Ch. 9: Net Present Value and Other Investment Criteria

Capital Budgeting

• What fixed assets should we buy? What projects should we invest in?
• Goal of Management: Maximize shareholder value
• How do we evaluate capital budgeting decision rules?
  • Does the decision rule adjust for the timing of the cash flows? (TVM)
  • Does the decision rule appropriately adjust for risk?
  • Does the decision rule provide information on value creation?
• How does capital budgeting differ from valuing stocks and bonds?
  • Unlike stocks, projects have cash flows that end.
  • Project cash flows typically vary through time, unlike a fixed coupon or a dividend that grows at a constant rate.

Example

• You are reviewing a new project and have estimated the following cash flows:
  • Year 0: CF = –165,000
  • Year 1: CF = 63,120; NI = 13,620
  • Year 2: CF = 70,800; NI = 3,300
  • Year 3: CF = 91,080; NI = 29,100
  • Average Book Value = 72,000
• Your required return for assets of this risk level is 12%.

Capital Budgeting Decision Rules

• Net Present Value (NPV)
  • Does the PV of cash inflows exceed the PV of cash outflows?
  • If the NPV is positive, accept the project.
  • In the case of our example, NPV is $12,627.41.
    • Use financial calculator’s CF registry.
    • Do we accept or reject the project?
  • Does this rule meet our criteria for a good capital budgeting decision rule?
    • Does the decision rule adjust for the timing of the cash flows? Yes.
    • Does the decision rule appropriately adjust for risk? Yes.
    • Does the decision rule provide information on value creation? Yes.
• Payback Period
  • How long does it take to get the initial cost back in a nominal sense?
  • If the payback period is shorter than some preset limit (typically 3–4 years), accept the project.
  • In the case of our example, payback occurs in 3 years (2.34 if cash flows are evenly spaced throughout the year).
    • Consider a benchmark payback period of 3 years.
    • Do we accept or reject the project?
  • Does this rule meet our criteria for a good capital budgeting decision rule?
    • Does the decision rule adjust for the timing of the cash flows? No.
    • Does the decision rule appropriately adjust for risk? No.
    • Does the decision rule provide information on value creation? No.
  • Consider two projects. One project costs $250 and pays out $100 each year over the next 4 years. The other project costs $250, pays out $100 in year one, and pays out $200 in year two. Assume a required rate of return of 15 percent.
    • Payback period: 2.5 years vs. 1.75 years
    • NPV: $35.50 vs. $–11.81
  • Features:
    • Easy
    • Biased toward liquidity (short-term projects)
    • Accounts for the uncertainty of long-term cash flows by ignoring them entirely
• Discounted Payback Period
  • How long does it take to get the initial cost back after discounting the cash flows?
  • If the discount payback period is shorter than some preset limit, then accept.
  • In the case of our example, payback occurs in 3 years.
    • Consider a benchmark payback period of 2 years.
    • Do we accept or reject the project?
  • Does this rule meet our criteria for a good capital budgeting decision rule?
    • Does the decision rule adjust for the timing of the cash flows? Yes.
    • Does the decision rule appropriately adjust for risk? Yes.
    • Does the decision rule provide information on value creation? No. The cutoff period is arbitrary.
• Average Accounting Return
  • What is the ratio of average net income to average book value?
  • If the average accounting return exceeds some threshold, accept the project.
  • In the case of our example, AAR is 21%.
    • Consider a benchmark AAR of 25%.
    • Do we accept or reject the project?
  • Does this rule meet our criteria for a good capital budgeting decision rule?
    • Does the decision rule adjust for the timing of the cash flows? No.
    • Does the decision rule appropriately adjust for risk? No.
    • Does the decision rule provide information on value creation? No.
  • This rule doesn’t even account for cash flows.
• Internal Rate of Return (IRR)
  • What rate of return makes the NPV zero?
  • If the IRR exceeds the required rate of return, then accept.
  • In the case of our example, IRR is 16.13%.
    • CF registry on financial calculator
    • Trial and error, otherwise
      • Remember relationship between price and rate of return.
      • If NPV > 0, then increase the IRR.
      • If NPV < 0, then decrease the IRR.
    • Do we accept or reject the project?
  • See Figure 9.5
  • Does this rule meet our criteria for a good capital budgeting decision rule?
    • Does the decision rule adjust for the timing of the cash flows? Yes.
    • Does the decision rule appropriately adjust for risk? Yes.
    • Does the decision rule provide information on value creation? Yes.
  • Generally, NPV and IRR give the same decision, except:
    • CFs that change sign more than once
      • Consider a strip mine that costs $60. The cash flows are $155 in the first year and -$100 in the second year.
      • The NPV is zero when the IRR is 25% and when the IRR is 33.33%.
    • Mutually exclusive investments
      • A situation in which taking one investment prevents the taking of another.
      • See Example
      • See Figure 9.8
      • Crossover Rate
        • The discount rate that makes the NPVs of the two projects equal
        • Example
          • Investment A CFs: -$400, $250, $280
          • Investment B CFs: -$500, $320, $340
          • Work with NPV(B-A) to find crossover.
    • In the case of conflicts, always use NPV.
• Modified IRR
  • Return to our previous example
    • Consider a strip mine that costs $60. The cash flows are $155 in the first year and -$100 in the second year.
    • The NPV is zero when the IRR is 25% and when the IRR is 33.33%.
    • The required rate of return is 20%.
  • Method 1: Discounting Approach
    • Discount negative cash flows to present at the required rate of return.
    • Now the initial cash flow is -$129.44, and the MIRR is 19.74%.
  • Method 2: Reinvestment Approach
    • Reinvest cash flows at the required rate of return.
    • Now the only inflow is $86 at year two, and the MIRR is 19.72%.
  • Method 3: Combination Approach
    • Discount negative cash flows to present.
    • Compound positive cash flows to end.
    • CF0 is -$129.44, CF2 is $186, and the MIRR is 19.87%.
• Profitability Index
  • What is the ratio of the present value of cash flows to the cost of the project? (this is equal to 1 + NPV/Cost)
  • If PI > 1, then accept.
  • Can lead to ranking problems in mutually exclusive investments.
    • Investment A: $5 cost, $10 PV of cash flows
    • Investment B: $100 cost, $150 PV of cash flows

In Practice

• Multiple criteria are used (NPV/IRR primary, Payback Period secondary)
• Why?
  • Liquidity may be an issue
  • NPV calculations can be costly/time consuming
  • Cash flows may be uncertain (``soft’’ NPV)
• Tie performance to firm value

Practice Problem

• An investment project has the following cash flows: CF0 = –1,000,000; C01 – C08 = 200,000 each
• If the required rate of return is 12%, what decision should be made using NPV?
• How would the IRR decision rule be used for this project, and what decision would be reached?
• How are the above two decisions related?