Chapter 9

Net Present Value and Other Investment Criteria

Prepared and Taught by Lecturer : YIN SOKHNG

E-mail: yin_sokheng@yahoo.com Tel: (855) 16889872 / 17989972

Chapter Outline 9.1 Net Present Value (NPV) 9.2 The Payback Rule (PR) 9.3 The Discounted Payback Period Rule (DPR) 9.4 The Average Accounting Return (AAR) 9.5 The Internal Rate of Return (IRR) 9.6 The Profitability Index (PI) 9.7 The Practice of Capital Budgeting
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9.1 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 The difference between the market value of a project and its cost How much value is created from undertaking an investment?
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The Net Present Value (NPV) Rule

Net Present Value (NPV) = Initial Investment (costs) + PV of future CFs Estimating NPV:
1. Estimate initial costs 2. Estimate future cash flows: how much? and when? 3. Estimate discount rate

Minimum Acceptance Criteria: Accept if NPV > 0 Ranking Criteria: Choose the highest NPV
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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.
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For example of NPV

Year Cash flow (net income) 0 $9,000 1 6,000 2 4,000 3 3,000 4 2,000 Initial cash flow = $9,000; IR = 10%; Do you Recommend this project?
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For example of NPV

PV = 6,000 /(1.1) + 4,000 /(1.1)2 + 3,000 /(1.1)3 + 2,000 /(1.1)4 = $12,377 NPV = $12,377 9,000 = $3,377 EX2: IBM Company has two projects to invest: 1. Project (A) is initial cost of $350,000 and cash inflow in year one is $400,000 2. Project (B) invests in treasury bill with 7% of interest rate, Do you recommend?
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For example of NPV

PV of Project (B)= 400,000 / (1.07) = $373,832 NPV = $373,832 350,000 = $23,832 Invest in project (A) is best

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9.2 The Payback Period

How long does it take the project to pay back its initial investment? Computation
Estimate the cash flows Subtract the future cash flows from the initial cost until the initial investment has been recovered Payback Period = number of years to recover initial costs
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The Payback Period Rule

Decision Rule Accept if the payback period is less than some preset limit Minimum Acceptance Criteria:
set by management

Ranking Criteria:
set by management

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The Payback Period Rule

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
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Computing Payback For The Project

Assume we will accept the project if it pays back within two years.
Year 1: 165,000 63,120 = 101,880 still to recover Year 2: 101,880 70,800 = 31,080 still to recover Year 3: 31,080 91,080 = -60,000 project pays back in year 3

Do we accept or reject the project?

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Payback Period
Assume ABC Co. plans to invest in a project that has a $50,000 initial outlay. It is estimated that the project will provide regular cash inflows of $30,000 in year 1, $20,000 in year 2, $10,000 in year 3, and $5,000 in year 4. Payback period = 2 years

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For example of Payback period

Year 0 1 2 3 4 A -100 30 40 50 60 B -200 40 20 10 C -200 40 20 10 130 D -200 100 100 10 200 E -50 100 -50,000 -200

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For example of Payback period

Payback period (A) = 2 years + (100 70 ) / 50 = 2.6 years Payback period (B) = Never payback Payback period ( C) = 4 years Payback period (D) = 2 years Payback period (E) = 6 months
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9.3 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.

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9.4 The Average Accounting Return Rule

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
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AAR

Average Net Income Average Book Value of Investent

Book value is a started investment Average book value of Investment = a stated investment / 2 Decision Rule: Accept the project if the AAR is greater than a preset rate.

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Computing AAR For The Project

Assume we require an average accounting return of 25% Average Net Income:
(13,620 + 3,300 + 29,100) / 3 = 15,340

AAR = 15,340 / 72,000 = .213 = 21.3% Do we accept or reject the project?

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Example of AAR
Assume we require an average accounting return of 25% Assume that net earnings for the next 4 years are estimated to be $10,000, 15,000, $20,000, and $30,000, respectively. If the initial investment is $100,000, find the average rate of return Average net earnings = 10,000 + 15,000 + 20,000 + 30,000 / 4 = $18,750 Average Book value = 100,000 / 2 = $50,000 AAR = $18,750 / $50,000 = 37.5% Do we accept or reject the project?
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9.5 The Internal Rate of Return (IRR) Rule

IRR: the discount that sets NPV to zero Minimum Acceptance Criteria: Ranking Criteria:
Select alternative with the highest IRR All future cash flows assumed reinvested at the IRR. Does not distinguish between investing and borrowing. IRR may not exist or there may be multiple IRR Problems with mutually exclusive investments Easy to understand and communicate
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Accept if the IRR exceeds the required return.

Reinvestment assumption: Disadvantages:

Advantages:

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The Internal Rate of Return: Example

Consider the following project:
$50 $100 $150

0 -$200

The internal rate of return for this project is 19.44%

NPV 0

$50 $100 $150 (1 IRR ) (1 IRR ) 2 (1 IRR )3

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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 0% 4% 8% 12% 16% 20% 24% 28% 32% 36% 40% NPV $100.00 $71.04 $47.32 $27.79 $11.65 ($1.74) ($12.88) ($22.17) ($29.93) ($36.43) ($41.86)
$120.00 $100.00 $80.00 $60.00
NPV

$40.00 $20.00 $0.00 -1% ($20.00) ($40.00) ($60.00) Discount rate 9% 19%

IRR = 19.44%

29%

39%

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Problems with the IRR Approach

Multiple IRRs. Are We Borrowing or Lending? The Scale Problem The Timing Problem

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Multiple IRRs
There are two IRRs for this project:
$200 0 -$200
NPV
$100.00 $50.00 $0.00 -50% 0% ($50.00) ($100.00) ($150.00)
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$800 2 3 - $800

Which one should we use?

100% = IRR2

50%

100%

150%

200%

0% = IRR1

Discount rate

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?

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The Timing Problem

$10,000 Project A 0 -$10,000 1 2 $1,000 3 $12,000 $1,000 $1,000

$1,000 Project B 0 -$10,000 1

The preferred project in this case depends on the discount rate, not the IRR.
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The Timing Problem

$5,000.00 $4,000.00 $3,000.00 $2,000.00

Project A Project B 10.55% = crossover rate

10% 20% 30% 40%

NPV

$1,000.00 $0.00 ($1,000.00) 0% ($2,000.00) ($3,000.00) ($4,000.00)

12.94% = IRRB 16.04% = IRRA

Discount rate

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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 $1,000.00 $0.00 ($1,000.00) 0% ($2,000.00) ($3,000.00) Discount rate
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10.55% = IRR
5% 10% 15% 20% A-B B-A

NPV

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.
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IRR and Mutually Exclusive Projects

Mutually exclusive projects
If you choose one, you cant choose the other Example: You can choose to attend graduate school next year at either Harvard or Stanford, but not both

Intuitively you would use the following decision rules:

NPV choose the project with the higher NPV IRR choose the project with the higher IRR
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Example With Mutually Exclusive Projects

Period 0 1 2 IRR NPV Project A Project B -500 325 325 19.43% 64.05 -400 325 200 22.17% 60.74
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The required return for both projects is 10%.

Which project should you accept and why?

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9.6 The Profitability Index (PI) Rule

PI
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
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Total PV of Future Cash Flows Initial Investent

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9.7 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.

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Example of Investment Rules

Compute the IRR, NPV, PI, and payback period for the following two projects. Assume the required return is 10%. Year 0 1 2 3 Project A -$200 $200 $800 -$800 Project B -$150 $50 $100 $150
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Example of Investment Rules

CF0 PV0 of CF1-3 NPV = IRR = PI = Project A -$200.00 $241.92 $41.92 0%, 100% 1.2096 Project B -$150.00 $240.80 $90.80 36.19% 1.6053
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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?
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Relationship Between NPV and IRR

Discount rate -10% 0% 20% 40% 60% 80% 100% 120% NPV for A -87.52 0.00 59.26 59.48 42.19 20.85 0.00 -18.93 NPV for B 234.77 150.00 47.92 -8.60 -43.07 -65.64 -81.25 -92.52
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NPV Profiles
NPV
$400 $300 $200 $100 $0
-15% 0% 15% 30% 45% 70% 100% 130% 160% 190%

IRR 1(A)

IRR (B)

IRR 2(A)

($100) ($200)

Cross-over Rate
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Discount rates

Project A Project B
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