Chapter 8

Net Present Value and Other Investment Criteria

Capital Budgeting

Ø The process of analysing long term investment projects that will generate
cash flow and deciding whether a particular project is acceptable or which
project to choose between a number of possible projects
Ø Importance of capital budgeting
• Capital expenditure typically require a substantial outlay of funds
• Capital assets have long term impacts on a business
Ø Capital budgeting process
• Generate project proposals
o Does the project fit with the firm’s long term goals?
• Screening
o How will the project affect the firm
o Type of project
§ Replacement
² Maintenance of existing business
- Replacing worn out/ damaged equipment
used to make profitable products
- Whether the operation should be continued
or not
² Cost reduction
- Replacing inefficient equipment
§ Expansion
² Existing markets and products
- Increasing output of existing products or
expanding retail outlets or distribution
facilities
- Generating accurate forecasts of future
growth in demand
² New markets or products
- Entering into a new product area or market
- Normally requires significant capital
expenditure
§ Safety and Environmental
² Mandatory investments to ensure compliance
with government legislation on safety or
environmental issues
² This investment may not result in positive cash
flow
 ² Analysis of how the firm will fund the investment
and its impact
§ Other projects
² Infrastructure development, buildings etc
² Analysis is carried out using the best approach of
the specific project under consideration
o Evaluating different options
§ One project: accept or reject
§ Multiple projects:
² Independent
- Projects have no impact on other’s cash flow
- One or more could be accepted
² Mutually exclusive projects
- Accepting one project requires rejecting all
other options
- Projects are analysed separately but need to
be ranked
² Contingent
- Projects in which acceptance and rejection of
a project is dependent on the decision to
accept or reject a related project
- Complementary or substitute
• Evaluation
o Quantitative analysis
§ Forecast cash flows
§ Determine risk of each flows
§ Apply evaluation method
o Qualitative analysis
• Implementation and control
o Monitoring actual cash flows relative to forecasts
• Post implementation audit
o Project follow up and review

Net Present Value

Ø The value of a project taking into account its initial outlay and the discounted
value of all the project’s future cash flows
Ø It determines whether the future benefits expected from a project exceed
the project’s cost
Ø It measures the increase in form value arising from undertaking the project
Ø The discount rate represents the rate of return that could be earned on an
investment in the capital market with equivalent characteristics
Ø Decision rule:
 • Positive NPV indicates that a project yields a future wealth of the
shareholders greater than if they were to invest the cash in the capital
market themselves
• Accept if the NPV is positive
• A Zero NPV indicates the project yields the same future wealth as the
capital market
• We would be indifferent between taking the investment and not
taking it
• For mutually exclusive projects, choose the project with the highest
positive NPV
!
Ø NPV = ∑'()* ! !
(#$%)
Ø
Advantages Disadvantages
Simple and clear decision rule Requires extensive forecasts of future
cash flows
Takes into account time value of Can be difficult in practice to choose an
money appropriate discount rate
Correctly ranks projects on The concept of NPV is often difficult for
shareholder wealth maximising non finance trained managers to
criterion understand
Considers all cash flows generated
by a project
Incorporates risk of the project

Payback rule

Ø The payback period is the amount of time required for an investment to

generate net cash flows sufficient to recover its initial cost
Ø Once the initial cost has been repaid, any other cash flows from the project
are considered profits
Ø Decision rule:
• Independent projects: accept projects within the target maximum
payback period
• Mutually exclusive projects: choose the project with the shortest
payback period
,!
Ø Payback period = Y(+# + !
• Where Yt-1 is the year before full recovery of the initial outlay
• UC is the amount of the initial outlay unrecovered at the start of the
yearY
• C is the cash flow during the year Y
Ø
Advantages Disadvantages
 Simple to estimate
Clear decision rule and simple to
interpret
Adjusts for uncertainty of later cash
flows
Biased towards liquidity
Used in making minor decisions and
small companies
Benchmark payback period are usually
arbitrary
It ignores any cash flows that occur
beyond the cut off date
It does not take into account time
value of money
Biased against long term projects and
new projects
Ignores risk differences between
projects

Discounted payback

Ø Extension of payback technique

Ø Difference is that future cash flows are discounted to present value at an
appropriate rate before they are cumulated
Ø Decision rule:
• Independent projects: accept projects within target discounted
payback period
• Mutually exclusive projects: choose the project with the shortest
discounted payback period
,!
Ø Payback period = Y(+# + !
Ø
Advantages Disadvantages
Simple to estimate and clear decision Benchmark maximum payback periods
rule are usually arbitrary
Takes into account the time value of Does not take into account any cash
money flows that occur after the project has
repaid the initial investment

Average Accounting Return

Ø An investment’s average net income divided by its average book value

Ø It measures the percentage return on invested physical capital
Ø It is based on accounting profit and historical cost asset figures
Ø Decision rule:
• Independent projects: accept the project if the AAR is greater than the
target AAR
• Mutually exclusive projects: choose the project with the highest AAR
-./%01/ '/( 3'456/
Ø AAR = -./%01/ 7558 .09:/
• Estimate average net income (less depreciation and tax) over the life
of the project
 • Estimate average book value of net investment (after depreciation)
over the life of the project
Ø
Advantages Disadvantages
Easy of obtain data (accounting Based on accounting numbers, not
numbers) cash flows and market values
Simple to calculate Ignores time value of money
Considers income over the life of the Benchmark AAR is usually arbitrary
project

Internal Rate of Return

Ø The discount rate that makes the NPV of an investment zero

Ø The expected rate of return on a project
Ø ‘Internal’ in the sense that it depends only on the cash flows of a particular
investment, not on rates offered elsewhere
Ø Decision rule:
• Independent projects: accept project if IRR exceeds the hurdle rate
(the required return on the project)
• Mutually exclusive projects: choose the project with the highest IRR
!!
Ø 0 = ∑'()* (#$%) !
, find r
• Trial and error
o If the result is positive, recalculate with a higher IRR
o If the result is negative, recalculate with a lower IRR
o Repeat this until the NPV = 0
Ø
Advantages Disadvantages
Simple decision rule Difficult to find IRR – trial and error
Easy to understand and communicate Decision rule changes depending on
(people prefer talking about rates of whether it is an investment or
return) financing project
Does not depend on the interest rate Assumes that short term = long term
in the market interest rates
Closely related to NPV, so often leads Possible to get multiple IRR or no IRR
to identical result if a project has non-conventional cash
flows (+ and -) over time
Can lead to incorrect decisions in
comparisons of mutually exclusive
investments
It assumes that cash flows can be
reinvested at the IRR rate. It is more
likely that reinvestment will be at the
required rate of return
Modified IRR

Ø This technique is a variation of the IRR

Ø It differs from IRR in that:
• MIRR assumes that cash flows are reinvested at the discount rate
• MIRR will not generate multiple results
Ø PV45;(; = PV(/%63'09 .09:/
<=! ∑"
!$% ?=! (#$%)
"#!
Ø ∑'()* =
(#$%)! (#$@?AA)!
• Where OF represents cash outflows and IF represents cash inflows
BC
Ø MIRR = (DC )#/' − 1
&'(!(
• Where TV represents the terminal value of the project’s cash flows
Ø Decision rule:
• Independent projects: accept project of MIRR exceeds hurdle rate
• Mutually exclusive projects: choose the project with the highest MIRR
Ø
Advantages Disadvantages
Simple decision rule and easy to Calculation can be complicated
understand
Does not generate multiple results in When comparing mutually exclusive
the presence of non conventional projects it does not account for
cash flows project size or life span (missing years
Assumes reinvestment of cash flows in the shorter project need to have
at the discount rate cash flows of 0)

Profitability index

Ø NPV of cash flows stated in relative rather than absolute terms

Ø The present value of an investment’s future cash flows divided by its initial
cost
Ø It is useful for ranking projects
Ø Decision rule:
• Independent projects: accept project if PI > 1
• Mutually exclusive projects: choose the project with the highest PI
)!
∑"
!$+ (+,-)!
Ø PI =
!%
Ø
Advantages Disadvantages
Similar benefits to NPV May lead to incorrect decisions in
Closely related of NPV, so often comparing mutually exclusive projects
leading to the same decision when there are constraints in addition
Useful for ranking (capital rationing) to capital