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Chapter 11 Net Present Value and Other Investment Criteria

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Good Decision Criteria
• We need to ask ourselves the following questions when evaluating decision criteria
1. Does the decision rule adjust for the time value of money? 2. Does the decision rule adjust for risk? 3. Does the decision rule provide information on whether we are creating value for the firm?

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The third step is to find the present value of the cash flows and subtract the initial investment. 3.Net Present Value • The difference between the market value of a project and its cost • How much value is created from undertaking an investment? 1. Estimate the expected future cash flows. Estimate the required return for projects of this risk level. California State University-East Bay 2-3 . 2.

Net Present Value 0 1 2 3 4 5 |----------|----------|----------|----------|----------| -250 -100 -100 -100 -100 -100 +200 +200 +200 +200 +200 +100 +100 +100 +100 +100 If conventional CFs. 0 1 2 3 4 5 |----------|----------|----------|----------|----------| (-) (+) (+) (+) (+) (+) California State University-East Bay 2-4 .

Net Present Value Cn C1 C2 NPV  C0      2 n 1  r  1  r  1  r  California State University-East Bay 2-5 .

NPV is a direct measure of how well this project will meet our goal. California State University-East Bay 2-6 . 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.NPV – Decision Rule • If the NPV is positive. • Since our goal is to increase owner wealth.

California State University-East Bay 2-7 .080 • Your required return for assets of this risk is 12%.000 CF = 63.120 CF = 70.800 CF = 91.Project Example Information • You are looking at a new project and you have estimated the following cash flows: Year 0: Year 1: Year 2: Year 3: CF = -165.

12)3 – 165.627.Computing NPV for the Project • Using the formulas: NPV = 63.080/(1.800/(1.42 • Do we accept or reject the project? California State University-East Bay 2-8 .120/(1.12) + 70.12)2 + 91.000 = 12.

2nd [CLR WORK] CF0 = -165.080 ENTER  NPV.Computing NPV for the Project • Using the calculator: CF.800 ENTER F02 = 1  C03 = 91. I = 12 ENTER CPT => 12.41 California State University-East Bay 2-9 .120 ENTER F01 = 1  C02 = 70.627.000 ENTER  C01 = 63.

California State University-East Bay 2 .10 .NPV • Does the NPV rule account for the time value of money? • Does the NPV rule account for the risk of the cash flows? • Does the NPV rule provide an indication about the increase in value? • NPV rule is our primary decision.Decision Criteria Test .

11 .IRR – Definition and Decision Rule • Definition: the return that makes the NPV = 0 Cn C1 C2 NPV  0  C0      2 n 1  IRR   1  IRR  1  IRR  • Decision Rule: Accept the project if the IRR is greater than the required return California State University-East Bay 2 .

Computing IRR For The Project • This is a trial and error process • Calculator CF.12 .000 ENTER  C01 = 63.13 • Do we accept or reject the project? California State University-East Bay 2 . 2nd [CLR WORK] CF0 = -165.800 ENTER F02 = 1  C03 = 91.080 ENTER  IRRCPT => 16.120 ENTER F01 = 1  C02 = 70.

16 0.NPV Profile For The Project 70.04 0.1 0.000 60.2 0.000 10.13% NPV 30.18 0.14 0.000 40.000 20.000 0 -20.000 Discount Rate 0.000 IRR = 16.12 0.08 0.000 0 -10.06 0.22 California State University-East Bay 13 .000 50.02 0.

Decision Criteria Test .IRR • Does the IRR rule account for the time value of money? • Does the IRR rule account for the risk of the cash flows? • Does the IRR rule provide an indication about the increase in value? • Should we consider the IRR rule for our primary decision criteria? California State University-East Bay 2 .14 .

Advantages of IRR • Knowing a return is intuitively appealing (This is why it is often used in practice) • It is a simple way to communicate the value of a project to someone who doesn’t know all the estimation details • It is based entirely on the estimated cash flows and is independent of interest rates found elsewhere • If the IRR is high enough.15 . which is often a difficult task California State University-East Bay 2 . you may not need to estimate a required return.

NPV Vs. IRR • NPV and IRR will generally give us the same decision • Exceptions Non-conventional cash flows – cash flow signs change more than once Mutually exclusive projects • Initial investments are substantially different • Timing of cash flows is substantially different California State University-East Bay 2 .16 .

IRR and Non-conventional Cash Flows • When the cash flows change sign more than once. there could be more than one IRR • When you solve for IRR you are solving for the root of an equation and when you cross the x-axis more than once.17 University-East Bay . which one California doState you use to make your decision? 2 . there will be more than one return that solves the equation • If you have more than one IRR.

IRR – Definition and Decision Rule • Definition: the return that makes the NPV = 0 Cn C1 C2 NPV  0  C0      2 n 1  IRR   1  IRR  1  IRR  California State University-East Bay 2 .18 .

0 1 2 3 4 5 |----------|----------|----------|----------|----------| (-) (+) (-) (+) (+) (-) Descartes Rule: There could be as many IRRs as there are sign changes.19 . California State University-East Bay 2 .IRR and Non-conventional Cash Flows If Non-conventional CFs.

20 .Non-conventional CFs Example • Suppose an investment will cost $90.000 initially and will generate the following cash flows: Year 1: 132.000 Year 3: -150.000 • The required return is 15%.000 Year 2: 100. • Should we accept or reject the project? California State University-East Bay 2 .

000.66% Discount Rate California State University-East Bay 21 .35 0.55 IRR = 10.00 $0.3 0.000.00 -$8.000.000.00 -$4.25 0.00 0 0.05 0.1 0.2 0.45 0.NPV Profile $4.00 NPV -$2.00 $2.5 0.00 -$6.4 0.15 0.00 -$10.000.000.11% and 42.000.

11% which would tell you to Reject • You need to recognize that there are nonconventional cash flows and look at the NPV profile California State University-East Bay 2 . you would get an IRR of 10.22 . so you should Accept • If you use the financial calculator.Summary of Decision Rules • The NPV is positive at a required return of 15%.

23 . you can’t choose the other – Example: You can choose to attend graduate school next year at either Harvard or Stanford.IRR and Mutually Exclusive Projects • Mutually exclusive projects – If you choose one. but not both • Intuitively you would use the following decision rules: – NPV – choose the project with the higher NPV – IRR – choose the project with the higher IRR California State University-East Bay 2 .

43% 64.05 -400 325 200 22.17% 60. Which project should you accept and why? 24 .Example: Mutually Exclusive Projects Period 0 1 2 IRR NPV California State University-East Bay Project A Project B -500 325 325 19.74 The required return for both projects is 10%.

I = 10 ENTER CPT => 64.Example: Mutually Exclusive Projects A: CF. I = 10 ENTER CPT => 60.05 IRR CPT => 19. 2nd [CLR WORK] CF0 = -400 ENTER  C01 = 325 ENTER F01 = 1  C02 = 200 ENTER  NPV. 2nd [CLR WORK] CF0 = -500 ENTER  C01 = 325 ENTER F01 = 1  C02 = 325 ENTER  NPV.25 .74 IRR CPT => 22.43 B: CF.17 California State University-East Bay 2 .

00 -$20.00 Discount Rate California State University-East Bay 26 IRR for A = 19.00 $140.00 $120.3 .05 B 0.00 $60.15 0.00 $40.00 $80.1 0.43% IRR for B = 22.8% NPV A 0.17% Crossover Point = 11.00 $100.2 0.NPV Profiles $160.00 $0.00 0 -$40.00 $20.25 0.

Conflicts Between NPV and IRR • NPV directly measures the increase in value to the firm • Whenever there is a conflict between NPV and another decision rule.27 . you should always use NPV • IRR is unreliable in the following situations Non-conventional cash flows Mutually exclusive projects California State University-East Bay 2 .