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After studying this chapter you will be able to: Understand the payback rule and its shortcomings, understand accounting rates of return and their problems, understand the internal rate of return and its strengths and weaknesses, understand the net present value rule and why it is the best decision criteria.
Net present value and other investment criteria Chapter Key concepts and skills • Understand: – the payback rule and its shortcomings – accounting rates of return and their problems – the internal rate of return and its strengths and weaknesses – the net present value rule and why it provides the best decision-making criteria – the modified internal rate of return – the profitability index and its relation to net present value 8-2 Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh Chapter outline • • • • • • Net present value The payback rule The average accounting return The internal rate of return The profitability index The practice of capital budgeting Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 8-3 Capital budgeting • • • • • Analysis of potential projects Long-term decisions Large expenditures Difficult/Impossible to reverse Determines firm’s strategic direction Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 8-4 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? Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 8-5 Net present value • The difference between the market value of a project and its cost • How much value is created from undertaking an investment? – Step 1: Estimate the expected future cash flows – Step 2: Estimate the required return for projects of this risk level – Step 3: Find the present value of the cash flows and subtract the initial investment to arrive at the net Copyright 2011 McGraw-Hill Australia Pty Ltd present value PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 8-6 Net present value Sum of the PVs of all cash flows n NPV = ∑ t=0 CFt (1 + R)t NOTE: t=0 • Initial cost often is CF0 and is an outflow n CFt CF NPV = ∑ t (1 + R) t=1 Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 8-7 NPV—Decision rule • If NPV is positive, accept the project • NPV > means: – project is expected to add value to the firm – project will increase the wealth of the owners • NPV is a direct measure of how well this project will achieve the goal of increasing shareholder wealth Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 8-8 Sample project data • You are looking at a new project and have estimated the following cash flows, net income and book value data: – – – – – Year 0: CF = -165 000 Year 1: CF = 63 120 NI = 13 620 Year 2: CF = 70 800 NI = 300 Year 3: CF = 91 080 NI = 29 100 Average book value = $72 000 • Your required return for assets of this risk is 12% • This project will be the example for all problem exhibits in this chapter Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 8-9 Computing NPV for the project • Using the formula: n NPV t CFt t ( R ) NPV = -165 000/(1.12)0 + 63 120/(1.12)1 + 70 800/ (1.12)2 + 91 080/(1.12)3 = 12 627.41 Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 8-10 Conflicts between NPV and IRR • NPV directly measures the increase in value to the firm • Whenever there is a conflict between NPV and another decision rule, you should always use NPV • IRR is unreliable in the following situations: – Non-conventional cash flows – Mutually exclusive projects Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 8-42 Advantages and disadvantages of IRR Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 8-43 Modified internal rate of return (MIRR) • Controls for some problems with IRR • Three methods: 1.Discounting approach = Discount future outflows to present and add to CF0 Reinvestment approach = Compound all CFs except the first one forward to end Combination approach = Discount outflows to present; compound inflows to end – MIRR will be unique number for each method – Discount (finance) /compound (reinvestment) rate externally supplied Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 8-44 MIRR vs IRR • Different opinions about MIRR and IRR • MIRR avoids the multiple IRR problem • Managers like rate of return comparisons, and MIRR is better for this than IRR • Problem with MIRR: different ways to calculate with no evidence of the best method • Interpreting a MIRR is not obvious 8-45 Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh Profitability index • Measures the benefit per unit cost, based on the time value of money • A profitability index of 1.1 implies that for every $1 of investment, we create an additional $0.10 in value • This measure can be very useful in situations where we have limited capital • Decision rule: If PI > 1.0 Accept Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 8-46 Advantages and disadvantages of profitability index Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 8-47 Capital budgeting in practice • We should consider several investment criteria when making decisions • NPV and IRR are the most commonly used primary investment criteria • Payback is a commonly used secondary investment criteria • All provide valuable information Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 8-48 Summary Calculate ALL—each has value Method NPV Payback AAR IRR PI What it measures Metric $ increase in VF $$ Liquidity Years Acct return (ROA) % E(R), risk % If rationed Ratio Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 8-49 NPV summary Net present value = – Difference between market value (PV of inflows) and cost – Accept if NPV > – No serious flaws – Preferred decision criterion Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 8-50 IRR summary Internal rate of return = – Discount rate that makes NPV = – Accept if IRR > required return – Same decision as NPV with conventional cash flows – Unreliable with: • non-conventional cash flows • mutually exclusive projects Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 8-51 Payback summary Payback period = – Length of time until initial investment is recovered – Accept if payback < some specified target – Doesn’t account for time value of money – Ignores cash flows after payback – Arbitrary cut-off period – Asks the wrong question Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 8-52 AAR summary Average accounting return = – Average net income/Average book value – Accept if AAR > some specified target – Needed data usually readily available – Not a true rate of return – Time value of money ignored – Arbitrary benchmark – Based on accounting data not cash 8-53 Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh Profitability index summary Profitability index = – Benefit–cost ratio – Accept investment if PI > – Cannot be used to rank mutually exclusive projects – May be used to rank projects in the presence of capital rationing Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 8-54 Quick quiz • Consider an investment that costs $100 000 and has a cash inflow of $25 000 every year for years The required return is 9% and required payback is years – What is the payback period? – What is the NPV? – What is the IRR? – Should we accept the project? • • What decision rule should be the primary decision-making method? When is the IRR rule unreliable? Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 8-55 Chapter END Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 8-56 ... concepts and skills • Understand: – the payback rule and its shortcomings – accounting rates of return and their problems – the internal rate of return and its strengths and weaknesses – the net present. .. t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 8-49 NPV summary Net present value = – Difference between market value (PV of inflows) and. .. PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 8-5 Net present value • The difference between the market value of a project and its