9

Net Present Value and Other Investment Criteria

Salman Masood Sheikh
M.Com, MBA, M.Phil, ACMA, FPA, CA (Int.)

Director Quality Assurance Superior University, Lahore

McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Key Concepts and Skills

Be able to compute payback and discounted payback and understand their shortcomings Understand accounting rates of return and their shortcomings Be able to compute the internal rate of return and understand its strengths and weaknesses Be able to compute the net present value and understand why it is the best decision criterion

9-1

Chapter Outline
Net Present Value The Payback Rule

The Internal Rate of Return

The Profitability Index The Practice of Capital Budgeting
9-2

Good Decision Criteria

We need to ask ourselves the following questions when evaluating capital budgeting decision rules
Does the decision rule adjust for the time value of money? Does the decision rule adjust for risk? Does the decision rule provide information on whether we are creating value for the firm? 9-3

Calculation of Future value:

FVn = PVn (FVIFk%, ny)

Where : FVn is Future value PVn is Present value FVIF is Future value interest factor k% is rate of interest ny is Number of year
9-4

Future Value Table

9-5

Calculation of Present value:

PVn = FVn (PVIFk%, ny)

Where : PVn is Present value FVn is Future value PVIF is Present value interest factor k% is rate of interest ny is Number of year
9-6

Present Value Table

9-7

Calculation Present value for Annuity: PVAD= PMTn (PVIFAk%, ny)

Where : PVAD is Present value annuity due PMTn is Payment made each period
PVIFA is Present value interest factor of annuity

k% is rate of interest ny is Number of year

9-8

Present Value of Annuity Table

9-9

Calculation Future value for Annuity: FVAD = PMTn (FVIFAk%, ny)

Where : FVAD is Future value annuity due PMTn is Payment made each period
FVIFA is Future value interest factor of annuity

k% is rate of interest ny is Number of year

9-10

Future Value of Annuity Table

9-11

Net Present Value

The difference between the market value of a project and its cost How much value is created from undertaking an investment?
The first step is to estimate the expected future cash flows. The second step is to estimate the required return for projects of this risk level. The third step is to find the present value of the cash flows and subtract the initial investment.
9-12

Computing NPV of the Projects

Table 9.1 Capital Expenditure Data for Bennett Company

9-13

NPV of the Project B

End of Year Cash Flows PVIF20%,ny Present Value

1 2 3 4 5

28,000 12,000 10,000 10,000 10,000

0.833 0.694 0.579 0.482 0.402

23,324 8,328 5,790 4,820 4,020. 46,282 (45,000). 1,282 .

9-14

Total Present Value of Cash Flows Less Initial Cash Out Flow Net Present Value

NPV Decision Rule

If the NPV is positive, accept the project A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners. Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal.
9-15

Payback Period
How long does it take to get the initial cost back in a nominal sense? Computation
Estimate the cash flows Subtract the future cash flows from the initial cost until the initial investment has been recovered

Decision Rule Accept if the payback period is less than some preset limit
9-16

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?

9-17

Advantages and Disadvantages of Payback

Advantages
Easy to understand Adjusts for uncertainty of later cash flows Biased toward liquidity

Disadvantages
Ignores the time value of money Requires an arbitrary cutoff point Ignores cash flows beyond the cutoff date Biased against longterm projects, such as research and development, and new projects

9-18

Internal Rate of Return

This is the most important alternative to NPV It is often used in practice and is intuitively appealing It is based entirely on the estimated cash flows and is independent of interest rates found elsewhere
9-19

IRR Definition and Decision Rule

Definition: IRR is the return that makes the NPV = 0 Decision Rule: Accept the project if the IRR is greater than the cost of capital

9-20

Computing IRR for the Project

If you do not have a financial calculator, then this becomes a trial and error process Calculator
Enter the cash flows as you did with NPV Press IRR and then CPT IRR = 16.13% > 12% cost of capital

Do we accept or reject the project?

9-21

Computing IRR of the Projects

Table 9.1 Capital Expenditure Data for Bennett Company

9-22

Computing IRR for the Project

IRR when Cash Flows are equal
1. Calculate the payback period of the project Payback Period = Initial Cash Outflow . Annual yearly Cash Flows Payback Period = 42,000 = 3.000 Years 14,000 2. The project life is 5 years so trace the closest PVIFA to the factor 3.000 in the year 5, we will get the initial findings IRR >19% <20% 3. At 19% the factor is 3.058 4. At 20% the factor is 2.991 9-23

Computing IRR for the Project

We can calculate the exact value of IRR by Interpolation Method
1. IRR = 19% + 1% x (PVIFA19%,5y PBP) 2. IRR = 19% + 1% x 3. IRR = 19% + 1% x 4. IRR = 19% + 0.86% 5. IRR = 19.86%
9-24

. (PVIFA19%,5y PVIFA20%,5y)

(3.058 3.000)
(3.058 2.991)

(0.058)
(0.067)

Computing IRR for the Project

IRR when Cash Flows are unequal
1. Calculate average annual Cash Flows Avg. Cash Flows = Total Cash Flows No of Total Years Avg. Cash Flows = 70,000 = Rs. 14,000 5 2. Calculate average payback period of the project Payback Period = Initial Cash Outflow . Annual yearly Cash Flows
9-25

Computing IRR for the Project

IRR when Cash Flows are unequal
Payback Period = 45,000 = 14,000 3.214 Years

3. The project life is 5 years so trace the closest PVIFA to the factor 3.214 in the year 5, we will get the initial findings 4. At 16% the factor is 3.274 5. At 17% the factor is 3.199
9-26

Computing IRR of the Projects

End of Year 1 2 3 4 5 Cash Flows 28,000 12,000 10,000 10,000 10,000 PVIF20%,ny 0.833 0.694 0.579 0.482 0.402 Present Value 23,324 8,328 5,790 4,820 4,020. PVIF22%,ny 0.820 0.672 0.551 0.451 0.370 Present Value 22,960 8,064 5,510 4,510 3,700

Total Present Value of Cash Flows

Less Initial Cash Out Flow Net Present Value

46,282
(45,000). 1,282 .

44,744
45,000 ( - 256)

9-27

Computing IRR for the Project

We can calculate the exact value of IRR by Interpolation Method
1. IRR = 20% + 2% x (NPV @ 20%) 2. IRR = 20% + 2% x 3. IRR = 20% + 1% x (1,282) (1,282)
(1,538)
. (NPV @ 20% NPV @ 22% . (1,282 ( 256)

4. IRR = 21.67%
9-28

NPV Profile for the Project

70,000 60,000 50,000 40,000
NPV

IRR = 16.13%

30,000 20,000 10,000 0 -10,000 0 -20,000 Discount Rate

9-29

0.02 0.04 0.06 0.08

0.1

0.12 0.14 0.16 0.18

0.2

0.22

Advantages of IRR
Knowing a return is intuitively appealing It is a simple way to communicate the value of a project to someone who doesnt know all the estimation details If the IRR is high enough, you may not need to estimate a required return, which is often a difficult task

9-30

Conflicts Between NPV and IRR

NPV directly measures the increase in value to the firm Whenever there is a conflict between NPV and another decision rule, you should always use NPV IRR is unreliable in the following situations
Non-conventional cash flows Mutually exclusive projects
9-31

Profitability Index
Measures the benefit per unit cost, based on the time value of money A profitability index of 1.1 implies that for every $1 of investment, we create an additional $0.10 in value This measure can be very useful in situations in which we have limited capital
9-32

Computing Profitability Index

Profitability Index for Given Cash Flows

Profitability Index = Present Values of Cash Flows Initial Cash Outflow Decision Criteria the project with higher Profitability Index will be accepted.
9-33

Computing Profitability Index

End of Year 1 2 3 4 5 Cash Flows 28,000 12,000 10,000 10,000 10,000 PVIF20%,ny 0.833 0.694 0.579 0.482 0.402 Present Value 23,324 8,328 5,790 4,820 4,020. PVIF22%,ny 0.820 0.672 0.551 0.451 0.370 Present Value 22,960 8,064 5,510 4,510 3,700

Total Present Value of Cash Flows

Initial Cash Out Flow Profitability Index

46,282
45,000 1.028 (Accept)

44,744
45,000 0.9943 (Reject) 9-34

Advantages and Disadvantages of Profitability Index

Advantages
Closely related to NPV, generally leading to identical decisions Easy to understand and communicate May be useful when available investment funds are limited

Disadvantages
May lead to incorrect decisions in comparisons of mutually exclusive investments

9-35

Capital Budgeting In Practice

We should consider several investment criteria when making decisions NPV and IRR are the most commonly used primary investment criteria Payback is a commonly used secondary investment criteria
9-36

Summary Discounted Cash Flow Criteria

Net present value

Difference between market value and cost Take the project if the NPV is positive Has no serious problems Preferred decision criterion
Discount rate that makes NPV = 0 Take the project if the IRR is greater than the required return Same decision as NPV with conventional cash flows IRR is unreliable with non-conventional cash flows or mutually exclusive projects Benefit-cost ratio Take investment if PI > 1 Cannot be used to rank mutually exclusive projects May be used to rank projects in the presence of capital rationing

Internal rate of return

Profitability Index

9-37

Summary Payback Criteria

Payback Period
Length of time until initial investment is recovered Take the project if it pays back within some specified period Doesnt account for time value of money and there is an arbitrary cutoff period
9-38

Quick Quiz
Consider an investment that costs $100,000 and has a cash inflow of $25,000 every year for 5 years. The required return is 9% and required payback is 4 years.
What is the payback period? What is the discounted payback period? What is the NPV? What is the IRR? Should we accept the project?

What decision rule should be the primary decision method? When is the IRR rule unreliable?
9-39

9
End of Chapter
Thank You for being with me

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.