Investment Decision Criteria

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Investment Decision Criteria

Chapter 11

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Principles Applied in This Chapter
 Principle 1: Money Has a Time Value.
 Principle 2: There is a Risk-Return Tradeoff.
 Principle 3: Cash Flows Are the Source of Value.
 Principle 5: Individuals Respond to Incentives.

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Learning Objectives
1. Understand how to identify the sources and types of
profitable investment opportunities.
2. Evaluate investment opportunities using net present
value and describe why net present value is the best
measure to use.
3. Use the profitability index, internal rate of return, and
payback criteria to evaluate investment opportunities.
4. Understand current business practice with respect to
the use of capital-budgeting criteria

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The Typical Capital-Budgeting Process
 Phase I: The firm’s management identifies promising
investment opportunities.

 Phase II: The investment opportunity’s value- creating


potential (for shareholders) is thoroughly evaluated.

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Types of Capital Investment Projects
1. Revenue enhancing Investments,
2. Cost-reduction investments, and
3. Mandatory investments that are a result of government
mandates

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Types of Capital Investment Projects
To determine the desirability of investment proposals, we
can use several analytical tools such as:
Net Present Value (NPV),
Equivalent Annual Cost (EAC),
Internal Rate of Return (IRR), and
Profitability Index (PI),
Discounted Payback Period.

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Net Present Value
 The net present value (NPV) is the difference
between the present value of cash inflows and the cash
outflows.
 NPV estimates the amount of wealth that the project
creates.
 Decision Criteria:
Investment projects should be
Accepted if the NPV of the project is positive and
Rejected if the NPV is negative.

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Calculating an Investment’s NPV

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The Problem
Saber Electronics provides specialty manufacturing services
to defense contractors located in the Seattle, WA area.
The initial outlay is $3 million and, management estimates
that the firm might generate cash flows for years one
through five equal to $500,000; $750,000; $1,500,000;
$2,000,000; and $2,000,000.
Saber uses a 20% discount rate for projects of this type.
Is this a good investment opportunity?

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Step 1: Picture the Problem

k=20%
Years 0 1 2 3 4 5

Cash flows -$3M +$0.5M +$0.75M +$1.5M $2M $2M


(in $ millions)
Net
Present
Value =?

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Step 2: Decide on a Solution Strategy
 We need to analyze if this is a good investment
opportunity.
 We can do that by computing the Net Present Value
(NPV), which requires computing the present value of all
cash flows.

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Step 3: Solve
Using a Mathematical Formula

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Step 3: Solve
 NPV = -$3m + $.5m/(1.2) + $.75m/(1.2)2 + $1.5m/(1.2)3
+ $2m/(1.2)4 + $2m/(1.2)4

 NPV = -$3,000,000 + $416,666.67 + $520,833.30 +


$868,055.60 + $964,506 + $803,755.10
 NPV = $573,817

 Use the cash flow keys

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Step 4: Analyze
 The project requires an initial investment of $3,000,000
and generates futures cash flows that have a present value
of $3,573,817.
 Consequently, the project cash flows are $573,817 more
than the required investment.
 Since the NPV is positive, the project is an acceptable
project.

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Independent Versus Mutually Exclusive
Investment Projects
 An independent investment project is one that
stands alone and can be undertaken without influencing
the acceptance or rejection of any other project.

 Accepting a mutually exclusive project prevents


another project from being accepted.

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Choosing Between Mutually Exclusive
Investments
If mutually exclusive investments have equal lives, we will
calculate the NPVs and choose the one with the higher
NPV.

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Choosing Between Mutually Exclusive
Investments
If mutually exclusive investments do not have equal lives, we
must calculate the Equivalent Annual Cost (EAC), the cost
per year.
 We will then select the one that has a lower EAC.

 We convert the PV into an annuity payment


 EAC = NPV/PVAIF

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Choosing Between Mutually Exclusive
Investments

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The Problem
What is the EAC for a machine that costs $50,000,
requires payment of $6,000 per year for maintenance and
operation expense, and lasts for 6 years?
Assume that the discount rate is 9% and there will be no
salvage value associated with the machine.
In addition, you intend to replace this machine at the end of
its life with an identical machine with identical costs.

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Step 1: Picture the Problem

k=9%
Years
0 1 2 3 4 5 6

Cash flows -$50 -$6 -$6 -$6 -$6 -$6 -$6


(in $, thousands)

EAC =?

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Step 2: Decide on a Solution Strategy
Here we need to calculate the EAC, which will tell us the
annual cost for a machine that lasts 6 years.
EAC can be computed using a mathematical formula or
financial calculator.

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Step 3: Solve
Using a Mathematical Formula

It requires 2 steps:
1. Computation of NPV
2. Computation of EAC
Convert PV into annuity payment - divide NPV by PVA interest factor

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Step 3: Solve (cont.)

NPV = -$50,000 + PV of $6,000 each year


= -$50,000 + -$6,000 (PV of Annuity Factor)
= -$50,000 + -$6,000 {[1-1/(1.09)6]/0.09}
= -$50,000 + -$6,000 {4.4859) = -$76,915

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Step 3: Solve (cont.)
EAC = NPV ÷ PVA Interest Factor
= -$76,915 ÷ 4.4859
= -$17,145.95

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Step 3: Solve (cont.)
Using a Financial Calculator
 Data and Key Input Display
CF; -50000; ENTER CFO=-50000
;-6000; ENTER CO1=-6000
;6; ENTER FO1=6.00
NPV;8; ENTER i=8
CPT NPV=-77,372

This is the PV of the cash flows

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Step 3: Solve (cont.)
The next step is to convert the PV into an annuity payment

Enter
 N=6
 1/y = 9
 PV = -76915
 FV = 0
 PMT = -17,145.86

Thus EAC = $-17,145.86

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Step 4: Analyze
EAC indicates the annual cost that is adjusted for time value
of money. Here EAC is equal to -$17,145.86.

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Internal Rate of Return
The internal rate of return (IRR) of an investment is the
discount rate that results in a zero NPV for the project
It is analogous to the yield to maturity (YTM) on a bond

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Internal Rate of Return

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Internal Rate of Return
Decision Criteria:
 Decision Criteria:
Investment projects should be
Accepted if the IRR is above the hurdle rate
Rejected if the IRR is below the hurdle rate

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The Problem
Knowledge Associates is a small consulting firm in Portland,
Oregon, and they are considering the purchase of a new
copying center for the office that can copy, fax, and scan
documents. The new machine costs $10,010 to purchase
and is expected to provide cash flow savings over the next
four years of $1,000; $3,000; $6,000; and $7,000.
If the discount rate the firm uses to value the cash flows
from office equipment purchases is 15%, is this a good
investment for the firm?

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Step 1: Picture the Problem

Years 0 1 2 3 4
Cash flows
-$10,010 +$1,000 +$3,000 +$6,000 +$7,000

IRR =?

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Step 2: Decide on a Solution Strategy
 Here we have to calculate the project’s IRR. IRR is equal
to the discount rate that makes the present value of the
future cash flows (in years 1-4) equal to the initial cash
outflow of $10,010.

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Step 3: Solve
Data and Key Input Display
CF; -100000; ENTER CFO=-100000
1000; ENTER CO1=1000
;1; ENTER FO1=1.00
;3000; ENTER C02=3000
;1; ENTER FO2=1.00
;6000; ENTER C03=6000
; 1; ENTER FO3=1.00
; 7000; ENTER CO4 = 7000
1; ENTER FO4 =1.00
IRR; CPT IRR = 19%

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Step 4: Analyze
The new copying center requires an initial investment of
$10,010 and provides future cash flows that offer a return
of 19%. Since the firm has decided 15% as the minimum
acceptable return, this is a good investment for the firm.

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Complications with IRR:
Unconventional Cash Flows

 If the cash flow pattern is non conventional i.e. cash inflow


followed by a series of cash outflows (as in the case of a
loan), NPV greater than zero indicates that IRR is less than
the discount rate used to calculate the NPV.
 NPV leads to the appropriate decision in both conventional
and unconventional cash flow pattern.

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Complications with IRR:
Multiple Rates of Return
Although any project can have only one NPV, a single
project can, under certain circumstances, have more than
one IRR

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The Problem
McClary Custom Printers is considering whether to purchase a
printer. The printer costs $200,000 to purchase, and McClary
expects it can earn an additional $1.2 million in cash flows in the
printer’s first year of use. However, there is a problem with
purchasing the printer today because it will require a very large
expenditure in year 2, such that year 2’s cash flow is expected to
be -$2.2million. Finally, in year 3, the printer investment is
expected to produce a cash flow of $1.2 million. Use the IRR to
evaluate whether the printer purchase will be worthwhile.

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Step 1: Picture the Problem

Years 0 1 2 3

Cash flows -$200,000 +$1.2m -$2.2m +$1.2m

IRR =?

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Step 2: Decide on a Solution Strategy
 To solve the problem, we can construct an
NPV profile that reports the NPV at several
discount rates.
 We will use discount rates of 0% to 200%, in
increments of 50%, to compute the NPV.

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Step 3: Solve
 The NPV profile on next slide is based on various
discount rates. For example, NPV at discount rate of 50%
is computed as follows:
 NPV = -$200,000 + $1,200,000/(1.5)1 + -2,200,000/(1.5)2
+ $1,200,000/(1.5)3
= -$22,222.22

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Step 3: Solve

Discount Rate NPV


0% $0
50% -$22,222.22
100% $0
150% $4,800
200% $0

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Step 4: Analyze
 There are three IRRs for this project 0%,
100% and 200%. At all of these rates, NPV
is equal to zero.
 However, NPV will be a better decision
tool to use under this situation as it is
not subject to multiple answers like IRR.

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Using the IRR with Mutually Exclusive
Investments

Figure 11.1 shows that if we use NPV, project AA+ is better


while if we use IRR, project BBR is better. How to select
under such circumstances?
 Use NPV as it will give the correct ranking for the
projects.

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Figure 11.1 Ranking Mutually
Exclusive Investments: NPV vs. IRR

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Figure 11.1 Ranking Mutually Exclusive
Investments: NPV vs. IRR (cont.)

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Figure 11.1 Ranking Mutually Exclusive
Investments: NPV vs. IRR

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Modified Internal Rate of Return
Modified Internal Rate of Return (MIRR) eliminates
the problem of multiple IRRs. MIRR rearranges the project
cash flows such that there is only one change in the sign of
the cash flows over the life of the project. There are two
steps to computing MIRR.

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Modified Internal Rate of Return

1. Modify the project’s cash flow stream by discounting the


negative future cash flows back to the present using the
discount rate. The present value of these future negative
cash flows is then added to the initial outlay to form a
modified project cash flow stream
2. MIRR = IRR (modified cash flow stream).

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Step 1: Picture the Problem

i=8%
Years 0 1 2

Cash flows -$235,000 $540,500 -$310,200

Second
First Sign
Sign change
change

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Step 2: Decide on a Solution Strategy
 If we use IRR, we will get multiple IRRs as there are two
sign changes in cash flow stream.

 We can use MIRR by doing the following:


 First, discount the year 2 negative cash flows back to year 0
using the 8% discount rate.
 Second, calculate the MIRR of the resulting cash flows for years
0 and 1.

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Step 3:Solve
Discount the year 2 negative cash flows to year 0.

Years
0 1 2

Cash flows -$235,000 $540,500 -$310,200


-$265,947
-$500,947

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Step 3: Solve (cont.)
The modified cash flow stream is as follows:

Years 0 1 2

Cash flows -$500,947 $540,500 -$0

Calculating
the IRR for the above modified cash flows
produces MIRR equal to 7.9%

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Step 4: Analyze
We were able to compute IRR by eliminating the second
sign change and thus modifying the cash flows.
MIRR is not the same as IRR as modified cash flows are
discounted based on the discount rate used to calculate
NPV (which is not the same as IRR).

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Profitability Index
The profitability index (PI) is a cost-benefit ratio equal
to the present value of an investment’s future cash flows
divided by its initial cost.

Decision Criteria:
 If PI is greater than one, the NPV will be positive and the
investment should be accepted
 When PI is less than one, which indicates a bad investment,
NPV will be negative and the project should be rejected.

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Profitability Index
Potential problems with PI:
Project A has PI = 1.3
Project B has PI = 1.1
This suggests should choose Project A

Suppose investments are $10MM,for A, $100MM for B


Which has larger NPV?

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The Problem
PNG Pharmaceuticals is considering an investment in a new
automated materials handling system that is expected to
reduce its drug manufacturing costs by eliminating much of
the waste currently involved in its specialty drug division.
The new system will require an initial investment of
$50,000 and is expected to provide cash savings over the
next six-year period as shown on next slide.

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The Problem

Year Expected Cash Flow

0 -$50,000
1 $15,000
2 $8,000
3 $10,000
4 $12,000
5 $14,000
6 $16,000

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Step 1: Picture the Problem

k=10%
0 1 2 3 4 5 6
Years
Cash flows -$50 +$15 +$8 +$10 +$12 +$14 +$16
(in $, thousands)

PI =?

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Step 2: Decide on a Solution Strategy
The PI for a project is equal to the present value of the
project’s expected cash flows for years 1-6 divided by the
initial outlay.
PI = PV of expected cash flows ÷ -Initial outlay

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Step 3: Solve
Step 1: Computing PV of Cash Inflows

Year Expected Present Value at


Cash flow 10% discount rate
1 $15,000 $13,636.36
2 $8,000 $6,611.57
3 $10,000 $7,513.14
4 $12,000 $8,196.16
5 $14,000 $8,692.90
6 $16,000 $9,031.58
NPV of Expected Cash flows, $53,681.72
Years 1-6

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Step 3: Solve
Step 2: Compute the PI

PI = PV of expected CF1-6 ÷ Initial Outlay


= $53,681.72 ÷ $50,000
= 1.073

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Step 4: Analyze
 PNG Pharmaceuticals requires an initial investment of
$50,000 and provides future cash flows that have a
present value of $53,681.72. Thus, PI is equal to 1.073.

 It is an acceptable project since PI is greater than one.

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Payback Period
 The Payback period for an investment opportunity is
the number of years needed to recover the initial cash
outlay required to make the investment.

 Decision Criteria: Accept the project if the payback


period is less than a pre-specified maximum number of
years.

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Limitations of Payback Period
1. It ignores the time value of money
2. It ignores cash flows that are generated by the project
beyond the end of the payback period.
3. It utilizes an arbitrary cutoff criterion.

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Table 11-1 Limitations of the Payback
Period Criterion

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Discounted Payback Period
 Discounted payback period approach is similar except
that it uses discounted cash flows to calculate the
payback period.

 Decision Criteria: Accept the project if its discounted


payback period is less than the pre-specified number of
years.

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Table 11.2 Discounted Payback Period
Example (Discount Rate 17 percent)

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Table 11.3 Basic Capital-Budgeting Techniques

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A Glance at Actual Capital Budgeting
Practices

 Figure 11.2 provides the results of a survey of the CFOs of


large US firms, showing the popularity of various tools.

 The results show that NPV and IRR methods are by far the
most widely used methods, although more than half the
firms surveyed did use the Payback method.

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Figure 11.2 Survey of the Popularity of
Capital-Budgeting Methods

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