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Chapter 8
Investment
Rules

IN CLASS
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8-2
Chapter Quiz – After watching
videos
1. Explain the NPV rule for stand-alone projects.
2. Under what conditions will the IRR rule lead to
the same decision as the NPV rule?
3. What is the most reliable way to choose between
mutually exclusive projects?
4. Explain why choosing the option with the highest
NPV is not always correct when the options have
different lives.
5. What does the profitability index tell you?

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8-3
Comprehensive Problem
• An investment project has the following
cash flows: CF0 = -1,000,000; C01 – C08 =
200,000 each
• If the required rate of return is 12%, what
decision should be made using NPV?
• How would the IRR decision rule be used for
this project, and what decision would be
reached?
• How are the above two decisions related?
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8-4
Mutually Exclusive Projects
• A company is analyzing two mutually exclusive
project, S and L, whose cash flows are as
follows:
0 1 2 3 4
S -1,000 900 250 10 10
L -1,000 0 250 400 800
• The company’s cost of capital is 10% and it
can get an unlimited amount of capital at that
cost.
• What is the IRR of the better project?
• What is the crossover rate and what is its
significance?

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8-5
10.73%
13.49%
11.74%
NPV
Discount Rate
$30.7
L
S
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8-6
Leasing Cash Flows
• Sharon Evans, who graduated from the local university 3
years ago with a degree in marketing, is manager of Ann
Naylor’s store in the Southwest Mall.
• Sharon’s store has 5 years remaining on its lease. Rent is
$2,000 per month, 60 payments remain, and the next
payment is due in one month.
• The mall’s owner plans to sell the property in a year and
wants rents at that time to be high so the property will
appear more valuable.
• Therefore, Sharon has been offered a “great deal” (owners’
words) on a new 5 year lease.
• The lease calls for 0 rent for 9 months, then payment of
$2,600 per month for the next 51 months.
• The lease cannot be broken, and Ann Naylor Corp.’s cost of
capital is 12% or 1% a month.
• Should Sharon accept the new lease?
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8-7
Lease Payments and Cost of Capital
• Suppose Sharon decided to bargain with
the mall’s owner over the new lease
payment.
• What new lease payment would make
Sharon indifferent between the new and old
leases?
• Sharon is not sure of the 12% cost of
capital – it could be higher or lower.
• At what nominal cost of capital would
Sharon be indifferent between the two
leases?


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8-8
Carlson Company
• Carlson Co. is choosing between two models of
production machinery.
• Model A costs $500 and has a life of 3 years.
• Maintenance expenses will amount to $120 to be
paid at the end of each of the three years.
• Model B costs $600 and has a life of 4 years.
• Carlson will have to spend $100 at the end of
each of these years to maintain model B.
• Which machine should be acquired if the discount
rate is 10%.
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8-9
Example 8.6a Profitability Index
with a Human Resource Constraint
Problem:
• AaronCo is considering several projects to
undertake.
• All of the projects currently under consideration
have a positive NPV, but AaronCo has a fixed
capital budget of $300 million.
• The company does not believe they will be able to
raise any additional funds.
• How should AaronCo prioritize the projects (listed
on the following slide)?
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8-10
Example 8.6a Profitability Index
with a Human Resource Constraint
Problem (cont’d):
Project NPV ($ Millions) Initial Cost ($ Millions)
A $15 $25
B $25 $75
C $110 $200
D $60 $150
E $25 $50
F $20 $35
G $35 $40
Total $290 $575
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8-11
Ethics Issues
• An ABC poll in the spring of 2004 found that one-
third of students age 12 – 17 admitted to cheating
and the percentage increased as the students got
older and felt more grade pressure. If a book
entitled “How to Cheat: A User’s Guide” would
generate a positive NPV, would it be proper for a
publishing company to offer the new book?

• Should a firm exceed the minimum legal limits of
government imposed environmental regulations and
be responsible for the environment, even if this
responsibility leads to a wealth reduction for the
firm? Is environmental damage merely a cost of
doing business?

• Should municipalities offer monetary incentives to
induce firms to relocate to their areas?
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8-12
Example 8.5a Computing an
Equivalent Annual Annuity Cost
Problem:
• You considering a maintenance contract from two
vendors.
• Vendor Y charges $100,000 upfront and then
$12,000 per year for the three-year life of the
contract.
• Vendor Z charges $85,000 upfront and then
$35,000 per year for the two-year life of the
contract.
• Compute the NPV and EAA for each vendor
assuming an 8% cost of capital.
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8-13
ADDITIONAL
PROBLEMS/SAME
CONCEPT AS PRIOR
PROBLEMS
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8-14
Mutually Exclusive Projects
• Davis Industries must choose between a gas
powered and an electric powered forklift truck.
• The electric powered truck will cost more, but it
will be less expensive to operate.
• It will cost $22,000 and the gas powered truck
will cost $17,500.
• The cost of capital is 12%. Each truck will last 6
years.
• The cash flows for the electric powered truck will
be $6,290/year and $5,000/year for the gas
powered truck.
• What is the NPV and IRR for each truck? Which
would you recommend?
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8-15
Example: The NPV Is Equivalent to
Cash Today
Problem:
• After saving $2,500 waiting tables, you are about
to buy a 50-inch LCD TV.
• You notice that the store is offering “one-year
same as cash” deal.
• You can take the TV home today and pay nothing
until one year from now, when you will owe the
store the $2,500 purchase price.
• If your savings account earns 4% per year, what
is the NPV of this offer? Show that its NPV
represents cash in your pocket.
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8-16
Example 8.2a Using the Payback
Rule
Problem:
• Assume a company requires all projects to have a
payback period of three years or less.
• For the project below, would the firm undertake
the project under this rule?

Year Expected Net Cash Flow
0 -$10,000
1 $1,000
2 $1,000
3 $12,000
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8-17
Example 8.3a NPV and Mutually
Exclusive Projects
Problem:
• You own a small piece of commercial land near a university. You are
considering what to do with it. You have been approached recently
with an offer to buy it for $300,000.
• You are also considering three alternative uses of the land for
yourself: a bar, a coffee shop, and an apparel store. You assume that
you would operate your choice indefinitely, eventually leaving the
business to your children.
• You have collected the following information about the uses. What
should you do?

Initial
Investment
Cash flow in the
First Year
Growth
rate
Cost of capital
Bar
$400,000 $65,000 5.0% 12.0%
Coffee shop
$250,000 $45,000 5.5% 12.5%
Apparel Store
$800,000 $90,000 4.5% 13.0%
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8-18
Example 8.4a Computing the
Crossover Point
Problem:
• Solve for the crossover point for the following two
projects.
Year
Expected Net Cash Flow
Project A Project B
0 -$12,000 -$10,000
1 $5,000 $4,100
2 $5,000 $4,100
3 $5,000 $4,100
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8-19
NPV Profiles Question
• The NPV profile provides a way to see how
the NPV changes according to the discount
rate or cost of capital.
• Why does uncertainty exist among these
elements?
• Is there any way to eliminate or reduce the
uncertainty of this highly important rate?

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8-20
Managers like rates--prefer IRR to
NPV comparisons. Can we give them
a better IRR?
Yes, MIRR is the discount rate which
causes the PV of a project’s terminal
value (TV) to equal the PV of costs.
TV is found by compounding inflows
at WACC.
Thus, MIRR assumes cash inflows
are reinvested at WACC.
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8-21
MIRR = 16.5%
10.0
80.0
60.0
0
1
2 3
10%
66.0
12.1
158.1
MIRR for Franchise L (r = 10%)
-100.0
10%
10%
TV inflows
-100.0
PV outflows
MIRR
L
= 16.5%
$100 =
$158.1
(1+MIRR
L
)
3
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8-22
• MIRR correctly assumes reinvestment
at opportunity cost = WACC. MIRR also
avoids the problem of multiple IRRs.
• Managers like rate of return
comparisons, and MIRR is better for this
than IRR.
Why use MIRR versus IRR?
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8-23
NPV Rule
• How is the NPV rule related to the goal of
maximizing shareholder wealth?
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8-24
IRR Rule
• What is the intuition behind the IRR rule?
What are some of its drawbacks?
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8-25
NPV and IRR
• Under what conditions will the IRR rule and
the NPV rule give the same accept/reject
decision?
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8-26
IRR
• When is it possible to have multiple IRRs?
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8-27
MIRR
• How does MIRR solve the problem of
multiple IRRs?
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8-28
Profitability Index
• What is the intuition behind the profitability
index?
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8-29
8.7 Putting It All Together
TABLE 8.5
Summary of
Decision Rules
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8-30
8.7 Putting It All Together
TABLE 8.5
Summary of
Decision Rules
(cont.)