SUMMARY CHAPTER 9

NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA

By Fidelia Agatha (2106715765)
Class MK-J

CHAPTER OUTLINE
• Net Present Value
• The Payback Rule
• The Discounted Payback
• The Average Accounting Return
• The Internal Rate of Return
• The Profitability Index
• The Practice of Capital Budgeting

Calculating The Net Present Value (NPV) and Understanding The

Advantages – Disadvantages
Net Present Value (NPV) Definition
- The difference between an investment’s market value and its cost.
- How much value is added or created today by undertaking an investment?
The steps :
1. Estimate the expected future cashflows
2. Estimate the required return for projects of this risk level
3. Find the present value of cashflow and substrack the initial
investment
Formula :
Estimating Net Present Value (NPV)
DCF Valuation : The process of valuing an investment by discounting its future
cashflows
For example, given that our fertilizer business has :
- Expected cashflow = $20,000/year
- Costs = $14,000/year
- Time = 8 years
- Salvage value = $2.000
- r = 15%
- Estimated cost = $30,000

Based on our calculations regarding the NPV, taking an investment would

decrease the total value of the stock by $2,422. With 1,000 shares outstanding,
the impact of this investment is a loss of value of $2,422/1,000 = $2,42 per share.
Decision rule:
“An investment should be accepted if the net present value is positive and
rejected if it’s negative.”
• Positive NPV – the project add value to the firm – increase the wealth of
the owners – ACCEPT!
• Negative NPV – the project doesn’t add any value to the firm – decrease
the wealth of the owners – REJECT!
Advantages vs Disadvantages of NPV
ADVANTAGES
- Takes account of time value of
money
- Concers of shareholders’ wealth
- Takes account of risk
- Look at the whole life of the
project
DISADVANTAGES
- Difficult to be understood by
managers
- Adverse effects on accounting
profit in the short – run
- Ignoring sunk cost and might
not boost EPS & RDE

Payback Period : “how long does it take to get the initial cost back in a
nominal sense?”
Payback Period is the amount of time required for an investment to generate
cash flows sufficient to recover its initial cost.
Computation:
1. Estimate the cash flows
2. Substract the future cash flows from the initial cost until the initial
investment has been recovered
Decision rule:
“Based on the payback rule, an investment is acceptable if its calculated
payback period is less than some prespecified number of years.”
Means, accept the project if the payback period is less than some preset limit.
Example:

Conclusion : we don’t accept the project

Advantages vs Disadvantages of Payback Rule
Advantage Disadvantage
Easy to understand Ignores the time value of money
Adjusts for uncertainty of later cash Requires an arbitrary cutoff point
flows
Biased toward liquidity Ignores cash flows beyond the cutoff
date
Biased against long – term projects,
such as RnD, and new projects

The Discounted Payback

Definition :
- The length of time when the sum of the discounted cashflows is equal to
initial investment
- Compute the present value of each cash flow, then determine how long it
takes to pay back on a discounted basis.
- Compute to a specified required period.
Decision rule : accept the project if it pays back on a discounted basis within the
specified time
Example :

In conclusion, we don’t accept the project.

The Average Accounting Return (AAR)
Definition :
- An investment’s average net income divided by its average book value
Note : the average book value depends on how the asset is depreciated.

=
Decision rule : accept the project if the AAR is greater than a preset rate (exceeds
a target average accounting return).
Example :

In conclusion, we should not accept the project because the AAR < average
accounting return.
Advantages vs Disadvantages of AAR

Internal Rate of Return (IRR)

Definiton :
- The discount rate that makes the NPV of an investment zero.
- The required return that results in a zero NPV when it’s used as the
discount rate.
- A way to find a single rate of return that summarizes the merits of a project.
- “internal” because it only depends on the cash flows of a particular
investment, not on rates offered elsewhere (independent of interest rates).
- Often used in practice and is intuitively appealing.
Decision rule : accept the project if the IRR is greater than the required return
(IRR > r)
Problems with IRR :
1. Nonconventional cash flows: cash flow signs change more than once
2. Mutually exclusive investments
- Issue of scale: initial investments are substantially different
- Timing of cash flows is substantially different.
Advantages vs Disadvantages of Internal Rate of Return (IRR)

The Modified Internal Rate of Return

Most of the times, we propose a modified version of IRR to address some of the
problems that’s wrapped up in the standard IRR.
Important points
- Calculate the NPV of all cash outflows using the borrowing rate
- Calculate the NFV of all cash inflows using the investing rate
- Find the rate of return that equates these values
- Benefits: single answer and specific rates for borrowing and
reinvestment.
3 methods
1. The discounting approach
The idea is to discount to all negative cash flows back to the present at the
required return and add them to the initial cost, then calculate the IRR.
2. The reinvestment approach
We compound all cash flows (positive and negative) except the first out to
the end of the period, then calculate the IRR.
3. The combination approach
A mixture of the discounting approach and the reinvestment approach.
Negative cash flows are discounted back to the present, and positive cash
flows are compounded to the end of the project.
The Profitability Index (PI) Index or Benefit – Cost Ratio
Definition :
- The present value of the future cash flows divided by the initial
investment.
- It measures the benefit per unit cost, based on the time value of
money.
- Implication: we create an additional $0.10 in value for every $1 of
invesment
Advantages vs Disadvantages of PI Index
 SUMMARY CHAPTER 10
MAKING CAPITAL INVESTMENT DECISIONS
By Fidelia Agatha (2106715765)
Class MK-J

Chapter Outline
• Project Cash Flows: A First Look
• Incremental Cash Flows
• Pro Forma Financial Statements and Project Cash Flows
• More about Project Cash Flow
• Alternative Definitions of Operating Cash Flow
• Some Special Cases of Discounted Cash Flow Analysis

Relevant Cash Flow or Incremental Cash Flows

Definition :
- A modification or difference in the company's overall future cash flow that
results directly from the choice to accept that project.
The Stand-Alone Principle is the presumption that a project's incremental cash
flows may be used to evaluate the project. By concentrating on incremental cash
flows, it enables us to examine each project independently of the company.
Ask yourself “will this cash flow occur only if we accept the project?”
Answer Conclusion
Yes Since it means the project is
incremental, it should be included in
the analysis
No The project should not be included in
the analysis because it will occur
anyway
Part of it We should include just a part that
occurs because of the project.

Common Types of Cash Flow

➢ Sunk Cost : costs that occured in the past (already paid/incured the liability
to pay), can’t be changed by decision today. Example : consulting fee
 ➢ Opportunity Cost : costs of lost options (the most valuable alternative that
is given up if a particular investment is undertaken)
➢ Side Effect
- Positive side effect: benefits to other projects
- Negative side effect: costs to other projects
➢ Changes in NWC:
- a project requires investments in NWC
- investment in NWC resembles loans
➢ Financing Costs: interest paid and other financing costs are not included in
analyzing a proposed investment
➢ Taxes
➢ Other issues :
- Interest only in measuring cash flows: when it actually occurs, not when
accrued
- Interested in aftertax cashflows: taxes are definitely a cashflow
Using Pro Forma Financial Statements
Pro Forma Financial Statements is financial statements projecting future years’
operations. Capital budgeting relies heavily on pro forma accounting statements,
particularly income statements.
Computing cash flows – refresher
• Operating Cash Flow (OCF) = EBIT + Depreciation – Taxes
• OCF = Net Income + depreciation (when there i sno interest expense)
• CFFA = OCF – Net Capital Spending (NCS) – changes in NWC
Project Cash Flows

Using Net Working Capital and Depreciation

Net Working Capital
In calculating OCF, we don’t explicitly consider the fact that some of sales might
be on credit, may not have actually paid some of the costs shown.
Depreciation
Depreciation expense used for capital budgeting should be the depreciation
schedule required by the IRS for tax purposes.
Depreciation itself is a non – cash expense; consequently, it’s only relevant
because it affects taxes.
Depreciation tax shield = D x T
D: depreciation expense
T: marginal tax rate
Computing Depreciation
➢ Straight – line depreciation
D = (initial cost – salvage) / number of years
Very few assets are depreciated straight – line for tax purposes.
➢ Accelerated Cost Recovery Systems (AACRS)
A depreciation method under U.S. tax law allowing for the accelerated
write – off of property under various classification.
➢ Modified ACRS Depreciation (MARCS)
- MARCS % sum up to 100% -> write – off 100% of cost of asset
- Need to know which asset class is appropriate for tax purposes
- Multiply percentage given in table by the initial cost
- Depreciation to zero
- Mid – year convention
➢ Book Value vs Market Value
- Book value < Market value : MV - BV > Depreciation, Pay tax
- Book value > Market value : a loss for tax purpose
After – Tax Salvage
We can identify a tax effect when there’s a difference between salvage value and
book value of the asset.
Book value = initial cost – accumulated depreciation
After tax salvage = salvage – T*(salvage – book value)
Various Counting Methods Operating Cash Flows (OCF)
The Top – Down Approach
- OCF = Sales – costs – taxes
- Don’t substract noncash deductions
The Bottom – Up Approach
- OCF = NI + Depreciation
- Works only when there’s no interest exp
The Tax Shield Approach
- OCF = (Sales – costs) (1 – T) + Depreciation*T
Several Variations on The Illustrations of Proposed Project Costs
Three common cases :
1. Investment that are primarily aimed at improving efficiency
2. When firm is involved in submitting competitive bids
3. Choosing between equipment option with different economic issues
Evaluating Cost – Cutting Proposals
Issue: whether the cost savings are large enough to justify the necessary capital
expenditure
Setting The Bid Price
Goal : determine the lowest price we can profitability charge
Key observations : the lowest possible price we can profitably charge with result
in a zero NPV at given required rate
Steps :
1. Draw timeline of project cashflow
2. NPV = 0, OCF = ...
3. Find Net Income from OCS = Net Income + Depreciation
4. Find sales from Net Income = (Sales – costs – depreciation) (I – T)
Evaluating Equipment Options with Different Lives
Goal : choose the most cost – effective