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Eco 9

This document discusses several capital budgeting techniques used to evaluate investment projects: 1. Net present value (NPV) measures the difference between the present value of cash inflows and outflows. A positive NPV means the project increases firm value. NPV is the preferred method. 2. Payback period measures the time to recover the initial investment. It ignores cash flows and time value of money after the payback period. 3. Internal rate of return (IRR) is the discount rate that makes NPV equal to zero. While intuitive, IRR can produce conflicting results with NPV for some projects. 4. Profitability index measures benefits relative to costs. A ratio over

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40 views36 pages

Eco 9

This document discusses several capital budgeting techniques used to evaluate investment projects: 1. Net present value (NPV) measures the difference between the present value of cash inflows and outflows. A positive NPV means the project increases firm value. NPV is the preferred method. 2. Payback period measures the time to recover the initial investment. It ignores cash flows and time value of money after the payback period. 3. Internal rate of return (IRR) is the discount rate that makes NPV equal to zero. While intuitive, IRR can produce conflicting results with NPV for some projects. 4. Profitability index measures benefits relative to costs. A ratio over

Uploaded by

Aurongo Nasir
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Investment Criteria

Net Present Value


The Payback Rule
The Internal Rate of Return
The Profitability Index
The Practice of Capital Budgeting
Good Decision Criteria

 All cash flows considered?


 TVM considered?
 Risk-adjusted?

 Ability to rank projects?


 Indicates added value to the firm?
Independent versus Mutually Exclusive
Projects
 Independent
The cash flows of one project are unaffected
by the acceptance of the other.
 Mutually Exclusive
The acceptance of one project precludes
accepting the other.
Net Present Value

 the difference between the present value of the benefits and the present value of the costs
 How much value is created from undertaking an investment?

Step 1: Estimate the expected future cash flows.


Step 2: Estimate the required return for projects of this risk level.
Step 3: Find the present value of the cash flows and subtract the initial
investment to arrive at the Net Present Value.
Net Present Value
Sum of the PVs of all cash flows

n CFt
NPV = ∑
(1 + R)t
t=0 NOTE: t=0

Initial cost often is CF0 and is an outflow.


n CFt
NPV = ∑ - CF0
(1 + R)t
t=1
NPV – Decision Rule

 If NPV is positive, accept the project


 NPV > 0 means:
 Project is expected to add value to the firm
 Will 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.
NPV

 Advantages of NPV  Disadvantages of


 Accounts for time value of money
and risk
NPV
 May be difficult to communicate
 Does not requires an arbitrary cutoff
point  May be difficult to calculate
 Balances long-term and short-term  Does not account for liquidity needs
goals
 Based on market values, not
accounting values
Sample Project Data
 You are looking at a new project and have estimated the
following cash flows:
 Year 0: CF = -165,000
 Year 1: CF = 63,120
 Year 2: CF = 70,800
 Year 3: CF = 91,080
 Your required return for assets of this risk is 12%.
Computing NPV for the Project

n
CFt
NPV  
 Using the formula:

t 0 (1  R ) t

NPV = -165,000/(1.12)0 + 63,120/(1.12)1 + 70,800/(1.12)2 +


91,080/(1.12)3 = 12,627.41

Capital Budgeting Project NPV


Required Return = 12%
Year CF Formula Disc CFs
0 (165,000.00) =(-165000)/(1.12)^0 = (165,000.00)
1 63,120.00 =(63120)/(1.12)^1 = 56,357.14
2 70,800.00 =(70800)/(1.12)^2 = 56,441.33
3 91,080.00 =(91080)/(1.12)^3 = 64,828.94
12,627.41
Rationale for the NPV Method

 NPV = PV inflows – Cost


NPV=0 → Project’s inflows are “exactly
sufficient to repay the invested capital
and provide the required rate of
return”

 NPV = net gain in shareholder wealth

 Rule: Accept project if NPV > 0


NPV Method
Meets all desirable criteria
Considers all CFs
Considers TVM
Adjusts for risk
Can rank mutually exclusive projects
Directly related to increase in VF
Dominant method; always prevails
Payback Period
 How long does it take to recover the initial cost of a
project?
 Computation
 Estimate the cash flows
 Subtract the future cash flows from the initial cost until initial
investment is recovered
 A “break-even” type measure
 Decision Rule – Accept if the payback period is less
than some preset limit
Calculate Payback Period

 If investment cost $100 and receive $50 a year for 3 years,


what is payback period?
 What if investment cost $75?
 Same project as before
 Year 0: CF = -165,000
 Year 1: CF = 63,120
 Year 2: CF = 70,800
 Year 3: CF = 91,080
Computing Payback for the Project

Capital Budgeting Project

Year CF Cum. CFs


0 $ (165,000) $ (165,000)
1 $ 63,120 $ (101,880)
2 $ 70,800 $ (31,080)
3 $ 91,080 $ 60,000

Payback = year 2 +
+ (31080/91080)
 Do we accept or reject the project?
Payback = 2.34 years
Advantages and Disadvantages of
Payback
 Advantages  Disadvantages
 Easy to understand  Ignores the time value of money
 Adjusts for uncertainty of  Requires an arbitrary cutoff point
later cash flows  Ignores cash flows beyond the
 Biased towards liquidity cutoff date
 Biased against long-term projects,
such as research and development,
and new projects
IRR

 Definition:

 Is the rate of interest at which The present value of


expected cash inflows from a project Equals The present
value of expected cash outflows of the project.
 IRR = discount rate that makes the NPV = 0

 Decision Rule:
 Accept the project if the IRR is greater than the required return/Cost of
capital
NPV vs. IRR
NPV: Enter R (rate of return), then
solve for NPV
n
CFt

t  0 (1  R )
t
 NPV

IRR: NPV = 0, solve for IRR.


n
CFt

t  0 (1  IRR )
t
0
Internal Rate of Return
 Most important alternative to NPV
 Widely used in practice
 Intuitively appealing
 Based entirely on the estimated cash flows
 Independent of interest rates
Is IRR always a good choice?

 IRR is useful in deciding whether or not to invest in a single


project
 When multiple projects are being considered, IRR is not a good
investment tool to use to evaluate which project to choose.
 The IRR calculation automatically assumes that all cash
outflows are reinvested at the IRR, but doesn’t evaluate what
the investor does with cash inflows, which would have an
effect on the true IRR.
Why do we use IRR?

 IRR is necessary from a capital budgeting standpoint.


 Justas NPV is a way to evaluate an investment, IRR
provides more insight into whether or not a
project/investment should be undertaken.
 More useful for long term investments, with multiple
cash flows
NPV vs. IRR?

 The NPV calculation will usually always provide a more


accurate indication of whether or not a project should be
undertaken or not.
 However, since IRR is a percentage, and NPV is shown in $$,
it is more appealing for a manager to show someone a
particular rate of return, as opposed to $$ amounts.
Computing IRR for the Project
Using the TI BAII+ CF Worksheet

Cash Flows:
CF0 = -165000
CF1 = 63120
CF2 = 70800
CF3 = 91080
Compute IRR for the Project
Cash Flows:
CF0 = -165000
CF1 = 63120
CF2 = 70800
CF3 = 91080
IRR - Advantages
 Preferred by executives
 Intuitively appealing
 Easy to communicate the value of a project
 Considers all cash flows
 Considers time value of money
IRR - Disadvantages
 Can produce multiple answers
 Cannot rank mutually exclusive projects
Example of Mutually Exclusive Projects

Period Project A Project B The required


return for both
0 -500 -400
projects is 10%.
1 325 325
2 325 200
Which project
IRR 19.43% 22.17% should you accept
NPV 64.05 60.74 and why?
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, always use NPV
 IRR is unreliable in the following situations:
 Non-conventional cash flows
 Mutually exclusive projects
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
 Can be very useful in situations of capital rationing
 Decision Rule: If PI > 1.0  Accept
Profitability Index
Example of Conflict with NPV

A B
CF(0) $ (10,000) $ (100,000)
PV(CF) $ 15,000 $ 125,000
PI $ 1.50 $ 1.25
NPV $ 5,000 $ 25,000
Capital Budgeting In Practice
 Consider all investment criteria when making decisions
 NPV and IRR are the most commonly used primary
investment criteria
 Payback is a commonly used secondary investment
criteria
 All provide valuable information
NPV Summary
Net present value =
Difference between market value (PV of
inflows) and cost
Accept if NPV > 0
No serious flaws
Preferred decision criterion
IRR Summary
Internal rate of return =
Discount rate that makes NPV = 0
Accept if IRR > required return
Same decision as NPV with
conventional cash flows
Unreliable with:
Non-conventional cash flows
Mutually exclusive projects
Payback Summary
Payback period =
Length of time until initial investment
is recovered
Accept if payback < some specified
target
Doesn’t account for time value of
money
Ignores cash flows after payback
Arbitrary cutoff period
Profitability Index Summary
Profitability Index =
Benefit-cost ratio
Accept investment if PI > 1
Cannot be used to rank mutually
exclusive projects
Problem:
 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 NPV?
 What is the IRR?
 Should we accept the project?
 What decision rule should be the primary decision
method?

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