Chap 2-1: NPV and Other Investment Rules

❖​ Net Present Value (NPV): is the present value of the expected cash flows less the
cost of the investment. NPV affects making capital budgeting decisions.
❖​ NPV is used to estimate:
1. Estimate future cash flows: how much? and when?
2. Estimate discount rate
3. Estimate initial costs
Formula
NPV = Initial Investment + PV of future return on investment = – Cost + PV
NPV= Total PV of future CF’s + Initial Investment
NOTE : PV and cost are market value
The Net Present Value rule
●​ Independent investments (Minimum Acceptance Criteria): accept a minimum
criterion that is at least acceptable
NPV > 0 → accept a project
NPV < 0 → reject a project
●​ Mutually Exclusive Investments (Ranking Criteria): choose only 1 of the potential
projects that can be chosen
Choose the highest NPV and NPV >0
❖​ Advantage and disadvantage
Advantages :
1. Using discounted cash flow valuation technique
2. Measure of how much a capital project will increase the value of the firm
- The value of the firm is the sum of the values of the different projects, divisions, or other
entities within the firm (value additivity)
- The contribution of any project to a firm’s value is the NPV of the project
3. Consistent with the target of maximizing shareholder wealth
4. Has no serious problems
Disadvantage: difficult to understand without an accounting and finance background
3 Reasons why the net present value approach is the best decision criterion:
●​ NPV uses cash flows
Cash flows from a project can be used for other corporate purposes (such as dividend
payments, other capital budgeting projects, or payments of corporate interest). By contrast,
earnings are an artificial construct. Although earnings are useful to accountants, they should
not be used in capital budgeting because they do not represent cash.
●​ NPV uses all the cash flows of the project
Some alternative approaches ignore cash flows beyond a particular date; beware of these
approaches.
●​ The NPV rule uses the discount rate for cash flow valuation
Other approaches may ignore the time value of money when handling cash flows. Beware of
these approaches, as well.
Reinvestment assumption: the NPV rule assumes that all cash flows can be reinvested at the
discount rate
 ❖​ Discount rate of NPV method
The discount rate on a risky project = the return on a financial asset of comparable risk
This discount rate is referred to as an opportunity cost because corporate investment in the
project takes away the stockholder’s option to invest the dividend in other opportunities.
We can look for the expected return of investments with similar risks available in the market.
The Payback Period Method
❖​ Payback Period: number of years to recover initial costs
-​ It is a short-term orientation
-​ Take the project if it pays back in some specified period.
-​ There is an arbitrary cutoff period.
❖​ Rules: set by management
+ Minimum acceptance criteria
+ Ranking criteria
❖​ Feature of the method
●​ Disadvantages:
+ Ignores the time value of money
+ Ignores all cash flows after the payback period
+ Biased against long-term projects
+ Requires arbitrary standard criteria
+ A project accepted based on the payback criteria may not have a positive NPV
●​ Advantages:
+ Easy to understand
+ Biased toward liquidity
+ Preferred decision criterion
❖​ The Payback method is used for:
-​ Large and sophisticated companies when making relatively small investment
decisions that are often made by lower-level management
-​ Small and private firms with good investment opportunities but no available cash or
limited access to the capital markets.
❖​ The features of payback method for managerial perspective
-​ It helps us can evaluate the manager’s decision-making ability
-​ Both payback and NPV lead to the same decision for the majority of real-world
projects
-​ When controlling and evaluating the manager become less important than making the
right investment or big decision, payback is used less frequently.
+ Preferred decision criterion
3. The Discounted Payback Period Method
-​ The discounted payback period is the payback period for these discounted cash flows.
-​ As long as the cash flows and discount rate are positive, the discounted payback
period will always be bigger than the payback period.
-​ Accept the project if it pays back on a discounted basis in some specified period.
-​ By the time you have discounted the cash flows, you might calculate NPV as well.
4. The Average Accounting Return Rule
AAR= Average Net Income/Average Book Value of Investment
Another attractive but fatally flawed approach.
Ranking Criteria and Minimum Acceptance Criteria set by management
❖​ Disadvantages:
-​ Ignores the time value of money
-​ Uses an arbitrary benchmark cutoff rate
-​ Based on book values, not cash flows and market values
❖​ Advantages:
-​ The accounting information is usually available
-​ Easy to calculate
4. The Internal Rate of Return (IRR): the discount rate that sets NPV to zero
IRR does not depend on the discount rate or interest rate prevailing in the capital market. It
only depends on the cash flows of the project.
A. Reinvestment assumption: all future cash flows are assumed to be reinvested at the IRR
B. Method of choosing IRR
Minimum Acceptance Criteria:
− Accept if the IRR exceeds the required return
− Reject if the IRR is lower than the required return
Ranking Criteria: select alternative with the highest IRR
C. Disadvantages and Advantages
❖​ Disadvantages:
-​ Does not distinguish between investing and borrowing
-​ IRR may not exist, or there may be multiple IRRs
-​ IRR is unreliable with non-conventional cash flows or mutually exclusive projects
❖​ Advantages: easy to understand and communicate
D. Problems with IRR approach
Independent Projects: accepting or rejecting one project does not affect the decision of the
other projects.Must exceed a MINIMUM acceptance criteria.
TWO PROBLEMS AFFECTING BOTH INDEPENDENT AND MUTUALLY EXCLUSIVE
PROJECTS
The Scale Problem (depend on an investment)
1. Compare the NPVs of the two choices → choose the bigger NPV
2. Calculate the incremental NPV (by subtracting the smaller NPV from the bigger one)
3. Compare the incremental IRR to the discount rate (incremental IRR > discount rate)
Subtract the smaller project’s cash flows from the bigger project’s cash flows
Use the basic IRR rule on the incremental flows
Incremental IRR is the rate that causes the incremental cash flows to have zero NPV
The firm has to determine the best size for the project
The Timing Problem (depend on discount rate)
The NPV of Project B declines more rapidly as the discount rate increases than does the NPV
of Project A because the cash flows of B occur later
1. Compare NPVs of the two projects
2. Compare incremental IRR to discount rate
Assume: B - A
+ incremental IRR > discount rate → Project B
+ incremental IRR < discount rate → Project A
The crossover rate and the incremental IRR are always the same
3. Calculate NPV on incremental cash flows
E. NPV versus IRR
NPV and IRR will generally give the same decision. Exceptions:
❖​ Cash flow signs change more than once (non-conventional cash flows)
❖​ Mutually exclusive projects :
- Initial investments are substantially different
-Timing of cash flows is substantially different
❖​ The discount rate is needed for deciding on either the NPV or IRR approach:
+ The discount rate is used to compute NPV
+ You must compare the IRR with the discount rate to apply IRR
5. The Profitability Index (PI) is the ratio of the present value of the future expected cash
flows after initial investment divided by the amount of the initial investment
PI is a benefit-cost ratio.
May be used to rank projects in the presence of capital rationing.
PI = Present value of the future cash flows after an initial investment/Initial investment
=(NPV +Co)/Co
❖​ 2 criteria of choosing PI
Minimum Acceptance Criteria: Ranking Criteria:
PI > 1 → Accept select alternative with highest PI
PI < 1 → Reject
❖​ Disadvantages and advantages
❖​ Disadvantages:
Cannot be used to rank mutually exclusive projects
❖​ Advantages:
+ May be useful when available investment funds are limited
+ Easy to understand and communicate
+ Correct decision when evaluating independent projects
❖​ Application of the Profitability Index
1. Independent projects
❖​ Accept the project if PI > 1
❖​ Reject project if PI < 1
2. Mutually exclusive projects
PI ignores differences of scale (scale problem)
Using incremental analysis
Assumption cash flow: A – B
-PI on the incremental cash flow > 1 → Project A
-PI on the incremental cash flow < 1 → Project B
3. Capital rationing
Capital rationing is the case when the firm does not have enough capital to fund all positive
NPV projects → we cannot rank projects according to their NPVs
Rank projects according to the PI rule: choose the higher PI ratios
+ The chosen projects must use up all of the $ available capital investment
+ The remaining $capital of combined initial investment of projects will be left in the bank
II/ The practice of capital budgeting
1.​ Large-scale capital spending is often an industrywide occurrence
2.​ The capital budgeting methods of large firms are more sophisticated than the methods
of small firms because large firms have the financial resources to hire more
sophisticated employees.
3.​ The most frequently used technique for a large corporation is IRR or NPV.
4.​ The most popular used decision criterion for all companies in the world is NPV
5.​ The use of quantitative techniques in capital budgeting varies with the industry. Firms
that are better able to estimate cash flows are more likely to use NPV
Chap 2-2: Making Capital Investment Decisions
1. Incremental Cash Flows
●​ Cash flows matter—not accounting earnings.
●​ Sunk costs don’t matter.
●​ Incremental cash flows matter.
●​ Opportunity costs matter.
 ●​ Side effects like cannibalism and erosion matter.
●​ Taxes matter: we want incremental after-tax cash flows.
●​ Inflation matters
Using incremental cash flow in calculating the NPV of a project
➢​ Incremental cash flows are the difference between the cash flows of the firm with the
project and the cash flows of the firm without the project.
➢​ Corporate finance (use cash flow) is different from financial accounting (use income)
➢​ Always discount cash flows, not earnings, when performing a capital budgeting
calculation
➢​ When considering a project, we discount the cash flows that the firm receives from
the project.
Some pitfalls of determining incremental cash flows
❖​ Sunk cost: a cost that has already occurred → not incremental cash outflows
When the company incurred the expense, the cost became irrelevant to any future decision.
❖​ Opportunity cost:
-​ The cost of taking the project and forgoing other opportunities for using other assets
→ cash outflows for capital budgeting
-​ Opportunity costs do matter. Just because a project has a positive NPV that does not
mean that it should also have automatic acceptance. Specifically if another project
with a higher NPV would have to be passed up we should not proceed.
❖​ Allocated costs: cost is allocated across the different projects when determining
income
The firm will spend the cost on whether or not the proposed project is accepted so it should
be ignored when calculating the NPV.
This cost is viewed as a cash outflow of a project only if it is an incremental cost of the
project for capital budgeting purposes.
❖​ Side effects (be included in the NPV calculation)
Erosion and cannibalism are both bad things. If our new product causes existing customers to
demand less of current products, we need to recognize that.
- Erosion: occurs when a new product reduces the cash flows of existing products
- Synergy: occurs when a new project increases the cash flows of existing projects
2. An analysis of the project
❖Three steps of analyzing the cash flows of the project:
1 - Generating cash outflows to invest at the beginning of the project
2 - Product sales provide cash inflows over the life of the project
3 - Plant and inventories are sold off at the end of the project, generating more cash inflow
★​ Estimating Cash Flows
Cash Flows from Operations = Operating Cash Flow = EBIT – Taxes + Depreciation
Net Capital Spending=Ending Net Fixed Assets−Beginning Net Fixed Assets+Depreciation
Change in NWC=Ending NWC−Beginning NWC
Net working capital is defined as the difference between current assets and current liabilities.
Segments for cash flow in analyzing the project
1.​ Investments
 -​ The initial cost of assets (machine, plant, land, …)->The purchase requires an
immediate in Year 0. (-)
-​ The firm realizes a cash inflow when initial machines are sold at the end of the
project.
-​ Accumulated depreciation → Adjusted assets after depreciation
-​ The opportunity cost
+​ The sales price is included as an opportunity cost in Year 0 (-)
+​ The asset (opportunity cost) will be sold in the last year if the project is accepted(+)
2.​ Net working capital Changes in working capital
Net working capital:
The investment in working capital must be funded by cash generated elsewhere in the firm
tied up in the project. Working capital rises over the early years as expansion occurs and
then it is completely recovered by the end of the project’s life (an assumption in capital
budgeting)
-​ An increase in investment of NWC (cash outflow):
+ Inventory is purchased
+ Cash is kept in the project as a buffer against unexpected expenditures
+ Sales are made on credit, generating accounts receivable rather than cash.
-​ A decrease in the investment of NWC (cash inflow):
+ Credit purchases that generate accounts payable
+ The project’s money from selling products is returned to the corporation
+ All remaining inventory is sold off and all Accounts Receivable are collected at the end of
the project
Changes in net working capital = NWCyear1 – NWCyear2
-​ It represents further cash flows from year to year
-​ For the first few years, they are negative numbers
-​ In the declining years of the project, they are positive figures (because net working
capital is reduced ultimately to zero in the end).
Total cash flow of investment = Initial cost of assets + Opportunity cost + Changes in NWC
3.​ Income (We need the income calculation to determine taxes)
-​ Sales revenues
-​ Operation costs (-)
-​ Depreciation (-)
+ Depreciation is expressed as a percentage of the asset’s initial cost.
+ Depreciation rule is based on MACRS that are set forth in IRS Publication 946.
+ This publication sorts different property types into classes to determine their depreciable
lives for tax purposes.
+ The IRS allows half a year of depreciation for the year in which property is disposed of or
retired.
-​ Income before taxes
-​ Tax (-)
-​ Net income
Cash flow from operations = Net income + Depreciation
❖Some important elements of the project analysis
Salvage Value: the value of the asset at the end of the project
The aftertax Salvage Value = Asset’s sales price – [(Asset’s sales price – Book value)×Tax
rate]= Asset’s sales price – [Capital gains×Tax rate]
-​ The book value: value has been depreciated through the project’s life
-​ Asset’s sales price: the estimated sale price of machine or equipment at the end of the
project
Note: If the book value exceeds the market value, the difference is treated as a loss for tax
purposes
Cash Flow (Incremental Cash Flows)
Total cash flow of the project = Total cash flow of the investment + Cash flow from
operations ⇒ calculate NPV
Net Present Value: can be calculated from the cash flows
-​ The appropriate discount rates that make NPV> 0 or NPV< 0; NPV = 0 → calculate
the project’s internal rate of return
Interest expense
-​ The NPV of the project is independent of financing decisions.
-​ Any adjustments for debt financing are reflected in the discount rate, not the cash
flows
Which set of books?
Corporations must provide a computation of profit or loss for their annual reports to both
their stockholders and tax authorities
❖​ Tax books
-​ Follow the rules of the Internal Revenue Service (IRS)
-​ Interest on municipal bonds is ignored for tax purposes
-​ Use accelerated depreciation
-​ You can only calculate cash flows after subtracting out taxes
❖​ Stockholders’ books
-​ Follow the rules of the Financial Accounting Standards Board (FASB)
-​ Interest on municipal bonds is treated as income
-​ Using straight-line depreciation
-​ Be not used for capital budgeting because they are relevant for accounting and
financial analysis
❖​ The differences benefit the firm:
-​ Income on the stockholders’ books is higher than income on the tax books
🡪management can look profitable to the stockholders without paying taxes on all of
that reported profit
-​ Large companies consistently report positive earnings to their stockholders while
reporting losses to the IRS
-​ Knowledge of local rules is needed before estimating international cash flows.This is
not the case in all
Inflation and Capital Budgeting
Consider the relationship between interest rates and inflation, often referred to as the Fisher
relationship:
 (1 + Nominal Rate) = (1 + Real Rate) × (1 + Inflation Rate)
For low rates of inflation, this is often approximated as
Real Rate Nominal Rate – Inflation Rate
❖Interest rate and inflation
Inflation is an important fact of economic life and must be considered in capital budgeting.
● Real interest rate: is what you are really earning through your saving account after
adjusting for inflation→ Lending lets you increase your consumption of any single goods or
combination of goods by real interest rate %
● Nominal interest rate: the money you earn through your saving account without inflation
❖Cash flow and inflation
A nominal cash flow: refers to the actual dollars to be received or paid out.
A real cash flow: refers to the cash flow's purchasing power.
Real cash flow =
Depreciation
Depreciation is a nominal quantity because yearly depreciation is the actual tax deduction
over each of the next years.
Depreciation becomes a real quantity if it is adjusted for purchasing power
❖Discounting cash flow
- Nominal cash flows must be discounted at the nominal rate
- Real cash flows must be discounted at the real rate.
The NPV is the same cash flows under the two different approaches.
Choose the approach that is easier.
4. Three approaches to determining Operating Cash Flow
All of the approaches are consistent with each other → “What cash goes into the owner’s
pockets and what cash goes out of his pockets?”
The different approaches are useful in different circumstances
Operating cash flow
= After-tax savings amount + Depreciation tax shield
= Annual pretax cost savings×(1-Tax rate) + Additional depreciation×Tax rate