1. Critique of NPV 04/29/08 Ch. 6

2. 2 Merits and Flaws of NPV We will examine issues that are sometimes problematic for NPV Project Interactions – Mutually Exclusive Unequal Lives Replacement Decisions Capital Rationing Side Costs Synergy Embedded Options But it is still the best model…

3. 3 Project Interactions Mutually Exclusive Projects Definition: Accepting one project means rejecting another project Example: When two projects require the same scare resource Scare resource, plot of land Projects, build restaurant or build service station Assumes you can not acquire a similar scarce resource, another plot of land Assumes you can not have a dual use of the land…Taco Bell Express at a Service Station NPV does a nice job of picking the right project but IRR may not...diagram to explain…

4. 4 Unequal Lives If two or more projects have different lives, the NPV model favors the longer lived project Can you correct for this bias? Extend shorter project to match life of longer project Assumptions are that you can “invest” at the termination of the short-term project in a very similar project, the cost of capital has not changed and you do not have access to additional capital at start of the project Compute NPV for the short project and the extension Compute Equivalent Annuities Equivalent Annuity = NPV x (r / [1-(1+r) -n ] Problem 3, Heating System for a Building

5. 5 Unequal Lives – Equivalent Annuity Problem 3 Solar Heating, Cost $12,000 with annual costs of $500, infinite life Gas Heating, Cost $5,000 with annual costs of $1,000, and will last twenty years Oil Heating, Cost $3,500 with annual costs of $1,200 and will last fifteen years Compute present value of costs at 10% cost of capital (1) Solar $17,000 (2) Gas $13,514 (3) Oil $12,627 Compute Equivalent Annuities (1) Solar $1,700 (2) Gas $1,587 (3) Oil $1,659 Pick the lowest equivalent annuity…Gas Issues with this approach?

6. 6 Replacement Decision Fits Mutually Exclusive as we only want one choice…either keep current system, immediately replace current system, or wait and replace later (which is keep current system) Issues that are important -- Salvage Value Let’s re-examine this and how we deal with salvage value Example…replace delivery truck with new delivery truck Old truck (five years old)…original cost $38,000 New truck (expected life is eight years) …cost of $64,000 Old truck depreciation life was five year life (MACRS), book value is 5.76% x $38,000 = $2,189 What if “blue book” is $1,200 for old truck What if “blue book” is $2,189 for old truck What if “blue book” is $4,800 for old truck Does replacement lower future costs? Does replacement increase future revenues? Why replace now?

7. 7 Solutions to Salvage Value Book Value of Truck is 38,000 x 0.0576 = $2,189 At sales price of $1,200 Loss on Disposal is $1,200 - $2,189 = $989 Tax Credit (40% tax rate) $989 x 0.40 = $396 Cash Flow at Disposal = $1,200 + $396 = $1,596 At sales price of $2189 No loss or gain Cash Flow at Disposal = $2,189 At sales price of $4,800 Gain on Disposal is $4,800 - $2,189 = $2,611 Tax (40% tax rate) $989 x 0.40 = $1,044 Cash Flow at Disposal = $4,800 - $1,044 = $3,756

8. 8 Profitability Index Example Problem #1 ($150 million max on spending) ProjectInitial Inv.NPVPI A$25$100.40 B$30$250.83 C$40$200.50 D$10$101.00 E$15$100.67 F$60$200.33 G$20$100.50 H$25$200.80 I$35$100.28 J$15$ 50.33

9. 9 Ranking by NPV vs PI Outlay $ Rank by NPVOutlay $ Rank by PI $ 30B$ 10D $ 65C & H*$ 30B $ 45D, G & E$ 25H $140$ 15E * Can’t pick F as it puts$ 60C and G you over the $150$140 Total NPV$95$95 With a portfolio approach both give the same answer!

10. 10 Problems with PI Assumes capital rationing applies to the current period only and that projects can only be done during current period… Assumes all investment is up front Projects with cash outflow in future periods will be overstated with PI Future cash outflow will constrain future periods PI may not spend all current capital – so other combinations may produce higher NPV

11. 11 Side Costs and Sunk Costs Should be included as part of the incremental costs of a project but may be difficult to quantify Opportunity costs Project must “carry” the lost revenues of other uses People – taken for new project Resources – taken for new project Sunk Costs Do not include if truly sunk costs Erosion – Substitute Products Include if truly eroding other products

12. 12 Synergy, 2+2 = 5 When adding new projects in the whole is greater than the parts, you get synergies Often used for mergers Firm A Value + Firm B Value < Firm (A+B) Value Where does synergy come from? Reduction in duplicate costs Using excess capacity Complementary Products Timing of synergy…immediate or much later?

13. 13 Embedded Options Not a problem with NPV… But, difficulty to quantify and properly add into the expected future cash flow There is an element of probability here…the probability that this project will lead to additional projects Option to delay…projects always compete with themselves over time…again, just need to find the NPV today versus the NPV tomorrow

14. 14 Embedded Options Expansion Once a project has been completed additional projects become available How do you incorporate this into the original NPV decision of the initial project? What happens if you do not take on the additional projects? Abandonment Is this an option for every project? How do you incorporate abandonment value in the future cash flow of a project?

15. 15 NPV remains the Best The problem with NPV is not in theory but in practice Problems with finding the right WACC for the project Problems with finding the right future cash flows for the project Usually the only comfortable number in cash flow is the initial outflow Other models all have these same cash flow estimation problems…plus other issues

16. 16 Weekly Homework for Thursday Problem 4 – Replacement, unequal lives Problem 5 – Unequal lives Problem 7 – Salvage Value Problem 15 – Capital Rationing Problem 16 – Opportunity costs Problem 18 – Lease option Problem 21 – Opportunity cost