chap009 instructors

8/18/2019 Chap009 Instructors

1/46

© 2003 The McGraw-Hill Companies, Inc. All rights

Net Present Value

and OtherInvestment Criteria

Chapter 9


2/46

McGraw-Hill!Irwin © 2003 The McGraw-Hill Companies, Inc. All rights

9.2 Key Concepts and Skills

• Be able to compute payback and discounted payback and understand their shortcomings

• Understand accounting rates of return and

their shortcomings• Be able to compute the internal rate of return

and understand its strengths and weaknesses

• Be able to compute the net present value andunderstand why it is the best decision criterion


3/46


9.3 Chapter Outline

• Net resent !alue• "he ayback #ule

• "he $iscounted ayback

• "he %verage %ccounting #eturn• "he &nternal #ate of #eturn

• "he rofitability &nde'

• "he ractice of (apital Budgeting


4/46


9.) Good Decision Criteria

• *e need to ask ourselves the following+uestions when evaluating decision criteria

, $oes the decision rule ad-ust for the time value of

money

, $oes the decision rule ad-ust for risk

, $oes the decision rule provide information on

whether we are creating value for the firm


5/46


9./ Project Eample In!ormation

• 0ou are looking at a new pro-ect and you haveestimated the following cash flows1 , 0ear 1 ( 4 567/8

, 0ear 61 ( 4 73862 N& 4 63872

, 0ear 21 ( 4 :8; N& 4 383

, 0ear 31 ( 4 968; N& 4 2986

, %verage Book !alue 4 :28

• 0our re+uired return for assets of this risk is62


6/46


9.7 Net Present Value

• "he difference between the market value of a pro-ect and its cost

• =ow much value is created from undertaking

an investment , "he first step is to estimate the e'pected future

cash flows.

, "he second step is to estimate the re+uired return

for pro-ects of this risk level.

, "he third step is to find the present value of the

cash flows and subtract the initial investment.


7/46McGraw-Hill!Irwin © 2003 The McGraw-Hill Companies, Inc. All rights

9.: NPV " Decision #ule

• If the NPV is positive, accept the project • % positive N! means that the pro-ect is

e'pected to add value to the firm and will

therefore increase the wealth of the owners.• >ince our goal is to increase owner wealth8

N! is a direct measure of how well this

pro-ect will meet our goal.



9.; Computin$ NPV !or the Project

• Using the formulas1 , N! 4 [email protected] :8;[email protected] 968;?

@6.62A3 , 67/8 4 62872:.)2

•Using the calculator1 , ( 4 567/8 (6 4 73862 6 4 6 (2 4

:8; 2 4 6 (3 4 968; 3 4 6 N! & 4

62 (" N! 4 62872:.)2

• Do we accept or reject the project?



9.9 Decision Criteria %est & NPV

• $oes the N! rule account for the time valueof money

• $oes the N! rule account for the risk of the

cash flows• $oes the N! rule provide an indication about

the increase in value

• >hould we consider the N! rule for our primary decision criteria



9.6 Calculatin$ NPVs 'ith a Spreadsheet

• >preadsheets are an e'cellent way to compute N!s8 especially when you have to compute

the cash flows as well.

• Using the N! function , "he first component is the re+uired return enteredas a decimal

, "he second component is the range of cash flows

beginning with year 1

, >ubtract the initial investment after computing the

N!



9.66 Pay(ack Period

• =ow long does it take to get the initial cost back in a nominal sense

• (omputation

, Cstimate the cash flows , >ubtract the future cash flows from the initial cost

until the initial investment has been recovered

• $ecision #ule , Accept if the payback period

is less than some preset limit



9.62 Computin$ Pay(ack )or %he Project

• %ssume we will accept the pro-ect if it pays back within two years.

, 0ear 61 67/8 , 73862 4 668;; still to

recover

, 0ear 21 668;; , :8; 4 368; still to recover

, 0ear 31 368; , 968; 4 578 project pays

back in year 3




9.63 Decision Criteria %est & Pay(ack

• $oes the payback rule account for the timevalue of money

• $oes the payback rule account for the risk of

the cash flows• $oes the payback rule provide an indication

about the increase in value

• >hould we consider the payback rule for our primary decision criteria



9.6) *dvanta$es and Disadvanta$es o! Pay(ack

• %dvantages

, Casy to understand

, %d-usts for uncertainty

of later cash flows

, Biased towards li+uidity

• $isadvantages

, &gnores the time value of

money

, #e+uires an arbitrary

cutoff point , &gnores cash flows

beyond the cutoff date

, Biased against long5term

pro-ects8 such asresearch and

development8 and new

pro-ects



9.6/ Discounted Pay(ack Period

• (ompute the present value of each cash flowand then determine how long it takes to

payback on a discounted basis

•(ompare to a specified re+uired period

• $ecision #ule 5 Accept the project if it pays

back on a discounted basis within the

specified time



9.67 Computin$ Discounted Pay(ack !or the Project

• %ssume we will accept the pro-ect if it pays back on a discounted basis in 2 years.

• (ompute the ! for each cash flow and

determine the payback period usingdiscounted cash flows

, 0ear 61 67/8 , 73862?6.626 4 6;87)3

, 0ear 21 6;87)3 , :8;?6.622 4 /2822

, 0ear 31 /2822 , 968;?6.623 4 562872: pro-ect

pays back in year 3




9.6: Decision Criteria %est " Discounted Pay(ack

• $oes the discounted payback rule account forthe time value of money

• $oes the discounted payback rule account for

the risk of the cash flows• $oes the discounted payback rule provide an

indication about the increase in value

• >hould we consider the discounted paybackrule for our primary decision criteria



9.6; *dvanta$es and Disadvanta$es o! Discounted Pay(ack

• %dvantages

, &ncludes time value of

money

, Casy to understand

, $oes not accept negativeestimated N!

investments

, Biased towards li+uidity

• $isadvantages

, Day re-ect positive N!

investments

, #e+uires an arbitrary

cutoff point , &gnores cash flows

beyond the cutoff point

, Biased against long5term

pro-ects8 such as #E$and new products



9.69 *vera$e *ccountin$ #eturn

• "here are many different definitions foraverage accounting return

• "he one used in the book is1 , %verage net income ? average book value

, Note that the average book value depends on howthe asset is depreciated.

• Need to have a target cutoff rate

• $ecision #ule1 Accept the project if the AAis !reater than a preset rate"



9.2 Computin$ **# )or %he Project

• %ssume we re+uire an average accountingreturn of 2/<

• %verage Net &ncome1

, @63872 383 2986A ? 3 4 6/83)• %%# 4 6/83) ? :28 4 .263 4 26.3<




9.26 Decision Criteria %est & **#

• $oes the %%# rule account for the time valueof money

• $oes the %%# rule account for the risk of the

cash flows• $oes the %%# rule provide an indication

about the increase in value

• >hould we consider the %%# rule for our primary decision criteria


22/46


9.22 *dvanta$es and Disadvanta$es o! **#

• %dvantages

, Casy to calculate

, Needed information will

usually be available

• $isadvantages

, Not a true rate of return

time value of money is

ignored

, Uses an arbitrary

benchmark cutoff rate

, Based on accounting net

income and book values8

not cash flows and

market values


23/46


9.23 Internal #ate o! #eturn

• "his is the most important alternative to N!• &t is often used in practice and is intuitively

appealing

• &t is based entirely on the estimated cash flowsand is independent of interest rates found

elsewhere


24/46


9.2) I## " De!inition and Decision #ule

• $efinition1 # is the return that makes the N! 4

• $ecision #ule1 Accept the project if the I

is !reater than the re#uired return


25/46


9.2/ Computin$ I## )or %he Project

• &f you do not have a financial calculator8 thenthis becomes a trial and error process

• (alculator

, Cnter the cash flows as you did with N! , ress # and then ("

, # 4 67.63< F 62< re+uired return



26/46


9.27 NPV Pro!ile )or %he Project

# 4 67.63<


27/46


9.2: Decision Criteria %est & I##

• $oes the # rule account for the time valueof money

• $oes the # rule account for the risk of the

cash flows• $oes the # rule provide an indication about

the increase in value

• >hould we consider the # rule for our primary decision criteria


28/46


29/46


9.29 Summary o! Decisions )or %he Project

Summary

Net resent !alue Accept

ayback eriod eject

$iscounted ayback eriod eject

%verage %ccounting #eturn eject

&nternal #ate of #eturn Accept


30/46


9.3 Calculatin$ I##s +ith * Spreadsheet

• 0ou start with the cash flows the same as youdid for the N!

• 0ou use the # function

, 0ou first enter your range of cash flows8 beginningwith the initial cash flow

, 0ou can enter a guess8 but it is not necessary

, "he default format is a whole percent , you will

normally want to increase the decimal places to atleast two


31/46


9.36 NPV Vs, I##

• N! and # will generally give us the samedecision

• C'ceptions

, Non5conventional cash flows , cash flow signschange more than once

, Dutually e'clusive pro-ects

• &nitial investments are substantially different

• "iming of cash flows is substantially different


32/46


9.32 I## and Non&conventional Cash )lo's

•*hen the cash flows change sign more thanonce8 there is more than one #

• *hen you solve for # you are solving for

the root of an e+uation and when you cross the

'5a'is more than once8 there will be more than

one return that solves the e+uation

• &f you have more than one #8 which one do

you use to make your decision


33/46


9.33 *nother Eample " Non&conventional Cash )lo's

•>uppose an investment will cost I98initially and will generate the following cash

flows1

, 0ear 61 6328

, 0ear 21 68

, 0ear 31 56/8

• "he re+uired return is 6/hould we accept or re-ect the pro-ect


34/46


9.3) NPV Pro!ile

# 4 6.66< and )2.77<


35/46


9.3/ Summary o! Decision #ules

•"he N! is positive at a re+uired return of6/


36/46


9.37 I## and -utually Eclusive Projects

•Dutually e'clusive pro-ects , &f you choose one8 you canHt choose the other

, C'ample1 0ou can choose to attend graduate

school ne't year at either =arvard or >tanford8 but

not both

• &ntuitively you would use the following

decision rules1

, N! , choose the pro-ect with the higher N!

, # , choose the pro-ect with the higher #


37/46


9.3: Eample +ith -utually Eclusive Projects

eriod ro-ect % ro-ect B

5/ 5)

6 32/ 32/

2 32/ 2

# 69.)3< 22.6:<

N! 7)./ 7.:)

"he re+uired returnfor both pro-ects is

6


38/46


9.3; NPV Pro!iles

# for % 4 69.)3<

# for B 4 22.6:<

(rossover oint 4 66.;<


39/46


9.39 Con!licts .et'een NPV and I##

• N! directly measures the increase in value tothe firm

• *henever there is a conflict between N! and

another decision rule8 you should always use

N!

• # is unreliable in the following situations

, Non5conventional cash flows

, Dutually e'clusive pro-ects


40/46


9.) Pro!ita(ility Inde

•Deasures the benefit per unit cost8 based onthe time value of money

• % profitability inde' of 6.6 implies that for

every I6 of investment8 we create an

additional I.6 in value

• "his measure can be very useful in situations

where we have limited capital


41/46


9.)6 *dvanta$es and Disadvanta$es o! Pro!ita(ility Inde

• %dvantages

, (losely related to N!8

generally leading to

identical decisions

, Casy to understand and

communicate

, Day be useful when

available investment

funds are limited

• $isadvantages

, Day lead to incorrect

decisions in comparisons

of mutually e'clusive

investments


42/46


9.)2 Capital .ud$etin$ In Practice

•*e should consider several investment criteriawhen making decisions

• N! and # are the most commonly used

primary investment criteria

• ayback is a commonly used secondary

investment criteria


43/46


9.)3 Summary " Discounted Cash )lo' Criteria

• Net present value

, $ifference between market value and cost , "ake the pro-ect if the N! is positive , =as no serious problems , referred decision criterion

• &nternal rate of return

, $iscount rate that makes N! 4 , "ake the pro-ect if the # is greater than re+uired return , >ame decision as N! with conventional cash flows , # is unreliable with non5conventional cash flows or mutually

e'clusive pro-ects• rofitability &nde'

, Benefit5cost ratio , "ake investment if & F 6 , (annot be used to rank mutually e'clusive pro-ects , Day be use to rank pro-ects in the presence of capital rationing


44/46


9.)) Summary " Pay(ack Criteria

• ayback period

, Kength of time until initial investment is recovered

, "ake the pro-ect if it pays back in some specified period

, $oesnHt account for time value of money and there is an

arbitrary cutoff period• $iscounted payback period

, Kength of time until initial investment is recovered on a

discounted basis

, "ake the pro-ect if it pays back in some specified period , "here is an arbitrary cutoff period


45/46


9.)/ Summary " *ccountin$ Criterion

• %verage %ccounting #eturn

, Deasure of accounting profit relative to book

value

, >imilar to return on assets measure

, "ake the investment if the %%# e'ceeds some

specified return level

, >erious problems and should not be used


46/46

9.)7 /uick /ui0

• (onsider an investment that costs I68 and has acash inflow of I2/8 every year for / years. "here+uired return is 9< and re+uired payback is )years.

, *hat is the payback period

, *hat is the discounted payback period

, *hat is the N!

, *hat is the #

, >hould we accept the pro-ect• *hat decision rule should be the primary decision

method

• *hen is the # rule unreliable

chap009 instructors

Documents