Net Present Value and Other Investment Rules Chapter

Net Present Value and Other Investment Rules Chapter 7 1

Capital Budgeting Every possible method for evaluating projects impacts the flow of cash. Where is the opportunity cost? Cash Investment opportunity (real asset) Firm Invest Shareholder Alternative: pay dividend to shareholders Investment opportunities (financial assets) Shareholders invest for themselves 2

Net Present Value NPV = the total PV of the future cash flows the initial outlay.

Net Present Value Estimating NPV: 1. Estimate future cash flows: how much? and when? 2. Estimate discount rate 3. Estimate initial costs Rule ◦ Accept if NPV > 0 ◦ Reject if NPV < 0. Ranking Criteria ◦ Choose the highest NPV 4

Why NPV? Accepting positive NPV projects benefits shareholders. üUses cash flows üUses all cash flows of the project üDiscounts the cash flows properly üAssumes all cash flows are reinvested at discount rate 5

Payback Period Years it takes before the cumulative forecasted cash flow equals the initial outlay Accept projects that “payback” in the desired time frame. Flawed ◦ Ignores later year cash flows and the present value of future cash flows 6

Payback Period Example Examine three projects and note the mistake we would make if we insisted on only taking projects with a payback period of 2 years or less. 7

Discounted Payback Period Calculate the PV of each cash flow – then calculate payback period. By the time you have discounted the cash flows, you might as well calculate the NPV! ◦ Still flawed! 8

Average Accounting Return Average income divided by average book value over project life. Also called book rate of return. Why is this not a good method for evaluating projects? 9

Average Accounting Return Flawed Ranking criteria/acceptance 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: ◦ Accounting information is usually available ◦ Easy to calculate 10

Internal Rate of Return § IRR is the rate of return that makes the PV of the cash flows equal to the initial outlay or the NPV = 0.

Calculating IRR with Spreadsheets You start with the cash flows the same as you did for the NPV. You use the IRR function: ◦ You first enter your range of cash flows, beginning with the initial cash flow. ◦ You can enter a guess, but it is not necessary. ◦ The default format is a whole percent – you will normally want to increase the decimal places to at least two.

Internal Rate of Return Decision Rule: ◦ Accept when IRR > Required Return ◦ Reject when IRR < Required Return Ranking Criteria: Reinvestment assumption Advantages: ◦ Highest IRR ◦ All future cash flows assumed reinvested at the IRR. ◦ Easy to understand communicate. 13

Internal Rate of Return Example You can purchase a turbo powered machine tool gadget for $4, 000. The investment will generate $2, 000 and $4, 000 in cash flows for two years, respectively. What is the IRR on this investment? 14

Internal Rate of Return 2500 2000 IRR=28% 1000 500 10 0 90 80 70 60 50 40 30 -500 20 0 10 NPV (, 000 s) 1500 -1000 -1500 -2000 Discount rate (%) 15

Internal Rate of Return Disadvantages: ◦ Does not distinguish between investing and borrowing. ◦ IRR may not exist or there may be multiple IRRs. ◦ Problems with mutually exclusive investments. Scale and timing 16

Internal Rate of Return Pitfall 1 – Investing or Financing? With some cash flows, the NPV of the project increases as the discount rate increases. Suppose your required return is 10%.

Internal Rate of Return Pitfall 2 - Multiple Rates of Return Certain cash flows can generate NPV=0 at two different discount rates. The following cash flow generates NPV=$3. 3 million at 10%. It has IRRs of (-44%) and +11. 56%. Cash Flows ($ millions)

Internal Rate of Return Why? When is this likely to occur? NPV 600 IRR=11. 6% 300 Discount Rate 0 -300 IRR=-44% -600 19

Internal Rate of Return Pitfall 2 - Multiple Rates of Return Related: It is possible to have no IRR and a positive NPV.

NPV -0, 1 -0, 05 0, 15 0, 25 0, 35 0, 45 0, 55 0, 600000001 0, 650000001 0, 700000001 0, 750000001 0, 850000001 0, 950000001 1 1, 05 1, 15 1, 25 1, 35 1, 45 1, 5 Internal Rate of Return $70, 00 $60, 00 $50, 00 $40, 00 $30, 00 $20, 00 $10, 00 $0, 00 Discount Rate

Internal Rate of Return Pitfall 3 - Mutually Exclusive Projects Mutually exclusive ◦ Only ONE of several potential projects can be chosen. Independent: Accepting/rejecting one project does not affect the decision of the other projects. ◦ Scale issues IRR sometimes ignores the magnitude of the project.

Incremental IRR In this case, can IRR be salvaged? ◦ Look at smaller project Acceptable? Yes. So, should you invest extra $$$ for larger project. Look at incremental CFs: INCREMENTAL IRR Now, which project is better?

Internal Rate of Return Timing Issues ◦ Preferred project depends on the discount rate, not the IRR (mutually exclusive projects) ($10, 000) $10, 000 $1, 000 0 1 2 3 Project A ($10, 000) $1, 000 $12, 000 0 1 2 3 Project B 24

Internal Rate of Return $5 000, 00 $4 000, 00 Project A $3 000, 00 Project B NPV $2 000, 00 $1 000, 00 $0, 00 ($1 000, 00) 0% 10% 20% 30% 40% ($2 000, 00) ($3 000, 00) ($4 000, 00) Discount rate 25

Internal Rate of Return To find crossover rate: Find Incremental IRR! $3 000, 00 NPV $2 000, 00 10. 55% = IRR $1 000, 00 $0, 00 ($1 000, 00) 0% A-B 10% 20% B-A ($2 000, 00) ($3 000, 00) Discount rate 26

Internal Rate of Return Note: IRR is better than payback or average accounting return ◦ Managers just need to be careful – especially with #3 ◦ Why is it used so much? Project C 0 C 1 C 2 C 3 NPV @ 8% IRR A -9, 000 2, 900 4, 000 5, 400 15. 58% 4, 530, 000 1, 400 8. 01% B -9, 000 2, 560, 000 3, 540, 000

Profitability Index Accept if PI > 1 Ranking Criteria ◦ Highest PI Disadvantages: ◦ Problems with mutually exclusive investments (scale). Advantages: ◦ May be useful when available investment funds are limited ◦ Easy to understand communicate. ◦ Correct decision when evaluating independent projects. 28

Profitability Index Project C 0 C 1 C 2 C 3 A -500 300 700 600 Assume discount rate is 10%. 29

CFO Decision Tools Survey Data on CFO Use of Investment Evaluation Techniques NPV 75% IRR 76% Payback 57% Discounted Payback 30% Book rate of return 30% Profitability Index 12% 0% 20% 40% 60% 80% SOURCE: Graham and Harvey, “The Theory and Practice of Finance: Evidence from the Field, ” Journal of Financial Economics 61 (2001), pp. 187 -243. 100%

Investment Problem Consider the following cash flows on two mutually exclusive projects for the Bahamas Recreation Corporation. Both require an annual return of 15%. Year Deepwater Fishing New Submarine Ride 0 -850, 000 -2, 100, 000 1 480, 000 1, 500, 000 2 430, 000 750, 000 3 320, 000 600, 000

Investment Problem If your decision is based on IRR, which project should you choose? What mistake did you just make? Show to fix it using only IRR. Now, compute the NPV. Is this consistent with the IRR? 32