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Corporate Finance Ross Westerfield Jaffe Seventh Edition

Seventh Edition

6Chapter Six

Some Alternative Investment Rules

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Chapter Outline

6.1 Why Use Net Present Value?6.2 The Payback Period Rule6.3 The Discounted Payback Period Rule6.4 The Average Accounting Return6.5 The Internal Rate of Return6.6 Problems with the IRR Approach6.7 The Profitability Index

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6.1 Why Use Net Present Value?

• Accepting positive NPV projects benefits shareholders.

• The discount rate on a risky project is the return that one can expect to earn on a financial asset of comparable risk.

• This discount rate is often referred to as an opportunity cost.

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The Net Present Value (NPV) Rule

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

• 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

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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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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

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The Payback Period Rule (continued)• Disadvantages:

– Ignores the time value of money– Ignores cash flows after the payback

period– Requires an arbitrary acceptance criteria

Advantages:– Easy to understand– Biased toward liquidity

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• The payback rule is often used by: large and sophisticated companies when making relatively small decisions, or firms with very good investment opportunities but no available cash (small, privately held firms with good growth prospects but limited access to the capital markets).

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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?

• Two other problems with the payback method still exist.

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6.4 The Average Accounting Return Rule

• 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

Investent of ValueBook AverageIncomeNet AverageAAR

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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

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The Internal Rate of Return: Example

Consider the following project:

0 1 2 3

$50 $100 $150

-$200

The internal rate of return for this project is 19.44%

32 )1(150$

)1(100$

)1(50$200$0

IRRIRRIRRNPV

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6.6 Problems with the IRR Approach• Are We Borrowing or Lending?

• Multiple IRRs.

• The Scale Problem.

• The Timing Problem.

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Definition of Independent and Mutually Exclusive Projects

– Independent project: one whose acceptance or rejection is independent of the acceptance or rejection of other projects.

– Mutually exclusively investments: you can accept A or B, or reject both of them, but you can not accept both of them.

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– The Scale Problem • We can handle any mutually exclusive example in

one of three ways: – Compare the NPVs of the two choices. – Compare the incremental NPV from making the large-

budget picture.– Compare the incremental IRR to the discount rate.

• We must not compare the IRRs of the two projects.

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The Timing Problem • The NPV of investment B is higher with low

discount rates, and the NPV of investment A of investment is higher with high discount rates.

• We also can select the better project with one of three different methods, but we should not compare the IRRs of the two projects.

• When working with mutually exclusive projects, we should simply use either an incremental IRR or an NPV approach.

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6.7 The Profitability Index (PI) Rule

• 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

Investent InitialFlowsCash Future of PV TotalPI

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• We consider three possibilities: – Independent Projects

• Accept an independent project if PI>1. Reject if PI<1. – Mutually Exclusive Projects

• The PI may lead to a wrong selection, because, like IRR, it ignores differences of scale for mutually exclusive projects. However, the flaw can be corrected using incremental analysis.

– Capital Rationing • When a firm does not have enough capital to fund all

positive NPV projects, they can use PI to make decisions. • The PI cannot handle capital rationing over multiple time

periods.

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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.

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