Chapter 8 Net Present Value and Other Investment Criteria Good Decision Criteria

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Gladys McKinney
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1 Chapter 8 Net Present Value and Other Investment Criteria Good Decision Criteria We need to ask ourselves the following questions when evaluating decision criteria Does the decision rule adjust for the time value of money? Does the decision rule adjust for risk? Does the decision rule provide information on whether we are creating value for the firm? Payback Period How soon is the initial investment recovered? t Project A Cumulative Cash Flows Project B Cumulative Cash Flows 0 $10,000-10,000 $10,000-10, ,000-7,000 1,000-9, ,000-3,000 2,000-7, ,000 2,000 3,000-4, ,000 5,000 1,000 Decision Rule: Accept if the payback period is less than some preset limit A: Payback period B: Payback period If the required payback is 3 years, accept Project A and reject Project B. Evaluate Payback against criteria Does the decision rule adjust for the time value of money? Does the decision rule adjust for risk? Does the decision rule provide information on whether we are creating value for the firm? Fin 311 Chapter 8 Handout Page 1

2 Advantages: 1. Easy to understand. 2. Adjusts for uncertainty of later cash flows 3. Biased toward liquidity Disadvantages 1. Ignores time value of money 2. Cutoff is arbitrary. 3. Ignores cash flows beyond cutoff date. 4. Biased against long-term projects such as R&D. Average Accounting Return The model is not covered in this class. Page 2 Fin 311 Chapter 8 Handout

3 Net Present Value NPV = PV of outflows + PV of inflows The difference between the market value of a project and its cost How much value is created from undertaking an investment? The first step is to estimate the expected future cash flows. The second step is to estimate the required return for projects of this risk level. The third step is to find the present value of the cash flows and subtract the initial investment. If the required return 10 percent, should you accept either project? t Project A Project B 0 $10,000 $10, ,000 1, ,000 2, ,000 3, ,000 5,000 I = 10% 10% Cpt. NPV = Decision Rule: If the NPV is positive, accept the project A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners. Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal. Evaluate NPV against criteria Does the decision rule adjust for the time value of money? Does the decision rule adjust for risk? Does the decision rule provide information on whether we are creating value for the firm? NPV is a primary model. Fin 311 Chapter 8 Handout Page 3

4 Disadvantages 1. Required return? Advantages 1. Accounts for time value of money. 2. Adjusts for risk. 3. Uses all cash flows. 4. Can be used to rank projects. Another Example t Project X Project Y 0 $175,000 $280, , , , , , , ,000 80,000 I = 10% 10% Cpt. NPV = What if Project X and Y are Mutual Exclusive Projects? Page 4 Fin 311 Chapter 8 Handout

5 Profitability Index PI = PV of inflows / PV of outflows t Project A Project B 0 $10,000 $10, ,000 1, ,000 2, ,000 3, ,000 5,000 I = 10% 10% PV Inflows = 13, , PV Outflows = 10,000 10, PI = If the required return is 10 percent, what is the PI of each project? t Project X Project Y 0 $175,000 $280, , , , , , , ,000 80,000 PI = Fin 311 Chapter 8 Handout Page 5

6 Advantages: 1. Closely related to NPV, and will give identical decision with normal cash flows. Assuming normal cash flows, if the NPV is positive, what is the profitability index? 2. Easy to understand and communicate. Disadvantages 1. Not appropriate with non-normal cash flows. 2. Cannot be used to rank mutually exclusive investments. Page 6 Fin 311 Chapter 8 Handout

7 Internal Rate of Return IRR is the interest rate that makes the NPV of the project equal to zero. If the required return is 10 percent, what is the IRR of each project? t Project X Project Y 0 $175,000 $280, , , , , , , ,000 80,000 Cpt. IRR: Evaluate IRR against criteria Does the decision rule adjust for the time value of money? Does the decision rule adjust for risk? Does the decision rule provide information on whether we are creating value for the firm? IRR is a primary model. Advantages: 1. Same decision as NPV for normal cash flows. 2. Easy to understand and communicate. Disadvantages 1. May result in multiple answers with non-normal cash flows. 2. May lead to incorrect decision with non-normal cash flows. 3. May not be used to rank mutually exclusive projects. 4. Others to come. Fin 311 Chapter 8 Handout Page 7

8 NPV NPV Profile Graph of NPV for different interest rates. t Project X Project Y 0 $175,000 $280, , , , , , , ,000 80,000 0% $115, % $82, % $55, % $32, % $12, % $3, IRR 23.85% Project X $140,000 $120,000 $100,000 $80,000 $60,000 $40,000 $20,000 $0 -$20,000 0% 5% 10% 15% 20% 25% Cost of Capital Page 8 Fin 311 Chapter 8 Handout

9 NPV Mutually Exclusive Projects t Project X Project Y Delta (Y X) 0 $175,000 $280, , , , , , , ,000 80,000 Crossover rate = Cpt. IRR: NPV Profiles 180, , , , ,000 80,000 60,000 40,000 20, ,000-40,000 0% 5% 10% 15% 20% 25% Cost of Capital NPV X NPV Y NPV Delta Fin 311 Chapter 8 Handout Page 9

10 NPV Problems with IRR 1. Investing or Financing? t Project R Project S 0 $100 $ % $30 $30 15% $13.04 $ % $0 $0 Investing or Borrowing % 5% 10% 15% 20% 25% 30% Cost of Capital Investing Borrowing Page 10 Fin 311 Chapter 8 Handout

11 NPV 2. Multiple IRRs Project AA CF0 -$90,000 CF1 $132,000 CF2 $100,000 CF3 -$150,000 WACC 15.00% IRR1 NPV BA II Plus IRR = 10.11% Non-Normal Cash Flows $4, $2, $0.00 -$2, $4, $6, $8, $10, % 5% 10% 15% 20% 25% 30% 35% 40% 45% Cost of Capital Proj AA What is the second IRR? Fin 311 Chapter 8 Handout Page 11

12 NPV 3. Scale t Project M Project N 0 $1 $ % IRR Scale % 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% Cost of Capital M N Page 12 Fin 311 Chapter 8 Handout

13 NPV 4. Timing t Project F Project G 0 $10,000 $10, ,000 1, ,000 1, ,000 12,000 0% $2, % $669 15% $109 IRR 16.04% Crossover rate Timing 5, , , , , , , % 5% 10% 15% 20% Cost of Capital F G Fin 311 Chapter 8 Handout Page 13

14 5. No IRR t Project Cash flows 0 $ b b 2a 2 4ac Page 14 Fin 311 Chapter 8 Handout

What is it? Measure of from project. The Investment Rule: Accept projects with NPV and accept highest NPV first

What is it? Measure of from project. The Investment Rule: Accept projects with NPV and accept highest NPV first Consider a firm with two projects, A and B, each with the following cash flows and a 10 percent cost of capital: Project A Project B Year Cash Flows Cash Flows 0 -$100 -$150 1 $70 $100 2 $70 $100 What