools menu) on the computer if you have mid-year cash flows

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Weaknesses of the Internal Rate of Return u Weaknesses of the internal rate of return: u It assumes that new projects will come along in future years that will pay at least the internal rate of return (reinvestment rate assumption u It ignores the size of the project

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Calculating the Modified Internal Rate of Return u Steps to calculate the modified internal rate of return: u Begin with year 1 and grow to the end of the project by multiplying by 1 plus the discount rate raised to the remaining years u Do this for all remaining cash flows u Sum the terminal values u Fill the intermediate years with zeros u Use the IRR function to solve for the modified IRR

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Strengths of the Modified Internal Rate of Return u Strengths of the modified internal rate of return: u It eliminates the reinvestment rate assumption u There appears to be many cases where companies in the US are generating more cash than worthwhile projects. In this case, the MIRR may give a better indication of the return from the project u MIRR is a worst case scenario which assumes that excess cash is used to retire debt and equity. By definition this action earns the cost of money

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Calculating a Payback Period u Steps to calculating the payback period: u Lay out your years and cash flow u Accumulate the cash flows u Identify where the accumulation goes from negative to positive u Use the year on the left u Use the result in step 4 and add the amount needed divided by the amount received

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Strengths and Weaknesses of the Payback Period Method u Weaknesses of the payback method: u It ignores the time value of money u It ignores all cash flows after the payback period u It ignores risk u Strengths of the payback method: u It is a measure of liquidity u It can be used as a short cut in industries where the product life is very short

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Calculating the Present Value Payback Period u Steps to calculate the present value payback u Lay out the years and cash flows u Bring the cash flows back to present by dividing by (1 + discount rate) raised to the number of years u Accumulate the cash flows u the accumulation should equal the NPV in the last year u Identify where the accumulation goes from negative to positive u Use the year on the left u Use the result in step 4 and add the amount needed divided by the present value amount received

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The Accounting Rate of Return u Calculating the accounting rate of return u There are many different ways to calculate an accounting rate of return u All of these methods ignore the time value of money

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Reasons for Multiple Measures u Different measures for different circumstances u Multiple measure allow members of the committee to use the measures with which they are comfortable u Multiple measures may provide better information

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1 Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows Overview and “vocabulary” Methods Payback, discounted payback NPV IRR, MIRR Profitability.

1 Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows Overview and “vocabulary” Methods Payback, discounted payback NPV IRR, MIRR Profitability.

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