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					6-0
                           Chapter Six
 Some Alternative
             Corporate Finance
              Ross Westerfield Jaffe
 Investment Rules
                                             6
                                         Seventh Edition



                                         Seventh Edition
6-1

      Chapter Outline

      6.1 Why Use Net Present Value?
      6.2 The Payback Period Rule
      6.3 The Discounted Payback Period Rule
      6.4 The Average Accounting Return
      6.5 The Internal Rate of Return
      6.6 Problems with the IRR Approach
      6.7 The Profitability Index
      6.8 The Practice of Capital Budgeting
      6.9 Summary and Conclusions
6-2

      6.1 Why Use Net Present Value?

      • Accepting positive NPV projects benefits
        shareholders.
      NPV uses cash flows
      NPV uses all the cash flows of the project
      NPV discounts the cash flows properly
6-3

      The Net Present Value (NPV) Rule

      • Net Present Value (NPV) =
          Total PV of future CF’s + Initial Investment

      • Estimating NPV:
         – 1. Estimate future cash flows: how much? and when?
         – 2. Estimate discount rate
         – 3. Estimate initial costs


      • Minimum Acceptance Criteria: Accept if NPV > 0
      • Ranking Criteria: Choose the highest NPV
6-4

      Good Attributes of the NPV Rule

      • 1. Uses cash flows
      • 2. Uses ALL cash flows of the project
      • 3. Discounts ALL cash flows properly

      • Reinvestment assumption: the NPV rule
        assumes that all cash flows can be reinvested
        at the discount rate.
6-5

      6.2 The Payback Period Rule

      • How long does it take the project to “pay
        back” its initial investment?
      • Payback Period = number of years to recover
        initial costs
      • Minimum Acceptance Criteria:
        – set by management
      • Ranking Criteria:
        – set by management
6-6

      The Payback Period Rule (continued)
        • Disadvantages:
          –   Ignores the time value of money
          –   Ignores cash flows after the payback period
          –   Biased against long-term projects
          –   Requires an arbitrary acceptance criteria
          –   A project accepted based on the payback
              criteria may not have a positive NPV
        • Advantages:
          – Easy to understand
          – Biased toward liquidity
6-7

      6.3 The Discounted Payback Period Rule

      • How long does it take the project to “pay
        back” its initial investment taking the time
        value of money into account?
      • By the time you have discounted the cash
        flows, you might as well calculate the NPV.
6-8

      6.4 The Average Accounting Return Rule
                       Average Net Income
           AAR 
                 Average Book Value of Investent
      • 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
6-9

      6.5 The Internal Rate of Return (IRR) Rule
      • IRR: the discount that sets NPV to zero
      • Minimum Acceptance Criteria:
         – Accept if the IRR exceeds the required return.
      • Ranking Criteria:
         – Select alternative with the highest IRR
      • Reinvestment assumption:
         – All future cash flows assumed reinvested at the IRR.
      • Disadvantages:
         – Does not distinguish between investing and borrowing.
         – IRR may not exist or there may be multiple IRR
         – Problems with mutually exclusive investments
      • Advantages:
         – Easy to understand and communicate
6-10

       The Internal Rate of Return: Example

       Consider the following project:
                      $50           $100         $150



          0            1             2             3
        -$200

       The internal rate of return for this project is 19.44%

                       $50        $100       $150
          NPV  0                        
                    (1  IRR ) (1  IRR ) (1  IRR )3
                                         2
6-11

       The NPV Payoff Profile for This Example
       If we graph NPV versus discount rate, we can see the IRR as
       the x-axis intercept.
       Discount Rate      NPV           $120.00
            0%         $100.00          $100.00
            4%          $71.04           $80.00
            8%          $47.32
                                         $60.00
           12%          $27.79
                                         $40.00
                                  NPV
           16%          $11.65
           20%          ($1.74)
                                                                          IRR = 19.44%
                                         $20.00
           24%         ($12.88)           $0.00
           28%         ($22.17)
           32%         ($29.93)
                                               -1%
                                        ($20.00)     9%       19%         29%    39%
           36%         ($36.43)         ($40.00)
           40%         ($41.86)         ($60.00)
                                                          Discount rate
6-12

       6.6 Problems with the IRR Approach
       • Multiple IRRs.
       • Are We Borrowing or Lending?
       • The Scale Problem.
       • The Timing Problem.
6-13

       Multiple IRRs
       There are two IRRs for this project:
                          $200      $800                Which one should
                                                                we use?
            0             1             2         3
          -$200                               - $800
        NPV




              $100.00
                                                   100% = IRR2
               $50.00

                 $0.00
          -50%        0%          50%       100%   150%       200%
             ($50.00)
                                 0% = IRR1             Discount rate
              ($100.00)

              ($150.00)
6-14

       The Scale Problem

        Would you rather make 100% or 50% on your
         investments?
        What if the 100% return is on a $1 investment
         while the 50% return is on a $1,000
         investment?
6-15

       The Timing Problem
                                   $10,000    $1,000     $1,000
          Project A
                             0         1           2         3
                           -$10,000
                                  $1,000       $1,000      $12,000
          Project B
                             0         1           2         3
                           -$10,000

       The preferred project in this case depends on the discount
       rate, not the IRR.
6-16

       The Timing Problem
              $5,000.00
              $4,000.00
                                                       Project A
              $3,000.00
                                                       Project B
              $2,000.00
                                            10.55% = crossover rate
              $1,000.00
        NPV




                  $0.00
              ($1,000.00) 0%      10%       20%       30%      40%

              ($2,000.00)
              ($3,000.00)
                            12.94% = IRRB    16.04% = IRRA
              ($4,000.00)

                                      Discount rate
6-17

       Calculating the Crossover Rate

       Compute the IRR for either project “A-B” or “B-A”
                      Year Project A Project B Project A-B Project B-A
                         0 ($10,000) ($10,000)          $0          $0
                         1 $10,000     $1,000      $9,000     ($9,000)
                         2 $1,000      $1,000           $0          $0
                         3 $1,000 $12,000        ($11,000)    $11,000


              $3,000.00
              $2,000.00
                                                        10.55% = IRR
              $1,000.00
        NPV




                                                                         A-B
                   $0.00
                                                                         B-A
              ($1,000.00) 0%     5%       10%         15%   20%
              ($2,000.00)
              ($3,000.00)
                                      Discount rate
6-18

       Mutually Exclusive vs. Independent Project
       • Mutually Exclusive Projects: only ONE of several
         potential projects can be chosen, e.g. acquiring an
         accounting system.

          – RANK all alternatives and select the best one.


       • Independent Projects: accepting or rejecting one
         project does not affect the decision of the other
         projects.

          – Must exceed a MINIMUM acceptance criteria.
6-19

       6.7 The Profitability Index (PI) Rule
                   Total PV of Future Cash Flows
              PI 
                          Initial Investent
       • Minimum Acceptance Criteria:
          – Accept if PI > 1
       • Ranking Criteria:
          – Select alternative with highest PI
       • Disadvantages:
          – Problems with mutually exclusive investments
       • Advantages:
          – May be useful when available investment funds are
            limited
          – Easy to understand and communicate
          – Correct decision when evaluating independent projects
6-20

       6.8 The Practice of Capital Budgeting

       • Varies by industry:
         – Some firms use payback, others use accounting
           rate of return.
       • The most frequently used technique for large
         corporations is IRR or NPV.
6-21

       Example of Investment Rules

       Compute the IRR, NPV, PI, and payback
       period for the following two projects. Assume
       the required return is 10%.

              Year    Project A     Project B
               0        -$200        -$150
               1         $200          $50
               2         $800         $100
               3        -$800         $150
6-22

       Example of Investment Rules


                          Project A   Project B
           CF0            -$200.00    -$150.00
           PV0 of CF1-3    $241.92     $240.80

           NPV =            $41.92      $90.80
           IRR =           0%, 100%    36.19%
           PI =             1.2096      1.6053
6-23

       Example of Investment Rules
       Payback Period:
                             Project A          Project B
          Time         CF     Cum. CF         CF Cum. CF
             0        -200        -200      -150    -150
             1         200           0        50    -100
             2         800         800       100        0
             3        -800           0       150     150

       Payback period for project B = 2 years.
       Payback period for project A = 1 or 3 years?
6-24

       Relationship Between NPV and IRR
       Discount rate   NPV for A   NPV for B
             -10%        -87.52      234.77
               0%          0.00      150.00
              20%         59.26       47.92
              40%         59.48       -8.60
              60%         42.19      -43.07
              80%         20.85      -65.64
            100%           0.00      -81.25
            120%         -18.93      -92.52
6-25

       NPV Profiles
               $400
         NPV

               $300
                          IRR 1(A)    IRR (B)        IRR 2(A)
               $200

               $100

                  $0
                   -15%    0%   15%   30%    45%   70%   100% 130% 160% 190%
               ($100)

               ($200)
                                                                   Project A
                                            Discount rates
        Cross-over Rate                                            Project B
6-26

       6.9 Summary and Conclusions

       • This chapter evaluates the most popular
         alternatives to NPV:
         –   Payback period
         –   Accounting rate of return
         –   Internal rate of return
         –   Profitability index
       • When it is all said and done, they are not the
         NPV rule; for those of us in finance, it makes
         them decidedly second-rate.

				
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