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WHY NET PRESENT VALUE
LEADS TO BETTER INVESTMENT DECISIONS
THAN OTHER CRITERIA
The objective of the financial manager is to maximize the value of the firm. In order to
attain this objective must decide which assets to invest in and how to finance them.
Thus there are three types of decisions the financial manager is called upon to make
Working capital management
In the current chapter we concentrate on capital budgeting decision
5.2 Capital Budgeting
Capital budgeting can be defined as the process of analyzing, evaluating, and
deciding whether resources should be allocated to a project or not.
Process of capital budgeting ensure the best possible allocation of resources and helps
management work towards the goal of shareholder wealth maximization.
Capital budgeting decisions are considered to be quite important to the success of any
business. The reasons are:
Involve enormous investment of resources
Are not easily reversible
Have long‐term implications for the firm
Entail uncertainty and risk for the firm
Due to the above factors, capital budgeting decisions become critical and must be
evaluated very carefully. Any firm that does not follow the capital budgeting process
will not be maximizing shareholder wealth and management will not be acting in the
Payback represents the number of years required for the original cash investment to be returned.3 Payback Period The payback period is simply the time taken by the project to return your initial investment.FIN-101 ___________________________________________________________________________ best interests of shareholders. Concorde Plane. Therefore. These are: Payback Period Approach Discounted Payback Period Approach Net Present Value Approach Internal Rate of Return Profitability Index We will use the following example to demonstrate the techniques of capital budgeting Example 51 Assume that your company is investigating a new labor‐saving machine that will cost $10. it will be misleading to __________________________________________________________________________________________ Loukia Evripidou 2 . The measure is very popular and is widely used.000. In practice there are five alternative investment criteria that can help us to identify the right investment alternative. Examples: Euro‐Disney. Saturn of GM all faced problems due to bad capital budgeting. while Intel became global leader due to sound capital budgeting decisions in 1990s. it is also an unsound and unreliable measure. The machine is expected to provide cost savings each year as shown in the following timeline: 5. but the time value of money is ignored.
firms will have some maximum allowable payback period against which all investments are compared. Otherwise.2 Decision Rule The shorter the payback period. PP = years full recovery + unrecovered cost at beginning of last year cash flow in last year For our example project.3. If the project’s payback period is less than the maximum acceptable payback period.7143 years (= 2500/3500) to recover the last 2. That is the cash flows from each year are added to find out the point in time at which the cumulative cash flows equal the initial investment. we will subtract the cash flows from the initial outlay until the entire cost is recovered: Since it will take 0. accept the project.1 Calculation The payback period measures the time that it takes to recoup the cost of the investment.500. as in the example.3.7143 years 5. reject the project. the payback period must be 3. __________________________________________________________________________________________ Loukia Evripidou 3 .FIN-101 ___________________________________________________________________________ think that all cash flows after payback represent profit. the better Generally. we subtract the cash flows from the cost until the remainder is zero. If the cash flows are an annuity. then we can simply divide the cost by the annual cash flow to determine the payback period. 5. If the project’s payback period is greater than the maximum acceptable payback period.
FIN-101 ___________________________________________________________________________ 5. the timeline with the PVs looks like this: __________________________________________________________________________________________ Loukia Evripidou 4 . Project C0 C1 C2 C3 A B 2000 500 500 5000 2000 500 1800 0 C 2000 1800 500 Project C0 C1 C2 Payback NPV@ 10% Period 0 C3 Payback Period 500 5000 3 NPV@ 10% + 2. Since our required return (WACC) is 12%.624 A 2000 500 B 2000 500 1800 0 2 58 C 2000 1800 500 0 2 + 50 5.3 Advantages and Disadvantages Advantages Computational simplicity Easy to understand Focus on cash flow Disadvantages Does not account properly for time value of money Does not account properly for risk Cutoff period is arbitrary Does not lead to value‐maximizing decisions Example 52 Examine the three projects and note the mistake we would make if we insisted on only taking projects with a payback period of 2 years or less.4 Discounted payback The discounted payback period is exactly the same as the regular payback period. except that we use the present values of the cash flows in the calculation. This is an improvement over the traditional payback in that the time value of money is recognized.3.
82 years Note that the discounted payback period is always longer than the regular payback period The discounted payback period solves the time value problem.4.1 Advantages and Disadvantages Advantages Includes time value of money Easy to understand Does not accept negative estimated NPV investments when all future cash flows are positive Biased towards liquidity Disadvantages May reject positive NPV investments Requires an arbitrary cutoff point Ignores cash flows beyond the cutoff point Biased against long‐term projects. you may reject projects that have large cash flows in the outlying years that make it very profitable. but it still ignores the cash flows beyond the payback period. In other words. any measure of payback can lead to a focus on short‐run profits at the expense of larger long‐term profits 5. such as R&D and new products __________________________________________________________________________________________ Loukia Evripidou 5 .FIN-101 ___________________________________________________________________________ The discounted payback period is 4. Therefore.
Following our initial example.5 Accounting Rate of Return The accounting rate of return (ARR) method may be known by other names such as the return on capital employed (ROCE) or return on investment (ROI). Since the asset has initial cost of $ 10.000 = $1.000 Depreciation Profit Yr1 2.000 ‐2000 1.000 per annum To calculate the profit for each year Taking into account the cash flow and the depreciation the profit for each year is: Yr0 ‐ Cash Flow 10.000 The next step is to calculate the average book income.2 Decision rule and interpretation Accept projects with returns greater than the average return on the book value of the firm.500 ‐2000 1. expressed as a percentage This is a rate of return measure based on accounting earnings and is defined as the ratio of book income to book assets.500 Yr5 4.000 + 1.5.FIN-101 ___________________________________________________________________________ 5.000 5 __________________________________________________________________________________________ Loukia Evripidou 6 .000 ‐2000 0 Yr2 2.500 + 2. It is also called book rate of return. 5.000 Yr4 3.000 and the asset a 5 year life then the depreciation is $2. in order to calculate the Accounting rate of return we need To calculate the depreciation of the asset.500 ‐2000 500 Yr3 3. or some external yardstick.5.1 Calculation Average Book rate of return = Average book income Avegage book asset value 5.000 ‐2000 2. ARR is a ratio of the accounting profit to the investment in the project. This can be found as follow: Average Book Income = 0 + 500 + 1.
time value of money is ignored Uses an arbitrary benchmark cutoff rate Based on accounting net income and book values.5.3 Advantages and Disadvantages Advantages Easy to calculate Needed information will usually be available Disadvantages Not a true rate of return. Is the difference between the market value of a project and its cost. the opportunity cost of capital is the expected rate of return that shareholders could have obtained by investing in financial assets.000 + 0 Average Book Asset Value = = = $5. NPV: The sum of the present values of a project’s cash inflows and outflows. which is Initial Cost + Scrap Value 10 . If cash are reinvested.000 Average Book Rate of Return = = 20% 5. It represents the increase in the market value of the stockholders’ wealth. The figure below represents a trade –off => the firm can either keep and reinvest cash or return it to investors (Arrows represent possible cash flows or transfers).000 2 2 The last step is to calculate the average book rate of return 1. __________________________________________________________________________________________ Loukia Evripidou 7 .6 Net Present Value The NPV represents the value added to the business by the project or the investment. Thus.FIN-101 ___________________________________________________________________________ Then we calculate the average book asset value. accepting a project with a positive NPV will make the stockholders better off by the amount of its NPV.000 5. not cash flows and market values Profit figures are very poor substitutes for cash flow 5.
the project is acceptable __________________________________________________________________________________________ Loukia Evripidou 8 .06 ⎝ ⎠ Since the NPV is positive.6. The third step is to find the present value of the cash flows and subtract the initial investment.12)1 + (1.12)3 + (1.12)4 + (1.FIN-101 ___________________________________________________________________________ Cash Investment opportunity (real assets) Firm Shareholder Invest Alternative: Pay dividend to shareholders Investment opportunities (financial assets) Shareholders invest for themselves NPV is the theoretically correct method to use in most situations. NPV = PV of cash inflows ‐ initial investment. Going to the initial example the NPV of the project ⎛ 2000 2500 3000 3500 4000 ⎞ ⎜ ⎟ ⎜ (1.1 Calculation The first step is to estimate the expected future cash flows. 5.12)2 + (1. They will not serve the best interests of the stockholders. Other measures are inferior because they often give decisions different from those given by following the NPV rule.12)5 ⎟ − 10000 = 408. The second step is to estimate the required return for projects of this risk level.
FIN-101 ___________________________________________________________________________ 5. Since our goal is to increase owner wealth. A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners.6. if the NPV is positive. Advantages Focuses on cash flows.2 Decision Rule and Interpretation If the NPV is positive. 5. For mutually exclusive projects.3 Advantages and Disadvantages NPV is the “gold standard” of investment decision rules.6. Disadvantages Doesn’t capture managerial flexibility (option value) well __________________________________________________________________________________________ Loukia Evripidou 9 . The discount rate should reflect the opportunity cost of capital or what the stockholders can expect to earn on other investments of equivalent risk. accept the project with the highest NPV. not accounting earnings Makes appropriate adjustment for time value of money Can properly account for risk differences between projects Clearly measures the increase in market value or wealth created by the project. NPV is a direct measure of how well this project will meet our goal. accept the project.
Start with a low discount rate and then calculate the NPV at progressively higher rates till the NPV calculated has a negative value.7 Internal Rate of Return (IRR) IRR is defined as the discount rate at which the NPV equals zero. What is the IRR on this investment? 2. For our example. It is often used in practice and i is based entirely on the estimated cash flows and is independent of interest rates found elsewhere.1 Calculation It is calculated by trial and error. the IRR is found by solving the following: 10. The IRR is that discount rate at which the line crosses the X‐axis (NPV=0). respectively.FIN-101 ___________________________________________________________________________ 5. the NPV will decrease as the discount rate is increased.000 = 2000 2500 3000 3500 4000 + + + + 1 2 3 4 (1 + IRR ) (1 + IRR ) (1 + IRR ) (1 + IRR ) (1 + IRR )5 In this case. This is the most important alternative to NPV. or Calculate the following formula IRR = lower rate + NPV at lower rate NPV at lower rate NPV at higer rate In general.000 NPV = −4 .7.000 in cash flows for two years.45% Example 53 You can purchase a turbo powered machine tool gadget for $4. 5. Follow the steps for calculating the NPV and calculate the NPV for several discount rates.000 + + =0 __________________________________________________________________________________________ (1 + IRR)1 (1 + IRR)2 Loukia Evripidou 10 .000. Then you can either Plot the NPVs (y‐axis) against the discount rate (x‐axis).000 4 . The investment will generate $2. the solution is 13.000 and $4.
reject the project. __________________________________________________________________________________________ Loukia Evripidou 11 .FIN-101 ___________________________________________________________________________ 2500 IRR = 28 . If IRR is less than the cost of capital.2 Decision Rule and Interpretation If IRR is greater than the cost of capital. the NPV for the project will be positive.7.000s) 1500 -1000 -1500 -2000 Discount rate (%) 5. accept the project. As long as the cost of capital is less than the IRR. 08 % 2000 1000 500 10 0 90 80 70 60 50 40 30 -500 20 0 10 NPV (.
000 + 35. The project should be accepted only if the IRR is less than the opportunity cost of capital. IRR can give incorrect decisions and should not be used to rank projects. These projects give cash inflows first. If one must use IRR for mutually exclusive projects. Example 54 Consider project E and F: Project E F C0 Ct IRR NPV @10% − 10.000 75 + 8 .818 richer! IRR can also be misleading in cases where the project cash flow patterns are reverses of the normal project.FIN-101 ___________________________________________________________________________ 5.818 With the IRR rule project E should be accepted since it has the higher IRR rate.000 + 20. the IRR decision rule should be reversed.3 Advantages and Disadvantages Advantages Properly adjusts for time value of money Uses cash flows rather than earnings Accounts for all cash flows It is a simple way to communicate the value of a project to someone who doesn’t know all the estimation details Disadvantages IRR can rank projects incorrectly.000 100 − 20. if you follow the NPV you are $11.182 + 11. it is like borrowing and in such cases. followed by outflows. it should be done by calculating the IRR on the differences between their cash flows.7. For mutually exclusive projects. you have the satisfaction of earning 100% rate of return. __________________________________________________________________________________________ Loukia Evripidou 12 . Nevertheless if you follow the IRR rule. Thus.
when we want to borrow money we want a low rate of return.500 IRR +50% +50 % NPV at 10% +364 ‐364 Each project has an IRR of 50%.000 +1. One will need to look into the “NPV profile” (the NPV‐discount rate graph) to identify the discount rate range for which the NPV is positive. In such cases.000 C1 +1. (multiple rates of return). it may not be obvious whether a high IRR is good or bad.FIN-101 ___________________________________________________________________________ Example 55 Consider the following projects A and B: Project A B C0 ‐1. NPV Discount Rate Another problem with IRR is that for projects whose cash flows change sign more than once there will have more than one IRR. But does this means that are equally attractive? CLEARLY NOT!!! In the case of A we are lending money at 50% In the case of B we are borrowing money at 50% When we want to lend money we want a high rate of return.500 ‐1. __________________________________________________________________________________________ Loukia Evripidou 13 .
8 Capital Rationing and Profitability Index: Occasionally. 5. stockholder wealth is maximized by taking up projects with the highest NPV per dollar of initial investment. This approach is facilitated by the profitability index (PI) measure.FIN-101 ___________________________________________________________________________ Example 56 The following cash flow generates NPV=0 at both (‐50%) and 15.1 Calculation Profitability Index = NPV Investment __________________________________________________________________________________________ Loukia Evripidou 14 .8. The amount available for investment is limited so that all positive NPV projects cannot be accepted.2%. In such cases. C0 C1 C2 C3 C4 C5 C6 − 1.000 + 800 + 150 + 150 + 150 + 150 − 150 NPV 1000 IRR=15. companies face resource constraint or capital rationing.2% 500 0 -500 Discount Rate IRR=-50% -1000 5.
3 Advantages and Disadvantages Advantages Closely related to NPV.10 in value.0408 10 .8.2 Decision Rule The decision rule for profitability index is to accept all projects with a PI greater than zero.FIN-101 ___________________________________________________________________________ Profitability Index measures the benefit per unit cost. 5.8.408. This rule is equivalent to the NPV rule. and so on till the investment dollars are exhausted. generally leading to identical decisions Easy to understand and communicate May be useful when available investment funds are limited Disadvantages May lead to incorrect decisions in comparisons of mutually exclusive investments __________________________________________________________________________________________ Loukia Evripidou 15 . If the resource constraint is on some other resources. we create an additional $0. This rule will maximize the NPV and stockholder wealth. based on the time value of money. followed by the one with next highest. The modified rule applied in the case of capital rationing is to accept projects with the highest profitability index first. A profitability index of 1.1 implies that for every $1 of investment. a more complicated (linear programming) analysis is needed.06 = 1. When more than one resource is rationed. For the example.000 5. the PI is: PI = 10 . the profitability index needs to be modified to measure the NPV per unit of the resource that is rationed.
However. make sure you use them in the best possible way and understand the limitations of them. Inadequate forecast of the cash flows can be far more disastrous than using the wrong appraisal technique. and iii) it clearly measures the value added to the stockholders’ wealth. properly adjusting for the opportunity cost of capital. Cash flow forecasts are difficult to make and can be expensive. For example. It does not make sense to waste the forecasts by using an inferior method of evaluation. If you have to use them.e. __________________________________________________________________________________________ Loukia Evripidou 16 . the other three criteria for the evaluation of projects are found to be popular in corporate practice.9 NPV and other criteria: The NPV is superior to other criteria because: i) it is the only measure which considers the time value of money. Remember that it is the cash flows that determine the value of a project. always compare mutually exclusive projects on the basis of the difference between their cash flows.FIN-101 ___________________________________________________________________________ 5. ii) gives consistent measures of the project’s value (i. not affected by packaging with other projects).
Ignore taxes. Average book income = $100.000 Book rate of return = $100.000 Book Income =$100.000 annually for 5 years.000.000 Cash flow = $400.500. The expansion will produce incremental operating revenue of $400.000/$750. The company’s opportunity cost of capital is 12 percent.33% __________________________________________________________________________________________ Loukia Evripidou 17 .500. Calculate (a) payback period.FIN-101 ___________________________________________________________________________ Example 5-7 Bar Breweries is considering an expansion project with an estimated investment of $1.000 = 13. Average book value of investment = ($1.500.75 years b. and (e) profitability index.000/$400.000. (c) NPV.000 a. (d) IRR. Solution First calculate the annual earnings and cash flows: Operating revenues =$400.000+0)/2 = $750.000 Less depreciation =$300. Payback = $1. (b) book rate of return.000 = 3. The equipment will be depreciated to zero salvage value on a straight‐line basis over 5 years.
000/$1.000.FIN-101 ___________________________________________________________________________ c.000 x 3. The opportunity cost of capital is 14 percent. (c) NPV. Operating income (before depreciation and taxes) is expected to be $800. Calculate the NPV at different discount rates: NPV at 10 % = $400. IRR is calculated by trial and error. 5 years) ‐ $1.04 Example 58 Black and Company is considering an investment in a new plant which will entail an immediate capital expenditure of $4.000 = ‐$21.791 ‐ $1.500.500.400/(16.442. Calculate (a) the book rate of return.500.000 = $400.000 Years 1 through 5 Cash flow $400. and (e) the profitability index.000. __________________________________________________________________________________________ Loukia Evripidou 18 . (d) IRR.500.000 = $16.000 = ‐0.000 x 3.500.00 3.000 per year over the 10‐year life of the plant.000(discount factor for 10%. (b) the payback and discounted payback periods. Profitability Index = NPV/Investment = ‐$58.600 IRR lies between 10 percent and 11 percent.500.400 NPV at 11 % = $400.400+21. There are no taxes.43% e.600)] = 10.000 ‐$58.696 ‐ $1. IRR = 10 %+[16. The plant is to be depreciated on a straight‐line basis over 10 years to zero salvage value.000 Net Present Value 1 ‐$1.605 $1.000 d. NPV calculation: Amount Discount Present value factor Year 0 Initial investment ‐$1.
000.000.1% __________________________________________________________________________________________ Loukia Evripidou 19 .000 Book Income = $400.216 = $4.FIN-101 ___________________________________________________________________________ Solution 1.000 = 20 % (b) Payback period = $4.000/$800.800 (d) IRR = 15. (a) Operating revenues = $800.000. (c) NPV: Present value of cash flows = $800.000 x 5.2 years.800 ‐ $4. Discounted payback = 9.000.000.172.000 Less depreciation = $400.000 Book rate of return = $400.000 Cash flow = $800.000 = $172.000/$2.000+0)/2 = $2.800 NPV = $4.000 = 5 years Discounted payback is the number of years needed to get the PV of the cash flows to equal the initial investment.000 Average book income = $400.000 Average book value of investment = ($4.172.
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