Finance 2 - Chapter 9 (Week 2)

1/16/20
Welcome to Week 2 Key Concepts and Skills

• Review of Week 1 • Be able to compute the net present value and understand
why it is the best decision criterion
• Questions/Comments/Concerns • Be able to compute payback and discounted payback
and understand their shortcomings
• Brief *Bonus* Quiz • Understand accounting rates of return and their
• Chapter 9 à Financial Calculator Required shortcomings
• Be able to compute the internal rate of return and
understand its strengths and weaknesses
• Understand the modified internal rate of return
• Understand the profitability index and its relation to net
present value
• Know how capital rationing affects a company’s ability to
accept projects
© 2019 McGraw-Hill Education Limited. All Rights Reserved. 1-0 © 2019 McGraw-Hill Education Limited. All Rights Reserved. 9-1
What Makes a Good Decision

Chapter 9 Outline
Criteria?
• Net Present Value • We need to ask ourselves the following
• The Payback Rule questions when evaluating decision criteria
• The Average Accounting Return • Does the decision rule adjust for the time value
• The Internal Rate of Return of money?
• The Profitability Index • Does the decision rule adjust for risk?
• The Practice of Capital Budgeting • Does the decision rule provide information on
• Capital Rationing whether we are creating value for the firm?
• Summary and Conclusions
• Appendix A – The Modified Internal Rate of Return
Project Example Information Net Present Value

• You are looking at a new project and you have • The difference between the market value of a
estimated the following cash flows: project and its cost
• Year 0: CF = -165,000 • How much value is created from undertaking an
• Year 1: CF = 63,120; NI = 13,620 investment?
• Year 2: CF = 70,800; NI = 3,300 • 1) The first step is to estimate the expected
• Year 3: CF = 91,080; NI = 29,100 future cash flows.
• Average Book Value = 72,000 • 2) The second step is to estimate the required
return for projects of this risk level.
• 3) The third step is to find the present value of
• Your required return for assets of this risk is
12%. the cash flows and subtract the initial
investment.
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NPV – Decision Rule Computing NPV for the Project

• If the NPV is positive, accept the project • Using the formulas:
• A positive NPV means that the project is • NPV = 63,120/(1.12) + 70,800/(1.12)2 +
91,080/(1.12)3 – 165,000 = 12,627.42
expected to add value to the firm and will
• Using the calculator:
therefore increase the wealth of the
• Use the Cash Flow and NPV functions on the
owners. TI BAII Plus
• Since our goal is to increase owner • CF0 = -165,000; C01 = 63,120; F01 = 1; C02 =
wealth, NPV is a direct measure of how 70,800; F02 = 1; C03 = 91,080; F03 = 1; NPV; I
= 12; CPT NPV = 12,627.41
well this project will meet our goal.
• Do we accept or reject the project?
Calculating NPVs with a

Decision Criteria Test - NPV
Spreadsheet
• Does the NPV rule account for the time • Spreadsheets are an excellent way to compute NPVs,
especially when you have to compute the cash flows
value of money? as well.
• Does the NPV rule account for the risk of • Spreadsheet:
the cash flows? • Using the NPV function
• Does the NPV rule provide an indication • The first component is the required return entered
as a decimal (0.12)
about the increase in value?
• The second component is the range of cash flows
• Should we consider the NPV rule for our beginning with year 1
primary decision criteria? • Subtract the initial investment after computing the
NPV
Payback Period Project Example Information

• How long does it take to get the initial cost • You are looking at a new project and you have
back in a nominal sense? estimated the following cash flows:
• Year 0: CF = -165,000
• Computation • Year 1: CF = 63,120; NI = 13,620
• 1) Estimate the cash flows • Year 2: CF = 70,800; NI = 3,300
• 2) Subtract the future cash flows from the initial • Year 3: CF = 91,080; NI = 29,100
cost until the initial investment has been
• Average Book Value = 72,000
recovered
• Decision Rule – Accept if the payback • Your required return for assets of this risk is
period is less than some preset limit 12%.
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Computing Payback For The

Decision Criteria Test - Payback
Project
• Assume we will accept the project if it pays back • Does the payback rule account for the time
within two years. value of money?
• Year 1: 165,000 – 63,120 = 101,880 still to
• Does the payback rule account for the risk
recover
of the cash flows?
• Year 2: 101,880 – 70,800 = 31,080 still to
recover • Does the payback rule provide an
• Year 3: 31,080 – 91,080 = -60,000 project pays indication about the increase in value?
back in year 3 • Should we consider the payback rule for
• If the preset limit is 3 years, do we accept or our primary decision criteria?
reject the project?
Advantages and Disadvantages of

Payback Discounted Payback Period
• Advantages • Disadvantages • Compute the present value of each cash
• Easy to understand • Ignores the time value flow and then determine how long it takes
• Adjusts for uncertainty of money
of later cash flows • Requires an arbitrary
to payback on a discounted basis
• Biased towards liquidity cutoff point • Compare to a specified required payback
• Ignores cash flows period
beyond the cutoff date
• Biased against long- • Decision Rule - Accept the project if it
term projects, such as pays back on a discounted basis within
research and
development, and new the specified time
projects
Computing Discounted Payback Decision Criteria Test – Discounted

for the Project Payback
• Assume we will accept the project if it pays back
• Does the discounted payback rule account
on a discounted basis in 2 years.
for the time value of money?
• Compute the PV for each cash flow and determine
the payback period using discounted cash flows • Does the discounted payback rule account
• Year 1: 165,000 – 63,120/1.121 = 108,643 for the risk of the cash flows?
• Year 2: 108,643 – 70,800/1.122 = 52,202 • Does the discounted payback rule provide
• Year 3: 52,202 – 91,080/1.123 = -12,627 project an indication about the increase in value?
pays back in year 3 • Should we consider the discounted payback
• Do we accept or reject the project? rule for our primary decision criteria?
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Discounted Payback Average Accounting Return
• Advantages • Disadvantages • There are many different definitions for
• Includes time value of • May reject positive average accounting return
money NPV investments • The one used in the book is:
• Easy to understand • Requires an arbitrary
• Average net income / Average book value
• Does not accept cutoff point
negative estimated • Ignores cash flows
• Note that the average book value depends on
NPV investments beyond the cutoff date
how the asset is depreciated.
• Biased towards • Biased against long- • Need to have a target cutoff rate
liquidity term projects, such as • Decision Rule: Accept the project if the
R&D, and new projects
AAR is greater than a preset rate.
Project Example Information Computing AAR For The Project

• You are looking at a new project and you have • Assume we require an average accounting
estimated the following cash flows: return of 25%
• Year 0: CF = -165,000
• Year 1: CF = 63,120; NI = 13,620
• Average Net Income:
• Year 2: CF = 70,800; NI = 3,300 • (13,620 + 3,300 + 29,100) / 3 = 15,340
• Year 3: CF = 91,080; NI = 29,100 • AAR = 15,340 / 72,000 = .213 = 21.3%
• Average Book Value = 72,000 • Do we accept or reject the project?
• Your required return for assets of this risk is

12%.
Advantages and Disadvantages

Decision Criteria Test - AAR
of AAR
• Does the AAR rule account for the time • Advantages • Disadvantages
value of money? • Easy to calculate • Not a true rate of
• Needed information is return; time value of
• Does the AAR rule account for the risk of usually available money is ignored
the cash flows? • Uses an arbitrary
benchmark cutoff rate
• Does the AAR rule provide an indication
• Based on accounting
about the increase in value? net income and book
• Should we consider the AAR rule for our values, not cash flows
and market values
primary decision criteria?
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IRR – Definition and Decision

Internal Rate of Return
Rule
• This is the most important alternative to • Definition: IRR is the return that makes
NPV the NPV = 0
• It is often used in practice and is intuitively • Decision Rule: Accept the project if the
appealing IRR is greater than the required return
• It is based entirely on the estimated cash
flows and is independent of interest rates
found elsewhere
Project Example Information Computing IRR For The Project

• You are looking at a new project and you have • If you do not have a financial calculator,
estimated the following cash flows: then this becomes a trial and error
• Year 0: CF = -165,000
process
• Year 1: CF = 63,120; NI = 13,620
• Year 2: CF = 70,800; NI = 3,300 • Calculator
• Year 3: CF = 91,080; NI = 29,100 • Enter the cash flows as you did with NPV
• Average Book Value = 72,000 • Press IRR and then CPT
• IRR = 16.13% > 12% required return
• Your required return for assets of this risk is • Do we accept or reject the project?
12%.
NPV Profile For The Project Calculating IRRs With A

Spreadsheet
70,000
• You start with the cash flows the same as you did
60,000 IRR = 16.13% for the NPV
50,000 • Spreadsheet:
40,000 • You use the IRR function
30,000
NPV
• You first enter your range of cash flows,

20,000
10,000
beginning with the initial cash flow
0 • The default format is a whole percent – you will
-10,000 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22 normally want to increase the decimal places to
-20,000 at least two
Discount Rate
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Decision Criteria Test - IRR Advantages of IRR

• Does the IRR rule account for the time • Knowing a return is intuitively appealing
value of money? • It is a simple way to communicate the value
• Does the IRR rule account for the risk of of a project to someone who doesn’t know all
the cash flows? the estimation details
• Does the IRR rule provide an indication • If the IRR is high enough, you may not need
about the increase in value? to estimate a required return, which is often
a difficult task
• Should we consider the IRR rule for our
primary decision criteria? • Generally leads to the same answers as the
NPV method
IRR and Non-conventional Cash

Disadvantages of IRR
Flows
• NPV and IRR will generally give us the • When the cash flows change sign more than
same decision once, there is more than one IRR
• Exceptions: • When you solve for the IRR, you are solving
• May result in multiple answers or no answer with for the root of an equation. When you cross
non-conventional cash flows the x-axis more than once, there will be more
• May lead to incorrect decisions in comparisons than one return that solves the equation
of mutually exclusive investments
• If you have more than one IRR, which one
do you use to make your decision?
Another Example – Non-conventional

Cash Flows NPV Profile
• Suppose an investment will cost $90,000 IRR = 10.11% and 42.66%
$4,000.00
initially and will generate the following cash $2,000.00
flows: $0.00
• Year 1: 132,000 ($2,000.00)
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55
NPV
• Year 2: 100,000 ($4,000.00)

• Year 3: -150,000 ($6,000.00)
• The required return is 15%. ($8,000.00)
• Should we accept or reject the project? ($10,000.00)

Discount Rate
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IRR and Mutually Exclusive

Summary of Decision Rules
Projects
• The NPV is positive at a required return of • Mutually exclusive projects
15%, so you should Accept • If you choose one, you can’t choose the other
• If you use the financial calculator, you • Example: You can choose to attend graduate
would get an IRR of 10.11% which would school next year at either Harvard or Stanford,
tell you to Reject but not both
• Intuitively you would use the following decision
• You need to recognize that there are non- rules:
conventional cash flows and look at the • NPV – choose the project with the higher NPV
NPV profile
• IRR – choose the project with the higher IRR
Example With Mutually Exclusive

Projects NPV Profiles
Period Project A Project B IRR for A = 19.43%
The required return $160.00
$140.00
for both projects is IRR for B = 22.17%
$120.00
0 -500 -400 10%. $100.00
Crossover Point = 11.8%
$80.00
1 325 325 A
NPV
$60.00
B
2 325 200 Which project $40.00
$20.00
should you accept
$0.00
IRR 19.43% 22.17% and why? ($20.00) 0 0.05 0.1 0.15 0.2 0.25 0.3
($40.00)
NPV 64.05 60.74
Discount Rate
Conflicts Between NPV and IRR Profitability Index

• NPV directly measures the increase in • Measures the benefit per unit cost, based
value to the firm on the time value of money
• Whenever there is a conflict between • A profitability index of 1.1 implies that for
NPV and another decision rule, you every $1 of investment, we create an
should always use NPV additional $0.10 in value
• IRR is unreliable in the following situations • This measure can be very useful in
• Non-conventional cash flows situations where we have limited capital
• Mutually exclusive projects
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Profitability Index The Practice of Capital Budgeting
• Advantages • Disadvantages • NPV and IRR are the most commonly used
• Closely related to NPV, • May lead to incorrect primary investment criteria
generally leading to decisions in
identical decisions comparisons of • Payback is a commonly used secondary
• Easy to understand mutually exclusive investment criteria
and communicate investments
• Capital budgeting techniques vary with
• May be useful when
available investment industry.
funds are limited • Firms that are better able to estimate cash flows
precisely are more likely to use NPV
Capital Rationing Quick Quiz

• Capital rationing occurs when a firm or • Consider an investment that costs $100,000 and has
a cash inflow of $25,000 every year for 5 years. The
division has limited resources required return is 9% and required payback is 4
• Soft rationing – the limited resources are years.
temporary, often self-imposed • What is the payback period?
• Hard rationing – additional capital cannot be • What is the NPV?
raised, due to financial distress or pre-existing • What is the IRR?
contractual agreements • Should we accept the project?
• The profitability index is a useful tool when • What decision rule should be the primary decision
faced with capital rationing method?
• When is the IRR rule unreliable?
Summary Summary Continued

• Net Present Value • Internal Rate of Return
• Discount rate that makes NPV = 0
• Difference between market value and cost
• Take the project if the IRR is greater than required
• Take the project if the NPV is positive return
• Has no serious problems • Same decision as NPV with conventional cash flows
• Preferred decision criterion • IRR is unreliable with non-conventional cash flows or
mutually exclusive projects
• Modified Internal Rate of Return
• Cash flows are modified at the required rate of return
• Can handle non-conventional cash flows
• Multiple methods give multiple results
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Summary Continued Summary Continued

• Profitability Index • Discounted Payback Period
• Benefit-cost ratio • Length of time until initial investment is recovered on a
• Take investment if PI > 1 discounted basis
• Cannot be used to rank mutually exclusive projects • Take the project if it pays back in some specified period
• May be used to rank projects in the presence of capital • There is an arbitrary cutoff period
rationing • Average Accounting Return
• Payback Period • Measure of accounting profit relative to book value
• Length of time until initial investment is recovered • Similar to return on assets measure
• Take the project if it pays back in some specified period • Take the investment if the AAR exceeds some specified
• Doesn’t account for time value of money and there is return level
an arbitrary cutoff period • Serious problems and should not be used
Appendix A – The Modified Internal MIRR Method #1

Rate of Return The Discounting Approach
• The MIRR is used on projects with non- • All negative cash flows Year 0 -$90,000
conventional cash flows are discounted back to
• The cash flows are modified first and then the the present at the
IRR is calculated using the modified cash flows required return and Year 1 $132,000
• There are three MIRR methods that are used: added to the initial
cost.
1. The Discounting Approach
• From the previous non- Year 2 $100,000
2. The Reinvestment Approach
conventional cash flow
3. The Combination Approach example, we had a
required return of 15% Year 3 -$150,000
and:
MIRR Method #2
MIRR Example - Continued The Reinvestment Approach
• Using Method #1, the cash flow at year 3 • All cash flows (positive and negative) except the first
would be discounted back to year 0 at 15% are compounded out to the end of the project’s life
• The cash flows would look like this: and then the IRR is calculated
• The cash flows would look like this:
Year 0: -$90,000 - $150,000/(1.153)
Year 0: -$90,000
= -$188,627.43
Year 1: $0
Year 1: $132,000
Year 2: $0
Year 2: $100,000 Year 3: $-$150,000 + $100,000(1.15) +
Year 3: $0 $132,000(1.152)
• MIRR using Method #1 is 15.77% • MIRR using Method #2 is 15.75%
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MIRR Method #3
The Combination Approach
MIRR vs. IRR
• All negative cash flows are discounted back to the • MIRR can handle non-conventional cash flows,
present and all positive cash flows are
compounded out to the end of the project’s life whereas the IRR can’t
• The cash flows would look like this: • But there are problems with MIRR:
Year 0: -$90,000 - $150,000/(1.153) • There are three methods, and three different
= -$188,627.43 MIRRs. Which MIRR is correct? The differences could
Year 1: $0 be larger on a more complex project
Year 2: $0 • MIRR is a rate of return on a modified set of cash flows,
Year 3: $100,000(1.15) + $132,000(1.152) not the project’s actual cash flows
= $289,570 • Since the MIRR depends on an externally supplied
discount rate, the result is not truly an “internal” rate of
• MIRR using Method #3 is 15.36%
return
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Finance 2 - Chapter 9 (Week 2)

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Finance 2 - Chapter 9 (Week 2)

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1/16/20

Welcome to Week 2 Key Concepts and Skills

What Makes a Good Decision

Project Example Information Net Present Value

NPV – Decision Rule Computing NPV for the Project

Calculating NPVs with a

Payback Period Project Example Information

Computing Payback For The

Advantages and Disadvantages of

Computing Discounted Payback Decision Criteria Test – Discounted

Advantages and Disadvantages of

Project Example Information Computing AAR For The Project

• Your required return for assets of this risk is

Advantages and Disadvantages

IRR – Definition and Decision

Project Example Information Computing IRR For The Project

NPV Profile For The Project Calculating IRRs With A

• You first enter your range of cash flows,

Decision Criteria Test - IRR Advantages of IRR

IRR and Non-conventional Cash

Another Example – Non-conventional

• Year 2: 100,000 ($4,000.00)

• The required return is 15%. ($8,000.00)

• Should we accept or reject the project? ($10,000.00)

IRR and Mutually Exclusive

Example With Mutually Exclusive

Conflicts Between NPV and IRR Profitability Index

Advantages and Disadvantages of

Capital Rationing Quick Quiz

Summary Summary Continued

Summary Continued Summary Continued

Appendix A – The Modified Internal MIRR Method #1

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