Chapter 8 – Net Present Value and Other Investment Criteria

Capital Budgeting and Project Classifications Capital budgeting is “the process of planning and evaluating expenditures on assets whose cash flows are expected to extend beyond one year.” Examples:

Capital Budgeting and Project Classifications Process Classifications Replacement decisions Expansion Decisions Independent Projects Mutually Exclusive Projects

Calculating the PV of Uneven Cash FlowStreams General pricing equations: Discount each cash flow to time 0 (i.e., today) and add them all up.

So far we’ve used this for “Asset Valuation”: Calculating Future and Present Values Valuing Annuities and Calculating Payments Valuing Loans and Calculating Payments Valuing Perpetuities Valuing Bonds Valuing Stocks Now use it for “Capital Budgeting”!

Techniques Used for Capital Budgeting Payback Period Discounted Payback Period Net Present Value (“NPV”) Internal Rate of Return (“IRR”)

Example: Should a company invest in the following project Example: Should a company invest in the following project? It requires an initial investment of $ 1,700 and is expected to generate the following positive cash flows: Year Cash Flow ($) 1 500 2 1,000 3 1,200 Assume the company requires a return of 10% on this type of project.

Payback Period Decision Rule: Definition: How long will it take to recover the initial investment? Payback period = the length of time before the original cost of an investment is recovered from the expected cash flows Decision Rule: Accept project if its payback period < Company’s cutoff criteria. Otherwise reject.

Strengths & Weaknesses of the Payback Method: Strengths Provides an indication of a project’s liquidity risk (how long will invested capital be tied up) Easy to calculate and understand Weaknesses Ignores the Time Value of Money Ignores the CFs occurring after the payback period

100 100 100 100 100 100 Project A 1 2 3 4 5 6 PB = 4.5 yrs 450 90 90 90 90 90 200 Project B 1 2 3 4 5 6 PB = 5 yrs 450 Project A has a shorter PB period but is it really the more preferable project? Compute NPV of each project (assume r = 8%): NPVA =12.28 NPVB = 35.38

Discounted Payback Period Similar to the Payback Period Expected future cash flows are discounted by the project’s cost of cap Thus the discounted payback period is defined as the number of years required to recover the investment from discounted net cash flows. Payback period = the length of time before the original cost of an investment is recovered from the expected cash flows Decision Rule: Accept project if its payback period < Company’s cutoff criteria. Otherwise reject.

Strengths & Weaknesses of the Discounted Payback Method: Provides an indication of a project’s liquidity risk Easy to calculate and understand Recognizes time value of money Recognizes opportunity cost of capital Weaknesses Ignores the CFs occurring after the payback period

Net Present Value (“NPV”) Definition: Calculate the present value of all expected cash flows, netting out the present value of all expected costs. Decision Rule: Accept project if its NPV > 0; Otherwise reject.

Internal Rate of Return (“IRR”) Definition: Calculate the discount rate (i.e., the rate of return or opportunity cost rate) that makes NPV equal 0. Solve for k - this k is our IRR Decision Rule: Accept project if its IRR > the Company’s required return. Otherwise reject.

How could you calculate IRR using your financial calculator?

Why use IRR? Answer: It suits those who want to directly express the benefits of a project as a rate of return (Corporate operation types selling a project to non-finance guys) It gives some indication of safety if future cash flows fall short of expectations:

Example: Project K has a cost of $52,125, and its expected net cash inflows are $12,000 per year for the next 8 years What is the project’s payback period? The required rate of return for the project is 12 percent. What is the discounted payback period? The required rate of return for the project is 12 percent. What is the project’s NPV? What is the project’s IRR?

Example: You are a financial analyst for Damon Electronics Company Example: You are a financial analyst for Damon Electronics Company. The director of capital budgeting has asked you to analyze 2 proposed capital investments, Projects X and Y. Each project has a cost of $10,000, and the required return for each project is 12%. The projects’ expected net cash flows are: Year X’s Cash Flow ($) Y’s Cash Flow ($) 0 - 10,000 - 10,000 1 6,500 3,500 2 3,000 3,500 3 3,000 3,500 4 1,000 3,500

Calculate each project’s payback period discounted payback period NPV IRR. Which project or projects should be accepted if they are independent? Which project should be accepted if they are mutually exclusive?