Other Criteria for Capital Budgeting Text: Chapter 6

The Net Present Value (NPV) Rule  Net Present Value (NPV) = Total PV of future CF’s + Initial Investment  Estimating NPV:  1. Estimate future cash flows: how much? and when?  2. Estimate discount rate  3. Estimate initial costs  Minimum Acceptance Criteria: Accept if NPV > 0  Ranking Criteria: Choose the highest NPV

But NPV is not the only approach of capital budgeting!

Survey from Graham and Harvey (2001) SOURCE: Graham and Harvey, “The Theory and Practice of Finance: Evidence from the Field,” Journal of Financial Economics 61 (2001), pp

The Pay-back Rule

The Payback Period Rule  How long does it take the project to “pay back” its initial investment?  Payback Period = # of years to recover initial costs  Minimum Acceptance Criteria: set by management  Ranking Criteria: set by management

The Payback Period Rule (continued)  Disadvantages:  Ignores the time value of money  Ignores CF after payback period  Biased against long-term projects  Requires an arbitrary acceptance criteria  A project accepted based on the payback criteria may not have a positive NPV  Advantages:  Easy to understand  Clear performance measurement

Average Accounting Return on Book Value

The Average Accounting Rate of Return (AAR)  AAR = Average NI / Average Book Value of Investment  Minimum Acceptance Criteria: set by management  Ranking Criteria: set by management  Disadvantages:  Ignores the time value of money  Uses an arbitrary benchmark cutoff rate  Based on book values, not cash flows and market values  Advantages:  The accounting information is usually available  Easy to calculate

Internal Rate of Return (IRR) C 0 C 1 C , r = 25%, NPV = = / (1+IRR) / (1+IRR) 2, IRR = 28% NPV Discount rate 28% If r < IRR  positive NPV If r > IRR  negative NPV

Some Pitfalls of IRR  If cash flow in the above example is reversed, C0C1C2C0C1C , NPV = -160, IRR=28% r=25% Borrowing or lending? A positive NPV project for lending is a negative NPV project for borrowing. You may claim that  in case of lending:  Accept (reject) projects if IRR > (<) opportunity costs  In case of borrowing:  Accept project if IRR < opportunity costs

Pitfalls of IRR  What about the following cases? C 0 = +1000, C 1 = -3600, C 2 = +4320, C 3 = -1728, IRR= 20%, NPV at 10% = -.75 Is this borrowing or lending?  Multiple rates of return C 0 = -100, C 1 =80, C 2 =15, C 3 =15, C 4 =15, C 5 =15, C 6 = -15

A Game  Which one do you prefer? Return Guaranteed!  Investing $1 now, and get $1.5 tomorrow.  Investing $10 now, and get 11 tomorrow.

Mutually exclusive projects: Scale Effect C 0 C 1 NPV (1%) IRR Project % Project %  How can this be corrected? ( Incremental cash flow) C0 C1 NPV (1%) IRR Project (-1) = = %

Mutually exclusive projects: Timing effect  C0C1 C2 C3 IRR NPV(10%) (15%) A-10, , B % 16% 10.5% Under IRR, project A is preferred, Under NPV, it depends on discount rate Which project is preferred?

The Profitability Index (PI) Rule  PI = Total Present Value of future CF’s / Initial Investment  Minimum Acceptance Criteria: Accept if PI > 1  Ranking Criteria: Select alternative with highest PI  Disadvantages:  Scale effect of mutually exclusive investments  Advantages:  May be useful when available investment funds are limited  Easy to understand  Correct decision when evaluating independent projects

Profitability Index  ProjectC0C1C2PV(12%)PINPV  How to select projects?  For mutually exclusive projects, choose 1 or 2?  If budget allows only $20, do we choose from the highest NPV?  Without capital rationing, NPV is preferred.  With capital rationing, PI is preferred.