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You are on page 1of 48

Chapter 7

NPV and Other Investment Criteria

Chapter Outline

Net Present Value (NPV)

Other Investment Criteria

IRR (Internal Rate of Return)

Payback and Discounted Payback

Book Rate of Return

Investment Criteria When Projects Interact

Pitfalls with IRR

Capital Rationing

Semih Yildirim ADMS 3530

7-2

Capital Budgeting Decision

Central to the success of any company is the

investment decision, also known as the

capital budgeting decision.

Assets acquired as a result of the capital

budgeting decision can determine the

success of the business for many years.

It is extremely important that we ensure that

the correct capital budgeting decision is

made!

Semih Yildirim ADMS 3530

7-3

Capital Budgeting Decision

Suppose you had the opportunity to buy a

Tbill (Treasury Bill) which would be worth

$400,000 one year from today.

Interest rates on Tbills are a risk free 7%.

What would you be willing to pay for this

investment?

-$400,000

PV today:

0 1 2

7-4

Capital Budgeting Decision

You would be willing to pay $373,382 for a risk free

$400,000 a year from today.

Suppose this were, instead, an opportunity to

construct a building, which you could sell in a year for

$400,000 with certainty (That means the project is

risk free.)

Since this investment has the same risk and promises

the same cash flows as the Tbill, it is also worth the

same amount to you:

$373,282

Semih Yildirim ADMS 3530

7-5

Capital Budgeting Decision

Now, assume you could buy the land for

$50,000 and construct the building for

$300,000. Is this a good deal?

Sure! If you would be willing to pay $373,382

for this investment and can acquire it for only

$350,000, you have found a very good deal!

You are better off by:

$373,382 - $350,000 = $23,832

7-6

Capital Budgeting Decision

We have just developed a way of evaluating

an investment decision which is known as Net

Present Value (NPV).

NPV is defined as the PV of the cash flows

from an investment minus the initial

investment.

NPV = PV Required Investment (C0)

= [$400,000/(1+.07)] - $350,000

= $23,832

7-7

Capital Budgeting Decision

This discount rate is known as the

opportunity cost of capital.

Itis called this because it is the return you give up

by investing in the project.

In this case, you give up the money you could

have used to buy a 7% tbill so that you can

construct a building.

But, a Tbill is risk free! A construction project is not!

We should use a higher opportunity cost of capital.

7-8

Risk and Net Present Value

Suppose instead you believe the building project is as

risky as a stock which is yielding 12%.

Now your opportunity cost of capital would be 12%

and the NPV of the project would be:

NPV = PV IC0

= [$400,000/(1+.12)] - $350,000

= $357,143 - $350,000 = $7,142.86

The project is significantly less attractive once you

take account of risk.

This leads to a basic financial principal: A risky dollar

is worth less than a safe one.

Semih Yildirim ADMS 3530

7-9

Valuing long lived projects

The NPV rule works for projects of any duration:

Simply discount the cash flows at the appropriate opportunity cost of

capital and then subtract the cost of the initial investment.

The amount and timing of the cash flows.

The appropriate discount rate.

NPV Rule: Accept Projects with Positive NPVs

7-10

7-11

Net Present Value vs Other Criteria

Use of the NPV criterion for accepting or

rejecting investment projects will maximize

the value of a firms shares.

Other criteria are sometimes used by firms

when evaluating investment opportunities.

Some of these criteria can give wrong answers!

Some of these criteria simply need to be used with

care if you are to get the right answer!

7-12

Internal Rate of Return (IRR)

IRR is simply the discount rate at which the NPV of the project

equals zero.

1. Setting the NPV of the project to zero.

2. Solving for r.

Unless you have a financial calculator, this calculation must be

done by using trial and error!

7-13

Internal Rate of Return (IRR)

To go back to our office example, we

discovered the following:

Discount Rate NPV of Project

7% $23,382

12% $7,143

of this project be equal to zero?

Semih Yildirim ADMS 3530

7-14

Internal Rate of Return (IRR)

If we solve for r in the equation below, we

find the IRR for this project is 14.29%:

which exceeds the opportunity cost of capital

Semih Yildirim ADMS 3530

7-15

Internal Rate of Return (IRR)

Another way of solving for IRR is to

graph the NPV at various discount

rates.

The point where this NPV profile

the project.

7-16

IRR BY GRAPH

NPV Profile for this Project

$60,000

$50,000

$40,000 IRR = 14.3%

(occurs where NPV = 0)

NPV ($)

$30,000

$20,000

$10,000

$0

($10,000) 5% 10% 15% 20%

($20,000)

Discount Rate

Semih Yildirim ADMS 3530

7-17

Internal Rate of Return (IRR) vs NPV:

The NPV Rule states that you invest in any project which

has a positive NPV when its cash flows are discounted at

the opportunity cost of capital.

The Rate of Return Rule states that you invest in any

project offering a rate of return which exceeds the

opportunity cost of capital.

i.e., if you can earn more on a project than it costs to undertake,

then you should accept it!

The NPV and IRR rules will give the same accept/reject

answer about a project as long as the NPV of a project

declines smoothly as the discount rate increases.

Do not confuse IRR and the opportunity cost of capital

Semih Yildirim ADMS 3530

7-18

Payback

Payback is the time period it takes for the cash flows generated

by the project to recover the initial investment in the project.

Example: You are paying $150 a month to park a car in your

apartments garage. You can purchase a parking spot for

$5,400. What is the payback for this project?

3 years $5,400 / (12 * $150)

The Payback Rule states that a project should be accepted if its

payback is less than a specified cutoff period.

For example, if your cutoff were 4 years to payback, then you would

buy the parking spot.

If it were 2 years, you wouldnt buy the parking spot:

3 years is longer than you consider desirable to get your money

out of a project.

7-19

Payback

Payback is a very poor way of determining a projects

acceptability:

It ignores all cashflows after your cutoff date. a

Calculate the payback and NPV for the following

projects if the discount rate is 10%:

Cash Flows in Dollars

Project: C0 C1 C2 C3

A -2,000 +1,000 +$1,000 +10,000

B -2,000 +1,000 +$1,000 -

C -2,000 - +$2,000 -

Semih Yildirim ADMS 3530

7-20

Project: Payback (years) NPV @ 10%

A 2 $7,248.69

B 2 - 264.46

C 2 - 347.11

Under NPV, only project A is acceptable. B and C have

negative NPVs and are thus both unacceptable.

But if your payback period is 2 years, then all the

projects are acceptable.

NPV and payback disagree what is the correct answer?

7-21

Payback vs NPV what to do?

Payback gives the same weight to all CFs which

occur before the cutoff period, while it completely

ignores the CFs after the cutoff

The firm decision will be biased towards too many short

term lived projects

And against some long-lived projects.

NPV gives the correct answer:

Only project A will increase shareholder value.

Therefore, it should be the only project accepted.

Lesson:

Use NPV if you want to make the correct

investment decision!

7-22

Discounted Payback

Discounted payback is the time period it takes for the

discounted cash flows generated by the project to

cover the initial investment in the project. a

acceptable with the Discounted Payback, it must have a

positive NPV (if the ignored Cashflows are all positive!)

Although better than payback, it still ignores all cash

flows after an arbitrary cutoff date.

Therefore it will reject some positive NPV projects.

NPV is thus always preferable to discounted payback

in evaluating projects!

Semih Yildirim ADMS 3530

7-23

Discounted Payback Example

(OCC=10%, cut-off = 4 years)

7-24

Book Rate of Return

Book rate of return equals the companys

accounting income divided by its assets. a

measurement to make decisions:

The components reflect historic costs and

accounting income, not market

values and cash flows.

a

Semih Yildirim ADMS 3530

7-25

Project Interactions

Investment Criteria When Projects Interact

NPV has proven to be the only reliable measure of a

projects acceptability.

But, what happens when we must choose among

projects which interact?

The NPV rule can be adapted to deal with the

following situations:

Mutually Exclusive Projects

The Investment Timing Decision

Long- vs Short-Lived Equipment (Unequal Lives)

Replacing an Old Machine

7-26

Project Interactions

Mutually Exclusive Projects

Most projects you deal with will be either-or

propositions.

For example, you own a vacant piece of land.

You have many either-or choices:

You could construct a townhouse or a condo.

other. They cannot be realized simultaneously.

Calculate the NPV of each project

From those, chose the project with the highest (positive) NPV.

7-27

Project Interactions

Mutually Exclusive Projects

In Example 7.4, you are going to replace your office network.

You can choose between a cheaper, slower package or a more

expensive, faster option.

Calculate the NPV for the two projects if the discount rate is 7%: a

Project: C0 C1 C2 C3 NPV @7%

Faster $ (800) $ 350 $ 350 $ 350 $ 118.50

Slower $ (700) $ 300 $ 300 $ 300 $ 87.30

However, you cannot do both of the these projects!

Since the faster system would make a greater contribution to the

value of the firm, it should be your preferred choice.

Semih Yildirim ADMS 3530

7-28

Project Interactions

The Investment Timing Decision

Sometimes your choice is start a project now

or wait and do it at a later date.

In Example 7.1, you looked at purchasing a

new computer system.

Itscost today was $50,000 and its NPV was

$19,740.

However, you know that these systems are

dropping in price every year.

From the numbers on the next slide, when should

you purchase the computer?

7-29

Project Interactions

NPV at

Year of PV of Year of NPV

Purchase Cost Savings Purchase Today

t=0 $50 $70 $20 $20.0

t=1 $45 $70 $25 $22.7

t=2 $40 $70 $30 $24.8

t=3 $36 $70 $34 $25.5

t=4 $33 $70 $37 $25.3

t=5 $31 $70 $39 $24.2

choose the investment date which results

in the highest net present value today.

Semih Yildirim ADMS 3530

7-30

Project Interactions

Long- vs Short-Lived Equipment

Suppose you must choose between buying

Machine D and E.

The two machines are designed differently, but

have identical capacity and do the same job.

The difference?

Machine D costs $15,000 and lasts 3 years. It

costs $4,000 per year to operate.

Machine E costs $10,000 and lasts 2 years. It costs

Which machine should the firm acquire?

Semih Yildirim ADMS 3530

7-31

Project Interactions

Long- vs Short-Lived Equipment

So far, this looks like a mutually exclusive

choice like problem 7.4

Calculate PV of the costs for the projects if the

a

Cash OutFlows in Dollars

Project: C0 C1 C2 C3 PV @ 6%

Machine D 15000 4000 4000 4000 $25,692.5

Machine E 10000 6000 6000 - $21,000

Should you accept Machine E

because the PV of its costs are lower?

. Semih Yildirim ADMS 3530

7-32

Project Interactions

Long- vs Short-Lived Equipment

Choosing Machine E may not be the best decision. Why not?

All we know is that Machine E costs less to run over 2 years than

Machine D does over 3 years.

D is being penalized by having one extra year of costs charged against

a

it!

What we should be asking is: How much would it cost per year to use

Machine E as versus Machine D?

We solve this problem by calculating the Equivalent Annual Cost

(EAC) of the two machines.

The EAC is the cost per period with the same PV as the cost of

the machine.

Think of it as calculating the annual rental charge for the machine.

There will be equal annual payments (an annuity).

The PV of these payments must equal the PV of the cost of the

machine.

7-33

Project Interactions

Calculating Equivalent Annual Cost:

Cash Flows in Dollars

Project: C0 C1 C2 C3 PV @ 6%

Machine D 15000 4000 4000 4000 $25,692.5

Equivalent

Annual cost: 9,611.5

? 9,611.5

? 9,611.5

? $25,692.5

Equivalent Annual Cost = PV of Costs / Annuity Factor

= $25,692.5 / 3 Year Annuity Factor

= $25,692.5 / 2.673

= $9,611.5 per year

. Semih Yildirim ADMS 3530

7-34

Project Interactions

Cash Flows in Dollars

Project: PV @ 6% Equivalent Annual Cost

D $25,692.5 $9,611.50

E $21,000 $11,454.37

Long- vs Short-Lived Equipment

We see from the equivalent annual costs that D is

actually the better choice because its annual cost is

lower than for Machine E.

If mutually exclusive projects have unequal lives, then

you should calculate the equivalent annual cost of the

projects.

This will allow you to select the project which will

maximize the value of the firm.

Semih Yildirim ADMS 3530

7-35

Project Interactions

Replacing an old machine

When should existing equipment be

replaced?

For example:

You are operating an old machine which will last 2

more years.

It costs $12,000 per year to operate.

A new machine costs $25,000 to buy, but is more

efficient and can be operated for $8,000 per year.

It will last for 5 years.

. Semih Yildirim ADMS 3530

7-36

Project Interactions

Replacing an old machine

Solve these problems by calculating for the new machine

the PV of the cash flows and its equivalent annual cost:

Project: C0 C1 C2 C3 C4 C5 PV @ 6%

New Machine 25 8 8 8 8 8 $58.70

Equivalent 13.93 13.93

Annual cost: ? ? 13.93

? 13.93

? 13.93

? $58.70

machine or $13,930 per year for the new machine.

. Semih Yildirim ADMS 3530

7-37

Project Interactions

Pitfalls with IRR: 1-Mutually Exclusive Projects

IRR can mislead you when choosing among mutually

exclusive projects.

Calculate the IRR and NPV for the following projects:

Cash Flows in Dollars

Project: C0 C1 C2 C3 IRR NPV @ 7%

H -350 400 - - 14.29% $24,000

12.96% $59,000

I -350 16 16 466

but Project I contributes more to the value of the firm.

. Semih Yildirim ADMS 3530

7-38

Project Interactions

Pitfalls with IRR

Remember: a high IRR is not an end in itself!

Higher IRR for a project does not necessarily

mean a higher NPV.

You goal should be to maximize the value of

the firm.

Remember:

NPV is the most reliable criterion for project

evaluation.

Only NPV measures the amount by which a project

would increase the value of the firm.

. Semih Yildirim ADMS 3530

7-39

Project Interactions

Pitfalls with IRR: 2 Lending vs Borrowing

Calculate the IRR and NPV for the projects below:

Project: C0 C1 IRR NPV @ 10%

J -100 +150 50% + $36.4

50% - $36.4

K +100 -150

but Project J contributes more to the value of the firm.

. Semih Yildirim ADMS 3530

7-40

Project Interactions

Pitfalls with IRR Lending vs Borrowing

Project J involves lending $100 at 50% interest.

Project K involves borrowing $100 at 50% interest.

Which option should you choose?

Remember:

When you lend money, you want a high rate of return.

When you borrow money, you want a low rate of return.

The IRR calculation shows that both projects have a

50% rate of return and are equally desirable.

You should see that this is a trap!

The NPV rule correctly warns you away from a project

which involves borrowing money at 50%.

7-41

Project Interactions

Other Pitfalls with IRR

3. Some projects will generate multiple internal

rates of return.

Look at Figure 7.4 on page 218 for an example.

4. Some projects have no internal rate of return.

Look at Footnote #6 on page 219 for an example.

. Semih Yildirim ADMS 3530

7-42

Capital Rationing

Capital Rationing

Occurs when a limit is set on the amount of

funds available to a firm for investment.

Soft Rationing

Occurs when these limits are imposed by

senior management.

Hard Rationing

Occurs when these limits are imposed by the

capital markets.

Semih Yildirim ADMS 3530

7-43

Capital Rationing

Rules for Project Selection

A firm maximizes its value by accepting all

positive NPV projects.

Withcapital rationing, you need to select a group

of projects which is within the companys

resources and gives the highest NPV.

This is done with the Profitability Index (PI)

pickthe projects that give the highest NPV per

dollar of investment.

7-44

Capital Rationing

Profitability Index (PI)

For example: Suppose your firm had the following

projects and only $20 million to spend:

NPV @

Project C0 C1 C2 10%

L -3.00 2.20 2.42 1.00

M -5.00 2.20 4.84 1.00

N -7.00 6.60 4.84 3.00

O -6.00 3.30 6.05 2.00

P -4.00 1.10 4.84 1.00

Budget -25.00

Semih Yildirim ADMS 3530

7-45

Capital Rationing

Profitability Index

NPV @

Project C0 10% PI

L 3.00 1.00 1/3 = 0.33 ACCEPT

N 7.00 3.00 3/7 = 0.43 ACCEPT

7-46

Summary of Chapter 6

NPV is the only measure which always gives

the correct decision when evaluating projects.

The other measures can mislead you into

making poor decisions if used alone.

The other measures are:

IRR

Payback

Discounted Payback

Book Rate of Return

Profitability Index (PI)

Semih Yildirim ADMS 3530

7-47

Summary of Chapter 6

7-48

Summary of Chapter 6

It should be noted that when capital rationing

is in place, NPV by itself, cannot lead you to

the correct decision.

You must combine NPV with the Profitability Index.

Ranking the projects this way will allow you to

choose the package of projects which will offer the

highest NPV per dollar of investment.

In summary:

NPV should always be used when

evaluating project acceptability!

Semih Yildirim ADMS 3530

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