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# What’s next?

 Capital Budgeting: involves making
 Chapter 7: Net Present Value and Other
Investment Criteria
 Chapter 8: Estimating cash flows for a potential
investment.
 Chapter 12: Estimating a required rate of return
for a potential investment = opportunity cost of
capital. (need chapters 10 & 11 to help us with
chapter 12)

Chapter 7
Net Present Value & Other
Investment Criteria

Topic Overview
 Project Types
 Capital Budgeting Decision Criteria
 Net Present Value (NPV)
 Payback Period
 Internal Rate of Return (IRR)
 Profitability Index (PI)
 Equivalent Annual Cost and Equivalent
Annual Annuity
 Capital Rationing

 Understand the advantages and disadvantages of each technique.  Understand which project to select when there is a ranking conflict between NPV and IRR. . NPV. IRR. & PI. Learning Objectives  Understand how to calculate and use capital budgeting decision techniques: Payback.

 Which of the following investment opportunities would you prefer?  #1) Give me \$1 now and I’ll give you \$2 at the end of class. Think about this as we cover Chapter 7 Investment Criteria.  #2) Give me \$100 now and I’ll give you \$150 at the end of class. .

Project Types  Independent Projects – don’t affect acceptance of other projects  Mutually Exclusive Projects – interact with other projects or accomplish the same objective  Normal Projects -only one sign change in sequence of cash flows  Non-normal Projects . .multiple sign changes in cash flow series.

000 3.000) 1 15. Time Falafel-Full How 'Bout A Pretzel? 0 (20.000 50.000 . Assume Marge's opportunity cost of capital is 12%. Our Case Study  We want to help Marge Simpson. analyze the following business opportunities by using the following cash flow information.000 2 15. Inc.000 2.000) (20.000 4 3.000 2.500 3 13.

Expected rate of return given up by investing in a project . Net Present Value Net Present Value . Opportunity Cost of Capital .Present value of cash flows minus initial investments.

.required investment Ct NPV  C0  (1  r ) t C1 C2 Ct NPV  C0   . (1  r ) (1  r ) 1 2 (1  r ) t .. Net Present Value NPV = PV .

Net Present Value Terminology C = Cash Flow t = time period of the investment r = “opportunity cost of capital”  The Cash Flow could be positive or negative at any time period. .

Net Present Value Net Present Value Rule Managers increase shareholders’ wealth by accepting all projects that are worth more than they cost. Therefore. . they should accept all projects with a positive net present value.

000) (20.253 3.000 11.000) 1 15. C04 = 50.000.000 2. C03 = 3. F01 = 2. F01=1.690  Calculator Steps. CPT NPV = 17. Falafel-Full: CF0 = -20. C01 = 15.000 1.907 50. C03 = 3.786 2 15.690 .000.000.135 4 3. F03=1.000) (20. F02=1.500.393 2. C02 = 13. C01 = 2.000.510  Pretzel: CF0 = -20. C02 = 2.000 13.000 9. F02 = 1. Marge’s NPVs: r = 12% Time Falafel-Full PV(CF) How 'Bout A Pretzel? PV(CF) 0 (20.993 3 13.000. NPV: I = 12. NPV: I = 12.000) (20.776 NPV 16.000 1.000.958 2.510 17.000.000 31.000.500 1. CPT NPV = 16.

. Excel and NPV: Why Microsoft deserves its legal troubles.  Excel’s NPV function is goofed up.  Solution to this spreadsheet problem: exclude initial cost (t = 0 cash flow) from NPV cell range and add initial cost (if already negative) to the NPV function. range of cash flows)  Assumes first cash flow in range occurs at t = 1.  See spreadsheet. =NPV(r.

 If the projects are mutually exclusive.  Both have positive NPV. Marge’s NPV Decision  If projects are independent. select How ‘Bout A Pretzel?  Pretzel NPV > Falafel NPV. . Marge should select both.

.  Decision Rule: Accept if PB < some maximum period of time. Payback Period (PB)  Measures how long it takes to recovers a project’s cost.  Easy to calculate and a good measure of a project’s risk and liquidity.

500) 3 13. . Marge’s Payback (Assume Marge’s max is 2 years) Time Falafel-Full Cumulative CF How 'Bout A Pretzel? Cumulative CF 0 (20.000) (20.000 (12.500 (15.000 23.000) 1 15.000 26.000 50.000 10.000 37.000) (20.000) 2 15.500  Falafel PB = less than 2 years  Pretzel PB = less than 4 years  Marge should choose Falafel using Payback Period.000 3.500) 4 3.000 (18.000 2.000) 2.000 (5.000) (20.

 Not a good investment decision technique. Problems with Payback  Ignores time value of money!  Ignores cash flows beyond payback period. .

 IRR is the interest rate where the PV of the project’s cash flows equals its cost.Internal Rate of Return (IRR)  Internal Rate of Return is a project’s expected rate of return on its investment.  ∑CFt/(1 + IRR)t = Cost  Decision Rule: Accept if IRR > r (opportunity cost of capital).  In other words.  Non-normal projects have multiple IRRs. the IRR is the rate where a project’s NPV = 0. . Don’t use IRR to decide on non-normal projects.

000.000.000 4 3. C03 = 3. F02 = 1.500. Calculator Steps. Marge’s IRRs Time Falafel-Full How 'Bout A Pretzel? 0 (20. C03 = 3.500 3 13.000 2 15.  Falafel-Full: CF0 = -20.000.7%  Pretzel: CF0 = -20. .000) 1 15. If independent projects: select both. C01 = 2. F01=1. then CPT: IRR = 33. Mutually exclusive: select Falafel.000.000 2.000  Best to use calculator.3%  r = 12%. then CPT: IRR = 54.000 3.000) (20. IRRs > 12%. higher IRR.000.000 2. F01 = 2.000. F02=1. Press IRR. C01 = 15. C02 = 2.000.000 50. F03=1. C04 = 50.000. C02 = 13. Press IRR.

 What to do. these methods can rank mutually exclusive projects differently. Comparison of NPV & IRR  For normal independent projects. all three methods give same accept/reject decision.  However. then? .  NPV > 0 yields IRR > r in order to lower NPV to 0.

899 10% 17.589 27.216 35% 5.  Below is a table of NPVs for Marge’s projects.849 20. r Falafel-Full How 'Bout A Pretzel? 0% 26.510 17.649 14.201) . NPV Profiles  A graph which shows a project’s NPV at different interest rates (opportunity cost of capital).  Can illustrate ranking conflicts between NPV and IRR.500 5% 21.690 15% 14.485 5.289 12% 16.000 37.190 25% 9.529 (874) 55% (68) (8.

Marge’s Projects .

a ranking conflict between NPV and IRR exists.  At a cost of capital less than this crossover rate. subtract one project’s cash flows from the other.  Find IRR of these cash flow differences to find rate where the two projects have the same NPV = crossover rate. . a ranking conflict exists.  If there is a change of signs of these cash flow differences. Determining NPV/IRR Conflict Range  For each year.

 Why? Cash flow timing differences in this case. Falafel has the higher NPV and IRR.000 2.000) (20.000 (47.  At cost of capital greater than 14. Marge’s crossover rate Time Falafel-Full How 'Bout A Pretzel? Falafel .000 C03 4 3. but not here. Pretzel has higher NPV but lower IRR = Ranking Conflict.000) C04 IRR = Crossover Rate 14.1%  At a cost of capital less than 14.1%.000 C01 2 15.500 12.CF0 1 15.500 C02 3 13.1%.000) .000 10.000 3.Pretzel 0 (20.000 2. .000 13.  Other cause: initial cost differences.000 50.

 Result: Choose project with highest NPV when NPV/IRR ranking conflict exists for mutually exclusive projects. IRR has the multiple IRR problem for non-normal projects like the following.  Also. Reconciling NPV/IRR Ranking Conflicts  Shareholder Wealth Maximization :  Want to add more value to the firm than less. .

Rocket-Powered Roller Blade Project  Acme is considering the following project which would market these roller blades to coyotes trying to catch road runners. Acme.8% . but an outflow in the 2 nd (last) year of the project due to liability claims from injured cartoon coyotes. Acme expects a cash inflow in the year 1.95 IRR = 26. Inc. Year 0 1 2 Cash Flow (5) 30 (30) NPV = -1. Acme’s opportunity cost of capital is 13%.

the project has a negative NPV even though the IRRs is greater than 13%. don’t use IRR to make decisions for non-normal projects! (or look for a first IRR that is less than cost of capital) . Rocket-Powered Roller Blade NPV Profile 4 NPV -1 0% 50% 100% 150% 200% 250% 300% 350% 400% 450% 500% 550% -6  At Acme’s 13% opportunity cost of capital.  Because of this conflict.

Comparing Projects with unequal lives  To replace the Budweiser sign that the ferret dropped in the frog pond.000 1 1. Louie the Lizard is evaluating two new signs.000 900 2 1.000 700 3 700 4 700   . Here are the annual costs for the two replacement signs. Louie must purchase and care for a replacement sign indefinitely.000 6.  Which sign should Louie choose given an opportunity cost of capital of 11%? Year Frying Frogs Lizards Leaping over Frogs 0 4.

Equivalent Annual Cost Equivalent Annual Cost .The cost per period with the same present value as the cost of buying and operating a machine. present value of costs Equivalent annual cost = annuity factor .

0=FV. 2=N.000 1 1.000 900 2 1. Louie The Lizard’s Decision. 4=N. 11=I/Y.000 6. r = 11% Year Frying Frogs Lizards Leaping over Frogs 0 4. CPT PMT = 3336  LL EAC: 8352=PV.000 700 3 700 4 700  Frying Frogs (FF) PV of costs = 5713  Lizards Leaping (LL) PV of costs = 8352  FF EAC: 5713=PV. . 0=FV. CPT PMT = 2692  Louie should choose the Lizards Leaping over Frogs sign because of its lower cost on an annual basis. 11=I/Y.

Comparing Projects (NPV>0) with unequal lives: Equivalent Annual Annuity  Burns Power is considering the following mutually exclusive projects in order to increase power consumption in Springfield indefinitely. Which project should be selected if Burns Power’s opportunity cost of capital is 10%? Year 0 1 2 3 Sun-Blocker (50) 60 60 Fog-Maker (30) 40 40 40 .

10=I/Y. .5=PV. 10=I/Y.5 m  Sun-Blocker EAA: -54. 0=FV. 3=N. CPT PMT = \$31.1=PV. CPT PMT = \$27.2m  Fog-Maker EAA: -69.1 m  NPV of Fog-Maker = \$69.9m  Burns should choose the Sun-Blocker because it would add the most value on an annual basis. Find NPV and Equivalent Annual Annuity net present value Equivalent annual annuity = annuity factor  NPV of Sun-Blocker = \$54. 2=N. 0=FV.

By doing so. A common example involves a tree farm. . Investment Timing Sometimes you have the ability to defer an investment and select a time that is more ideal at which to make the investment decision. yet increase the cash flow. You may defer the harvesting of trees. you defer the receipt of the cash flow.

0=FV.  Should you purchase the scanner today or wait if your discount rate is 10%?  PV of annual benefits: 60=PMT. CPT PV = \$369  NPV = \$369 – Expected Scanner Cost . However. pg 207 of textbook  Can purchase a scanner today for \$400 that would provide \$60 in annual benefits for 10 years. 10=I/Y. scanner prices are expected to decrease 20% per year. 10=N.Investment Timing: #31.

Investment Timing Example (cont.): r = 10% Year Cost PV Benefits NPV at Purchase NPV Today 0 400 369 -31 -31 1 320 369 49 45 2 256 369 113 93 3 205 369 164 123 4 164 369 205 140 5 131 369 238 148 6 105 369 264 149 7 84 369 285 146 To maximize value. you should wait 6 years to buy the .

Limit set on the amount of funds available for investment.Limits on available funds imposed by the unavailability of funds in the capital market. Hard Rationing . . Capital Rationing Capital Rationing .Limits on available funds imposed by management. Soft Rationing .

 PI = NPV/Cost  Decision Rule: Accept if PI > 0  PI can be used to rank projects under capital rationing conditions. .  CAUTION: PI can rank mutually exclusive projects that have different initial costs differently than NPV. Accept highest PI projects under the capital constraint to maximize NPV. Profitability Index (PI)  The ratio of the net present value of a project’s cash flows to its cost.

. Summary of Capital Budgeting Methods  Want a method the uses the time value of money with all project cash flows: NPV.  Overall. NPV is the best and preferred method. PI. under capital rationing (budget restraint).  However.  IRR can give erroneous decision for non- normal projects. IRR. ranking projects by PI can be useful in helping to maximize NPV under capital constraint.