Chapter 9 Net Present Value and Other Investment Criteria Konan Chan Financial Management, Fall 2018 Topics Covered Investment Criteria Net Present Value (NPV) Payback Period Discounted Payback Average Accounting Return (AAR) Internal Rate of Return (IRR) Profitability Index (PI) Conflicts between NPV and IRR Multiple rates of return Mutually exclusive projects Financial Management Konan Chan 2 Net Present Value (NPV) Net Present Value (NPV) Present value of all expected cash flows of a project at the cost of capital (required return) Cost of capital is the expected return given up by investing in a project (required return demanded by investors) Cash flows can be positive or negative in any period Financial Management Konan Chan 3 NPV = PV of future cash flows initial costs NPV is the difference between investment s market value (i.e., total present value) and its cost Financial Management Konan Chan 4
NPV Rule Managers increase shareholders wealth by accepting all projects that are worth more than they cost Therefore, managers should accept all projects with positive net present values That is, accept the project if NPV > 0 NPV Example You plan to purchase an office building Then you will lease out the building, and the tenant will pay $16,000 per year for three years At the end of three years you anticipate selling the building for $450,000. How much would you be willing to pay for the building if cost of capital is 7%? Financial Management Konan Chan 5 Financial Management Konan Chan 6 Net Present Value NPV Example (continued) Present Value 14,953 13,975 380,395 $466,000 $450,000 $16,000 $16,000 $16,000 0 1 2 3 If the building is being offered for sale at a price of $350,000, would you buy the building and what is the added value generated by your purchase and management of the building? $409,323 Financial Management Konan Chan 7 Financial Management Konan Chan 8
Payback Method Measures how long to recover a project s initial cost Easy to calculate and a good measure of a project s liquidity Many firms use this rule for its simplicity Decision rule: accept the project, if Payback < some prespecified period of time Payback Method - Example The three projects below are available. The company accepts all projects with a 2 year or less payback period. Show how this decision will impact the firm value Cash Flows Project C 0 C 1 C 2 C 3 Payback NPV@10% A -2000 +1000 +1000 +10000 2 + 7,249 B -2000 +1000 +1000 0 2-264 C -2000 0 +2000 0 2-347 Financial Management Konan Chan 9 Financial Management Konan Chan 10 Payback Problems Ignores time value of money Do not consider the risk of cash flows Requires an arbitrary cutoff period Ignores cash flows beyond payback period Biased against long-term or new projects So, it s not a good decision criterion Discounted Payback Period Compute the present value of each cash flow and then determine how long it takes to pay back on a discounted basis Decision rule: accept the project, if Discount payback < some prespecified period of time Financial Management Konan Chan 11 Financial Management Konan Chan 12
Computing Discounted Payback Projected cash flows C0 = -165,000, required return = 12% CF1 = 63,120 CF2 = 70,800 CF3 = 91,080 Compute the PV for each cash flow and determine the payback period using discounted cash flows Year 1 cash flow: 165,000 63,120/1.12 1 = 108,643 Year 2 cash flow: 108,643 70,800/1.12 2 = 52,202 Year 3 cash flow: 52,202 91,080/1.12 3 = -12,627 project pays back in year 3 (2.805 to be exact) Financial Management Konan Chan 13 Discounted Payback Problems Although discounted payback considers the time value of money, it still maintains the major problems of payback method Requires an arbitrary cutoff period Ignores cash flows beyond payback period Biased against long-term or new projects May reject projects with positive (or higher) NPV Financial Management Konan Chan 14 Average Accounting Return AAR= average accounting income divided by average accounting value In this course, we use Average net income / average book value Easy to compute and implement Decision rule: accept the project, if AAR > target average accounting return Computing AAR Net Income NI 1 = 13,620, NI 2 = 3,300, NI 3= 29,100 Average Book Value = 72,000 Assume target avg. accounting return of 25% Average Net Income: (13,620 + 3,300 + 29,100) / 3 = 15,340 AAR = 15,340 / 72,000 =.213 = 21.3% Reject because AAR < target rate Financial Management Konan Chan 15 Financial Management Konan Chan 16
AAR Problems Ignores time value of money, so it s not a true measure of return Requires an arbitrary cutoff rate Based on accounting net income and book values, not cash flows and market values So, it s not a good decision criterion Internal Rate of Return (IRR) Discount rate at which NPV = 0 Project s expected rate of return IRR rule: accept the project, if IRR > cost of capital (required return) Financial Management Konan Chan 17 Financial Management Konan Chan 18 Internal Rate of Return This is the most important alternative to NPV It is often used in practice and is intuitively appealing It is based entirely on the estimated cash flows and is independent of interest rates offered elsewhere IRR Example You pay $350,000 to buy an office building which will generate $16,000 per year for three years, and sell for $450,000 at the end. What is the IRR on this investment? IRR = 12.96% Financial Management Konan Chan 19 Financial Management Konan Chan 20
Internal Rate of Return IRR=12.96% NPV>0 NPV<0 NPV profile How to Get NPV and IRR Take office building as an example Initial cost = 350,000 Lease out for 16,000 for 3 years Sell at 450,000 at the end of year 3 Enter cash flow worksheet: CF CF0 = -350,000 Enter ; C01 = 16,000 Enter; F01 = 2 Enter; C02 = 466,000 Enter; F02=1Enter Go to NPV worksheet: NPV let I = 7 Enter, CPT NPV = 59,323 Go to IRR worksheet: IRR CPT IRR = 12.96% Financial Management Konan Chan 21 Financial Management Konan Chan 22 IRR and NPV Generally speaking, when IRR > cost of capital, NPV will be also positive However, there are exceptional situations where NPV and IRR decisions are not equivalent Financial Management Konan Chan 23 IRR Rule Does Not Work when Multiple rates of return Certain cash flows can generate NPV=0 at two different discount rates Mutually exclusive projects IRR sometimes ignores the magnitude of the project Financing type project the NPV of the project increases s the discount rate increases Financial Management Konan Chan 24
Project Types Independent vs. mutually exclusive projects Independent: acceptance of the project doesn t affect acceptance of other projects. Mutually Exclusive: projects that accomplish the same task; cannot be pursued simultaneously Conventional vs. non-conventional projects Conventional: cash outflow at the beginning, and cash inflow thereafter (sign of cash flows changes only once) Non-conventional: sign of cash flows changes more than once (cash outflow in the middle) Financial Management Konan Chan 25 Multiple Rates of Return Suppose a project will generate a cash inflow in the year 1, but an outflow in the 2nd (last) year of the project. ABC s cost of capital is 13%. NPV= -1.95, IRR=26.8% So, take the project or not? Financial Management Konan Chan 26 Multiple Rates of Return Mutually Exclusive Projects NPV rule for two or more projects Independent projects: Accept all if NPV >0 Mutually exclusive: among the positive NPV projects, accept the highest NPV project Example (assume 7% discount rate) There are two IRRs, one is 26.8% and the other is 373.2%. When discount rate is 13%, the project has a negative NPV despite IRR > cost of capital Because of this conflict, don't use IRR to make decisions for non-conventional projects Financial Management Konan Chan 27 If these two are mutually exclusive, we will choose the Faster, given 7% discount rate Financial Management Konan Chan 28
Mutually Exclusive Projects NPV, IRR Conflicts You have two proposals to evaluate: the initial (I) and revised (R). Using IRR, which do you prefer? Financial Management Konan Chan 29 NPV (,000s) 50 40 30 20 10 0-10 -20 Initial proposal Revised proposal Crossover rate = 12.26% IRR= 12.96% IRR= 14.29% 8 10 12 14 16 Discount rate (%) Financial Management Konan Chan 30 Comparison of NPV and IRR For conventional independent projects, both methods give same accept/reject decision. NPV > 0 yields IRR > r, because IRR has to be greater than r in order to lower NPV to 0. However, these methods can rank mutually exclusive projects differently. So, how do we know there is conflict in NPV and IRR? Determining Conflict Range For each year, subtract one project s cash flows from the other. If there is a change of signs of these cash flow differences, a ranking conflict exists. Compute difference in cash flows between projects. The IRR of these cash flows is the crossover rate. Financial Management Konan Chan 31 Financial Management Konan Chan 32
Determining Conflict Range If the cost of capital > crossover rate, there is no conflict between NPV and IRR rules. If the cost of capital < crossover rate, a ranking conflict between NPV and IRR exists. Then, what do we do if a conflict exists? Reconcile Ranking Conflicts Shareholder wealth maximization: Want to add more value to the firm Choose the project with highest NPV when NPV/IRR ranking conflict exists for mutually exclusive projects Financial Management Konan Chan 33 Financial Management Konan Chan 34 Investing or Financing? The typical project has inflows after outflows (investing type, I), but there are projects with outflows precede inflows (financing type, F) For financing type projects, the NPV of the project increases as the discount rate increases. Financial Management Konan Chan 35 Financing type project With 50% IRR, should we accept both projects (assume cost of capital is 10%)? Financing type project is like borrowing money, and thus the lower the rate the better Accept the (financing type) project only if IRR < cost of capital Financial Management Konan Chan 36
Profitability Index Measures the benefit per unit cost The ratio of present value to initial cost A profitability index of 1.1 implies that for every $1 of investment, we create an additional $0.10 in value Decision Rule: accept if PI > 1 This measure can be very useful in situations in which we have limited capital Pro Profitability Index Closely related to NPV, generally leading to identical decisions Easy to understand and communicate Maybe useful when investment funds are limited Con May lead to incorrect decisions in comparisons of mutually exclusive investments Financial Management Konan Chan 37 Financial Management Konan Chan 38 Profitability Index - Example Which of the following projects will be chosen? If no capital limit, choose all. But with limited capital, choose projects with higher PI Financial Management Konan Chan 39 Summary of Capital Budgeting Analytically, NPV, IRR, PI, discounted payback consider the time value of money IRR can give an erroneous decision for nonconventional projects So, NPV is the best and preferred method In practice, We should consider several investment criteria when making decisions NPV and IRR are the most commonly used primary investment criteria Payback is also used commonly by CFOs Financial Management Konan Chan 40
Survey on CFOs Financial Management Konan Chan 41 Ethics Issues An ABC poll in the spring of 2004 found that onethird of students age 12 17 admitted to cheating and the percentage increased as the students got older and felt more grade pressure. If a book entitled How to Cheat: A User s Guide would generate a positive NPV, would it be proper for a publishing company to offer the new book? Should a firm exceed the minimum legal limits of government imposed environmental regulations and be responsible for the environment, even if this responsibility leads to a wealth reduction for the firm? Is environmental damage merely a cost of doing business? Financial Management Konan Chan 42