Chapter 6 Net present value and other investment rules by lpx20272

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									Chapter 6: Net present value and
    other investment rules

               Corporate Finance
               Ross, Westerfield, and
               Jaffe
Outline

6.1 Net present value (NPV)
6.2 The payback period method
6.3 The discounted payback period method
6.4 The Internal rate of return (IRR)
6.5 The profitability index
Announcement

   Your group needs to submit a typed report
    for mini-case: Bullock Gold Mining, p. 196,
    after we finish this chapter.
Good decision criteria

   Does the rule take the time value of money
    into consideration?
   Does the rule adjust for risk?
   Does the rule tell us whether and by how
    much the project add value to the firm?
A proposed project

   Your company is looking at a new project
    that has the following cash flows.
   Year 0: initial cost, C0 = $100,000.
   Year 1: CF1 = $30,000.
   Year 2: CF2 = $50,000.
   Year 3: CF3 = $60,000.
   The applicable discount rate is 10%.
1st method: the NPV rule

   NPV = PV – C0: the difference between the
    present value of the investment’s future net
    cash flows, i.e., benefits, and its initial cost.
   Ideas: (1) an investment is worth undertaking
    if it creates value for its owners, and (2) an
    investment creates value if it worth more than
    it costs within the time value of money
    framework (Chapter 4).
Decision rule

   If NPV > 0, accept the project.
   If NPV < 0, reject the project.
   A positive NPV suggests that the project is expected
    to add value to the firm, and the project should
    improve shareholders’ wealth.
   Because the goal of financial management is to
    increase shareholders’ wealth, NPV is a good
    measure of how well this project will meet this goal.
Project NPV

     Year         CF      C(0)      PV      NPV
      0                  100000            13674
      1          30000            27272.7    >0
      2          50000            41322.3 Accept!
      3          60000            45078.9
                                  113674
 Discount rate    0.1
Judging the NPV rule

   Does the NPV rule take the time value of
    money into consideration?
   Does the NPV rule adjust for risk?
   Does the NPV rule tell us whether and by
    how much the project add value to the firm?
Finally, they listen

   CFOs are using what academics consider better
    measures in their capital-budgeting analysis.
    According to a recent survey, more than 85 percent
    say they use net present value (NPV) analysis in at
    least three out of four decisions…."Finance
    textbooks have taught for years that NPV is superior,
    but this is the first known survey to show it's the
    preferred tool," says co-author Patricia A. Ryan, a
    professor of corporate finance at Colorado State
    University.
   Source: CFO.com.
2nd method: payback period

   Payback period: the amount of time required
    for an investment to generate after-tax cash
    flows sufficient to recover its initial cost.
Decision rule

   An investment is accepted (rejected), if
    payback period < (>) some specified number
    of time period.
   The cutoff is arbitrarily chosen by the
    manager or the entrepreneur.
Project payback period

Year CF   C(0) Accu. CF $ to be recoved Payback period
 0       100000
 1 30000        30000         70000
 2 50000        80000         20000          >2
 3 60000        140000       -40000          <3
The decision

   The payback period is longer than 2 years
    and shorter than 3 years.
   If the cutoff is 2 years, we’d reject the project.
   If the cutoff is 3 years, we’d accept the
    project.
Judging the payback period rule

   Does the payback period rule take the time
    value of money into consideration?
   Does the payback period rule adjust for risk?
   Does the payback period rule tell us whether
    and by how much the project add value to
    the firm?
The good and the bad

   Advantage:
    –   Easy to understand and communicate.
   Disadvantages:
    –   Ignores the time value of money.
    –   Fail to consider the riskness of the project, no i.
    –   Requires an arbitrary cutoff point.
    –   Ignores cash flows beyond the cutoff.
    –   Biased against long-term projects, such as R&Ds.
3rd method: discounted payback period

   Discounted payback period: the length of
    time required for an investment’s discounted
    cash flows to equal its initial cost.
Decision rule

   An investment is accepted (rejected), if
    discounted payback period < (>) some
    specified number of time period.
   Again, the cutoff is arbitrarily chosen.
Project discounted payback period

    Year         CF      C(0)      PV    Accu. PV To be recovered Dis. Payback
     0                  100000
     1          30000            27272.7 27272.73    72727.27273
     2          50000            41322.3 68595.04    31404.95868       >2
     3          60000            45078.9 113673.9   -13673.92938       <3

Discount rate    0.1
The decision

   The discounted payback period is longer
    than 2 years and shorter than 3 years.
   If the cutoff is 2 years, we’d reject the project.
   If the cutoff is 3 years, we’d accept the
    project.
Judging discounted payback period

   Does the payback period rule take the time
    value of money into consideration?
   Does the payback period rule adjust for risk?
   Does the payback period rule tell us whether
    and by how much the project add value to
    the firm?
The good and the bad

   Advantage:
    –   Still fairly easy to understand and communicate.
    –   Take TVM into consideration.
   Disadvantages:
    –   Requires an arbitrary cutoff point.
    –   Ignores cash flows beyond the cutoff.
    –   Biased against long-term projects, such as R&Ds.
4th method: IRR

   IRR: the discounted rate that makes the NPV
    of an investment zero.
Decision rule

   An investment is accepted (rejected), if the
    IRR > (<) the required rate.
Project IRR

Year    CF    C(0)  IRR-CF    IRR    PV
 0           100000 -100000   17%
 1     30000         30000           25686
 2     50000         50000           36654
 3     60000         60000           37660
                                    100000
The decision

   The computed IRR is 17%, which is higher
    than the 10% required rate. Thus, we accept
    the project.
Judging the IRR

   Does the IRR rule take the time value of
    money into consideration?
   Does the IRR rule adjust for risk?
   Does the IRR rule tell us whether and by how
    much the project add value to the firm?
NPV vs. IRR

   For most projects, NPV and IRR lead to the same
    conclusion.
   Practitioners really like to use IRR because this
    measure gives practitioners a good idea about at
    what rate they are able to earn. Knowing a return is
    intuitively appealing.
   IRR provides a measure about the value of a project
    to someone who doesn’t know all the estimation
    details.
   If the IRR is high enough, one may not need to
    estimate the required return at all.
A warning

   Typical IRR calculations build in
    reinvestment assumptions.
   This makes projects look better than they
    actually are.
But, non-unique IRR solutions

 Year Costs   CF    IRR-CF   IRR   But, how about:    NPV
  0    100            -100   10%         20%          -100
  1           230     230                            191.67
  2    132            -132                           -91.67
                                                        0
Lesson

   Before you use your IRR estimate, always
    verify the result with the NPV result.
   In real life, NPV and IRR are the 2 most
    popular decision rules used by modern (big)
    U.S. corporations. And, they tend to be used
    together.
5th method: the profitability index

   Profitability index (PI) = PV / C0.
   Often used for government or other non-for-
    profit investments.
   Measures the benefit per unit cost, based on
    the time value of money.
   A profitability index of 1.2 suggests that for
    every $1 of initial investment, we create an
    additional $0.20 in value.
Decision rule

   For a project, we accept the project only if PI
    > 1.
   For mutually exclusive projects, practitioners
    sometimes choose the project with the
    highest PI. However, this approach is
    problematic.
   If there is no capital constraint, one should
    choose the project with the highest NPV from
    the mutually exclusive pool.
Project PI

    Year         CF      C(0)      PV       PI
     0                  100000            1.1367
     1          30000            27272.73   >1
     2          50000            41322.31 Accept!
     3          60000            45078.89
                                 113673.9
Discount rate    0.1
The good and the bad

   Advantages:
    –   Related to NPV, generally leading to identical
        decisions.
    –   Easy to understand and communicate.
   Disadvantage:
    –   Should not be used for making mutually exclusive
        decisions.
Real options

   So far, you know that NPV is the best
    criterion; IRR is another almost equally good
    and important one.
   But these analyses mainly address
    independent projects whose acceptance or
    rejection has no implications on the
    acceptance or rejection of other projects.
   When projects have (real) options, NPV and
    IRR may perform poorly.
An example: timing option

   Suppose that the NPV for a developer to built a
    building on a vacant land now is positive. The
    simple version of the NPV rule would lead to the
    conclusion that the developer should build the
    building now.
   In real life, the developer may choose to wait. For
    instance, the developer may believe that this is not
    the best timing (although the NPV is positive). The
    developer may want to wait for another few years
    when the real estate market is stronger to realize a
    even larger NPV at that time.
More real options

   In real life, there are several more types of
    real options that will make capital budgeting
    a even more complex task.
   Chapter 8, pp. 241-245 has an introduction
    to another two types of real options: (1) the
    option to expand, and (2) the option to
    abandon.
   I bet these will be treated in your
    intermediate corporate finance course.
Mini-case report due

   Please submit your report for mini-case:
    Bullock Gold Mining, p. 196, in 1 week.
   For task #1, please calculate (1) the payback
    period, (2) the discounted payback period,
    (3) NPV, and (4) IRR. Ignore modified IRR.
   Ignore task #3; i.e., do not need to write a
    VBA script.

								
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