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You are on page 1of 41

Salman Masood Sheikh

M.Com, MBA, M.Phil, ACMA, FPA, CA (Int.)

McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Be able to compute payback and discounted payback and understand their shortcomings Understand accounting rates of return and their shortcomings Be able to compute the internal rate of return and understand its strengths and weaknesses Be able to compute the net present value and understand why it is the best decision criterion

9-1

Chapter Outline

Net Present Value The Payback Rule

The Profitability Index The Practice of Capital Budgeting

9-2

We need to ask ourselves the following questions when evaluating capital budgeting decision rules

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? 9-3

Where : FVn is Future value PVn is Present value FVIF is Future value interest factor k% is rate of interest ny is Number of year

9-4

9-5

Where : PVn is Present value FVn is Future value PVIF is Present value interest factor k% is rate of interest ny is Number of year

9-6

9-7

Where : PVAD is Present value annuity due PMTn is Payment made each period

PVIFA is Present value interest factor of annuity

9-8

9-9

Where : FVAD is Future value annuity due PMTn is Payment made each period

FVIFA is Future value interest factor of annuity

9-10

9-11

The difference between the market value of a project and its cost How much value is created from undertaking an investment?

The first step is to estimate the expected future cash flows. The second step is to estimate the required return for projects of this risk level. The third step is to find the present value of the cash flows and subtract the initial investment.

9-12

Table 9.1 Capital Expenditure Data for Bennett Company

9-13

End of Year Cash Flows PVIF20%,ny Present Value

1 2 3 4 5

9-14

Total Present Value of Cash Flows Less Initial Cash Out Flow Net Present Value

If the NPV is positive, accept the project A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners. Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal.

9-15

Payback Period

How long does it take to get the initial cost back in a nominal sense? Computation

Estimate the cash flows Subtract the future cash flows from the initial cost until the initial investment has been recovered

Decision Rule Accept if the payback period is less than some preset limit

9-16

Assume we will accept the project if it pays back within two years.

Year 1: 165,000 63,120 = 101,880 still to recover Year 2: 101,880 70,800 = 31,080 still to recover Year 3: 31,080 91,080 = -60,000 project pays back in year 3

9-17

Advantages

Easy to understand Adjusts for uncertainty of later cash flows Biased toward liquidity

Disadvantages

Ignores the time value of money Requires an arbitrary cutoff point Ignores cash flows beyond the cutoff date Biased against longterm projects, such as research and development, and new projects

9-18

This is the most important alternative to NPV It is often used in practice and is intuitively appealing It is based entirely on the estimated cash flows and is independent of interest rates found elsewhere

9-19

Definition: IRR is the return that makes the NPV = 0 Decision Rule: Accept the project if the IRR is greater than the cost of capital

9-20

If you do not have a financial calculator, then this becomes a trial and error process Calculator

Enter the cash flows as you did with NPV Press IRR and then CPT IRR = 16.13% > 12% cost of capital

9-21

Table 9.1 Capital Expenditure Data for Bennett Company

9-22

IRR when Cash Flows are equal

1. Calculate the payback period of the project Payback Period = Initial Cash Outflow . Annual yearly Cash Flows Payback Period = 42,000 = 3.000 Years 14,000 2. The project life is 5 years so trace the closest PVIFA to the factor 3.000 in the year 5, we will get the initial findings IRR >19% <20% 3. At 19% the factor is 3.058 4. At 20% the factor is 2.991 9-23

We can calculate the exact value of IRR by Interpolation Method

1. IRR = 19% + 1% x (PVIFA19%,5y PBP) 2. IRR = 19% + 1% x 3. IRR = 19% + 1% x 4. IRR = 19% + 0.86% 5. IRR = 19.86%

9-24

. (PVIFA19%,5y PVIFA20%,5y)

(3.058 3.000)

(3.058 2.991)

(0.058)

(0.067)

IRR when Cash Flows are unequal

1. Calculate average annual Cash Flows Avg. Cash Flows = Total Cash Flows No of Total Years Avg. Cash Flows = 70,000 = Rs. 14,000 5 2. Calculate average payback period of the project Payback Period = Initial Cash Outflow . Annual yearly Cash Flows

9-25

IRR when Cash Flows are unequal

Payback Period = 45,000 = 14,000 3.214 Years

3. The project life is 5 years so trace the closest PVIFA to the factor 3.214 in the year 5, we will get the initial findings 4. At 16% the factor is 3.274 5. At 17% the factor is 3.199

9-26

End of Year 1 2 3 4 5 Cash Flows 28,000 12,000 10,000 10,000 10,000 PVIF20%,ny 0.833 0.694 0.579 0.482 0.402 Present Value 23,324 8,328 5,790 4,820 4,020. PVIF22%,ny 0.820 0.672 0.551 0.451 0.370 Present Value 22,960 8,064 5,510 4,510 3,700

Less Initial Cash Out Flow Net Present Value

46,282

(45,000). 1,282 .

44,744

45,000 ( - 256)

9-27

We can calculate the exact value of IRR by Interpolation Method

1. IRR = 20% + 2% x (NPV @ 20%) 2. IRR = 20% + 2% x 3. IRR = 20% + 1% x (1,282) (1,282)

(1,538)

. (NPV @ 20% NPV @ 22% . (1,282 ( 256)

4. IRR = 21.67%

9-28

70,000 60,000 50,000 40,000

NPV

IRR = 16.13%

9-29

0.1

0.2

0.22

Advantages of IRR

Knowing a return is intuitively appealing It is a simple way to communicate the value of a project to someone who doesnt know all the estimation details If the IRR is high enough, you may not need to estimate a required return, which is often a difficult task

9-30

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

9-31

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 in which we have limited capital

9-32

Profitability Index for Given Cash Flows

Profitability Index = Present Values of Cash Flows Initial Cash Outflow Decision Criteria the project with higher Profitability Index will be accepted.

9-33

End of Year 1 2 3 4 5 Cash Flows 28,000 12,000 10,000 10,000 10,000 PVIF20%,ny 0.833 0.694 0.579 0.482 0.402 Present Value 23,324 8,328 5,790 4,820 4,020. PVIF22%,ny 0.820 0.672 0.551 0.451 0.370 Present Value 22,960 8,064 5,510 4,510 3,700

Initial Cash Out Flow Profitability Index

46,282

45,000 1.028 (Accept)

44,744

45,000 0.9943 (Reject) 9-34

Advantages

Closely related to NPV, 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

9-35

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

9-36

Net present value

Difference between market value and cost Take the project if the NPV is positive Has no serious problems Preferred decision criterion

Discount rate that makes NPV = 0 Take the project if the IRR is greater than the required return Same decision as NPV with conventional cash flows IRR is unreliable with non-conventional cash flows or mutually exclusive projects Benefit-cost ratio Take investment if PI > 1 Cannot be used to rank mutually exclusive projects May be used to rank projects in the presence of capital rationing

Profitability Index

9-37

Payback Period

Length of time until initial investment is recovered Take the project if it pays back within some specified period Doesnt account for time value of money and there is an arbitrary cutoff period

9-38

Quick Quiz

Consider an investment that costs $100,000 and has a cash inflow of $25,000 every year for 5 years. The required return is 9% and required payback is 4 years.

What is the payback period? What is the discounted payback period? What is the NPV? What is the IRR? Should we accept the project?

What decision rule should be the primary decision method? When is the IRR rule unreliable?

9-39

9

End of Chapter

Thank You for being with me

McGraw-Hill/Irwin

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