Principles of Corporate Finance Brealey and Myers Sixth
Principles of Corporate Finance Brealey and Myers Sixth Edition Why Net Present Value Leads to Better Investment Decisions than Other Criteria u Slides by Matthew Will Irwin/Mc. Graw Hill Chapter 5 ©The Mc. Graw-Hill Companies, Inc. , 2000
5 - 2 Topics Covered w NPV and its Competitors w The Payback Period w The Book Rate of Return w Internal Rate of Return w Capital Rationing Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
5 - 3 NPV and Cash Transfers w Every possible method for evaluating projects impacts the flow of cash about the company as follows. Cash Investment opportunity (real asset) Firm Invest Irwin/Mc. Graw Hill Shareholder Alternative: pay dividend to shareholders Investment opportunities (financial assets) Shareholders invest for themselves ©The Mc. Graw-Hill Companies, Inc. , 2000
5 - 4 Payback w The payback period of a project is the number of years it takes before the cumulative forecasted cash flow equals the initial outlay. w The payback rule says only accept projects that “payback” in the desired time frame. w This method is very flawed, primarily because it ignores later year cash flows and the present value of future cash flows. Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
5 - 5 Payback 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. Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
5 - 6 Payback 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. Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
5 - 7 Book Rate of Return - Average income divided by average book value over project life. Also called accounting rate of return. Managers rarely use this measurement to make decisions. The components reflect tax and accounting figures, not market values or cash flows. Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
5 - 8 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? Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
5 - 9 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? Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
5 - 10 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? Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
5 - 11 Internal Rate of Return IRR=28% Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
5 - 12 Internal Rate of Return Pitfall 1 - Lending or Borrowing? w With some cash flows (as noted below) the NPV of the project increases s the discount rate increases. w This is contrary to the normal relationship between NPV and discount rates. Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
5 - 13 Internal Rate of Return Pitfall 1 - Lending or Borrowing? w With some cash flows (as noted below) the NPV of the project increases s the discount rate increases. w This is contrary to the normal relationship between NPV and discount rates. NPV Discount Rate Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
5 - 14 Internal Rate of Return Pitfall 2 - Multiple Rates of Return w Certain cash flows can generate NPV=0 at two different discount rates. w The following cash flow generates NPV=0 at both (50%) and 15. 2%. Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
5 - 15 Internal Rate of Return Pitfall 2 - Multiple Rates of Return w Certain cash flows can generate NPV=0 at two different discount rates. w The following cash flow generates NPV=0 at both (-50%) and 15. 2%. NPV 1000 IRR=15. 2% 500 Discount Rate 0 -500 IRR=-50% -1000 Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
5 - 16 Internal Rate of Return Pitfall 3 - Mutually Exclusive Projects w IRR sometimes ignores the magnitude of the project. w The following two projects illustrate that problem. Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
5 - 17 Internal Rate of Return Pitfall 4 - Term Structure Assumption w We assume that discount rates are stable during the term of the project. w This assumption implies that all funds are reinvested at the IRR. w This is a false assumption. Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
5 - 18 Internal Rate of Return Calculating the IRR can be a laborious task. Fortunately, financial calculators can perform this function easily. Note the previous example. Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
5 - 19 Internal Rate of Return Calculating the IRR can be a laborious task. Fortunately, financial calculators can perform this function easily. Note the previous example. HP-10 B EL-733 A BAII Plus -350, 000 CFj -350, 000 CFi CF 16, 000 CFj 16, 000 CFfi 2 nd 16, 000 CFj 16, 000 CFi -350, 000 ENTER 466, 000 CFj 466, 000 CFi 16, 000 ENTER {IRR/YR} IRR {CLR Work} 466, 000 ENTER All produce IRR=12. 96 Irwin/Mc. Graw Hill IRR CPT ©The Mc. Graw-Hill Companies, Inc. , 2000
5 - 20 Profitability Index w When resources are limited, the profitability index (PI) provides a tool for selecting among various project combinations and alternatives. w A set of limited resources and projects can yield various combinations. w The highest weighted average PI can indicate which projects to select. Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
5 - 21 Profitability Index Example We only have $300, 000 to invest. Which do we select? Proj A B C D Irwin/Mc. Graw Hill NPV 230, 000 141, 250 194, 250 162, 000 Investment 200, 000 125, 000 175, 000 150, 000 PI 1. 15 1. 13 1. 11 1. 08 ©The Mc. Graw-Hill Companies, Inc. , 2000
5 - 22 Profitability Index Example - continued Proj NPV A 230, 000 B 141, 250 C 194, 250 D 162, 000 Investment 200, 000 125, 000 175, 000 150, 000 PI 1. 15 1. 13 1. 11 1. 08 Select projects with highest Weighted Avg PI WAPI (BD) = 1. 13(125) + 1. 08(150) + 1. 0 (25) (300) = 1. 09 Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
5 - 23 Profitability Index Example - continued Proj NPV A 230, 000 B 141, 250 C 194, 250 D 162, 000 Investment 200, 000 125, 000 175, 000 150, 000 PI 1. 15 1. 13 1. 11 1. 08 Select projects with highest Weighted Avg PI WAPI (BD) = 1. 09 WAPI (A) = 1. 10 WAPI (BC) = 1. 12 Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
5 - 24 Linear Programming w Maximize Cash flows or NPV w Minimize costs Example Max NPV = 21 Xn + 16 Xb + 12 Xc + 13 Xd subject to 10 Xa + 5 Xb + 5 Xc + 0 Xd <= 10 -30 Xa - 5 Xb - 5 Xc + 40 Xd <= 12 Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000
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