Bma 5- Net Present Value

7/25/2019 Bma 5- Net Present Value

1/19

ol these

rate uf retum

cal

culata and

rules

resent e

t

er

Invest

to be rleh rather lhan

in eveht

The difteranee

shareholders

pesitive

NPV

end

thrr net prrrsrrnt value

somrr other measures that

0 r '0n:, , , , , , , ;;

investment deoisiuns The flrst Tho

Its dook

more aecurate when r l , inninn

financial manager

suhstantial

mere han a rule l thumh when

investment deelslen

NPV

e

Instecd

eompnre the exeretod

wilh me retum thel shareholdrrrs rrould

rram

on

invectmrrnts in tha madrrrt Phe ecmpany aoerrpts thosrr

prcjects hal previdrr rrrtum thec sharaholdrrrs erruld

thrrmsatrec If usod this rale 1 ratum rula

shrruld

situatinns whrrn thrr

frm

has

odo

ehonsa thnsrr

thal Inerrursa jjrm vrtua n w ~

savrrrrt traps fnr me unwruy

enprr with

n l ~

Invrrstrrd bUI mnre rrlabnratrr

nrrrrdrrd

what? NPV

1 5


2/19

ne Value

flews


3/19

Net Present Vrr ue rrnd

mlrrstmrrnt


4/19

Valua

Proltablity miau:

Payl:ck:

o

t FIGURE Suuxeyevltlent:e

hwestment projec s.

60

%

wh

I

80

particular technique

al Finance: Evidenee lrom the Fel, Jaumal

ar Financlal

cormmies 5 ZIJOll,

measures do nnl have this

and

Book

slmph:

h . ; : ; ~ r J . n m 5

uf no v onk

rtturn

cakulkJ anu

of

the differtnce

f 1 o \ l , - ~ Rt:?o th,;; if

yOS)

tu refrtdl. yuur uncln-smlng nf

thl

5tH], do lhr


5/19

Net Present Value

500

1

+ 2,624

shouk1 i:. ktn J cunt

n


6/19

ne Value

also an inital

of 52,000

1 and 81,800 yca: 2,

At 10

500

1,800

~ 2 0 0 0

~ 5 8

10

as thc two

first

1,800

500

~ 2 0 0 0

+ 50

.10

Yoo

as illustrated

discuunted cash flows fcu our


7/19

w

makes PV O

In ,,,, 'I,,, 'ot

ritera

the dscount


8/19

Valu6

rate

PV

Actual calcularan of

IRR

of

the

PV

=

~ 4 0 0 0

~

zero discmmt rote

lJlOO

~ 4 O O O

~ l

4 000

o

Dol zero but

~ 8 8 9

O

the

be


9/19

Present Value and

Other Investment

~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~

SCOllrlt

rata

%

the discmmt rate

FIGURE 5.3

duccs

2,000

4,000

intcma 01

(IRR) is 213 , thc mtc

01 whlch

NPV

o

+

,000


10/19

1

One

The mine

mR

and its follows:

Note rhat [here are tw rates that NPV

o.

3,

o

ments

m

o

m

NPV

~ 3 0

..

o

.035

BEYOND

m

10 10

rrrrrrrrrr

N

~ 3 0

o

1.1954

L

In

otOer

internal

1111 \1,

A billons

iRriR iR - t w O m - t ~ 1

+1

R iR 1

+1

11

lO 15

30

35

[)iSGount (ate,

t FIGURE 5iR

[W

'

O whon

rato


11/19

5

Net Present Value and Other m U D , , , r r , , ~ n r

company

of rcturo

lCompanks urouad the pmbk-m of muhiplt rates of return

unUl femulns 00.1) one changt ;n the sign nf1he c.J.sn

flh'S,

tnen

be

cakuh.ted

nn

hi, llw

i\HRR

calculated follow",

L

nO

ull he subseqcenl uow:

PV lu \GiU lO/U' IOiU' y OIU'

AJd

o Ihe

now he presenl value al' subStquenl r


12/19

1

Value

foHows:

FIGURE

Projec

G

Jiscount rata, %

o YDU mar, DO\1cver,

tba1 ynu

jumpeJ uf tnt' frying Km the f n ~ The

lnvoh'f

in sign, in his Ihtf ft likdy bn ffiullip0 mR, nn w l be

l

Ihe

h often

suggfst2-d

1hu tht ChOlc(, bebt>fen lhe

Dei

presen

v:due

ruk and

intnnal

rale of ftturn ruie

snu1d

De:pend On

J.bk

Ths v w n g ~ The prospective on anthe(

indeprnd nt

lnvcs nwnl should

m'h'Tbe

alkHvtQ to

Ihe


13/19

Net Present Value Investment riteria


14/19

8

alue

on

4ln 9

nther for

L.n:g+:rm c;}sh

Hm< .

COmpilOj t day n d ~ r t ; l . k m g J

d ,'D, _''W_ITHnn'V (pruject generJJly

pa}';;

to

' < d ~ ~ n ~ t h > m o n e (

{ p r n j ~ c t

n II mJ.kes


15/19

Net

Other nvestment

he

Jtnomim or

"hould be lhe rrosen

value

of hu

nUllayu.

comptmt

Jo

nnt Tbe 58iJ Jonu he buBer

value u inHLd ouday, that b,

si m,, }'

ucid

LO lO

ueh prn[;hilty inciex,


16/19

12 ODa

H H I H I I r ~

apital ratoning mojels

5

O

j 5

mnner

lm ,, er prnt1tablBty

h ~ t in he

Aprend

lo Chrrptff

Dad

12

the


17/19

I IRR Internal

XIRR The

But that h too a


18/19

- - - 122

Pan

One

SUMMARY

Value

1s not rationed, other resources may be.

The

availabilit}'

of

management

or even other capital equipment often constitutes an important cOl1straint

011

a

Hard should never cost the

fi1 m

constraints

become tight

to hurt- in

the sense that with NPVs are

passed

up-then

the firm raises more money and ooseos the constraint. But what if

ir

alll t

mise more

money-what

if it faces

Ulrd

Hard rationing implies market

to

thmw

away net present value

as

a crHerion fm

of the imperfection.

mean

we

have

on the nature

Arizona Aquaculture, ne. (AA ), bormws as much

as

the banks

willlend it t

still has

good investment opportunities. This is not hard so as AAI can issue stock But

perhaps it can't. Perhaps the fouoder and majority shareholder vetoes the idea from fear

control of the frm. Perhaps a stock ssue would bring red or

This doe:; flot invalidate the NPV rule. AA 's s wrellOlders can borrow or

shares,

or

buy more. The}' have free access to security markets.

The

type

is independent

of

AA 's

finandng Ol"

investment decisions. The way AAI can

shareholders s

to rpak,e

them richer

.Thus

AAI should invest its available casI in the

pac:Kaj;;e

of

projects having the largest aggregate net present valuc.

A barrier between the firm and capital markets does

BOt

ul1dermine net value so

long

as

the barder is the

oll y

market imperfection.

The

important

i5

that the firn

slwrellOlders

have free acces:; to well-functioning capital markets.

The net present value rule is undermined when imperfections restrict shareholders'

folio choice. Suppose that Nevada Aquaculture, ne. (NA ), Is solely owned by its

Alexander

Turhot

Mr. Turbot

ha5110

cash or credit remaining, but he is convinced that expan

sion

of

his operation is a high-NPV investment. He has tried to seH stock but has found that

investors, skeptical

of

prospects for [sh farming in the desert, offer him much less

than he thinks his [rm s worth. For Mr. Turbot capital markets hardly

exist It

makes Hule

seme

fm him to discount prospective cash

tlOW5

at a market opportunity cost

of

capital.

A

nllljorly ",,"oer

"1,,,

is Iockd

-

""d

11 ,

nlllcJ

pcrsmml wcal h le. up in

AA

mal' be

efic,tivc r

cut off

[mm

capital market5.

The NI'V ruk mol' nol

mOKC

sen" lo ,d, on

OIVlle,.

""gil il \VII

n

lile Ihcr 'MrdwIJers.

IfyOl are gaing to persuade yuur campany to use the net value yau must be

to explain

why

other rules may

lIal

ead

to

correct decisions. That

is we

have examined three

alternatve investment crteria in this chapter.

Some firms look at the book rate of return on the project In this case the company decides

whieh cash payments are capital expenditures and picks the appropriate

cate

to depreciate these

lt

then calculates the ratio of book income to the book value

of

the investmcnt

Few

w ~ ' ' ' ' v < base their investment dedsion simply on the book rate of retum, but share

holders

pay

attention

lO

book measures of frm prontability and sorne managers therefore look with

a that would the company's book rate of return.

So me

method to make lnvestment decisions. In other words,

accept that recover

thei.

initiai nvestment within sorne specified

Payback

i5

ao ad hoc rule.

It

of cash flows within the payback period,

and it ignores cash flows It therefore takes no account

of

the opportunity

cest of capital.

The internal rate of rcturn (IRR)

i5

defined

as

the rate of discount at whieh a would

have zera NPV.

It

is a handy measure and widely used in finan

ce; you

should therefore know how


19/19

Net Present

Other

nVAnt

riteria

:mil

DecisioflS,

Documents

Bma 5- Net Present Value