Chapter 5 Principles of Corporate Finance Eighth Edition Why Net Present Value Leads to Better Investment Decisions Than Other Criteria Slides by Matthew

Chapter 5

Principles of

Corporate FinanceEighth Edition

Why Net Present Value Leads to

Better Investment Decisions Than Other Criteria Slides by

Matthew Will

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved

McGraw-Hill/Irwin


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Topics Covered

A Review of The Basics– NPV and its Competitors

The Payback Period– The Book Rate of Return

Internal Rate of ReturnCapital Rationing


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NPV and Cash TransfersEvery possible method for evaluating projects

impacts the flow of cash about the company as follows.

Cash

Investment opportunity (real

asset)Firm Shareholder

Investment opportunities

(financial assets)

Invest Alternative: pay dividend to shareholders

Shareholders invest for themselves


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CFO Decision Tools

Profitability Index, 12%

Payback, 57%

IRR, 76%

NPV, 75%

Book rate of return, 20%

0% 20% 40% 60% 80% 100%

Survey Data on CFO Use of Investment Evaluation Techniques

SOURCE: Graham and Harvey, “The Theory and Practice of Finance: Evidence from the Field,” Journal of Financial Economics 61 (2001), pp. 187-243.


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Book Rate of ReturnBook Rate of Return - Average income divided by average book value over project life. Also called accounting rate of return.

Managers rarely use this measurement to make decisions. The components reflect tax and accounting figures, not market values or cash flows.

assetsbook

incomebook return of rateBook


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Payback

The payback period of a project is the number of years it takes before the cumulative forecasted cash flow equals the initial outlay.

The payback rule says only accept projects that “payback” in the desired time frame.

This method is flawed, primarily because it ignores later year cash flows and the the present value of future cash flows.


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Payback

Example

Examine the three projects and note the mistake we would make if we insisted on only taking projects with a payback period of 2 years or less.

050018002000-C

018005002000-B

50005005002000-A

10% @NPVPeriod

PaybackCCCCProject 3210


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Payback

Example

Examine the three projects and note the mistake we would make if we insisted on only taking projects with a payback period of 2 years or less.

502050018002000-C

58-2018005002000-B

2,624350005005002000-A

10% @NPVPeriod

PaybackCCCCProject 3210


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Internal Rate of Return

Example

You can purchase a turbo powered machine tool gadget for $4,000. The investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment?


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Example

You can purchase a turbo powered machine tool gadget for $4,000. The investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment?

0)1(

000,4

)1(

000,2000,4

21

IRRIRRNPV

%08.28IRR


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-2000

-1500

-1000

-500

0

500

1000

1500

2000

2500

10 20 30 40 50 60 70 80 90 100

Discount rate (%)

NP

V (

,00

0s

)

IRR=28%


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Pitfall 1 - Lending or Borrowing? With some cash flows (as noted below) the NPV of the

project increases s the discount rate increases. This is contrary to the normal relationship between NPV and

discount rates.

364%50500,1000,1

364%50500,1000,1

%10@Project 10

B

A

NPVIRRCC


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Pitfall 2 - Multiple Rates of Return Certain cash flows can generate NPV=0 at two different discount

rates.

The following cash flow generates NPV=$A 3.3 million at both IRR% of (-44%) and +11.6%.

15121260

............ 10910

CCCC

Cash Flows (millions of Australian dollars)


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Internal Rate of ReturnPitfall 2 - Multiple Rates of Return Certain cash flows can generate NPV=0 at two different discount rates.

The following cash flow generates NPV=$A 3.3 million at both IRR% of (-44%) and +11.6%.

600NPV

300

0

-30

-600

Discount Rate

IRR=11.6%

IRR=-44%


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Pitfall 2 - Multiple Rates of Return It is possible to have a zero IRR and a positive NPV

339500,2000,3000,1

%10@Project 210

NoneC

NPVIRRCCC


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Pitfall 3 - Mutually Exclusive Projects IRR sometimes ignores the magnitude of the project. The following two projects illustrate that problem.

818,11%75000,30000,20

182,8%100000,20000,10

%10@Project 10

E

D

NPVIRRCC


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Pitfall 3 - Mutually Exclusive Projects


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Pitfall 4 - Term Structure Assumption We assume that discount rates are stable during the term of the

project. This assumption implies that all funds are reinvested at the IRR. This is a false assumption.


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Calculating the IRR can be a laborious task. Fortunately, financial calculators can perform this function easily.

HP-10B EL-733A BAII Plus

-350,000 CFj -350,000 CFi CF

16,000 CFj 16,000 CFfi 2nd {CLR Work}

16,000 CFj 16,000 CFi -350,000 ENTER

466,000 CFj 466,000 CFi 16,000 ENTER

{IRR/YR} IRR 16,000 ENTER

466,000 ENTER

IRR CPT All produce IRR=12.96


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Profitability Index

When resources are limited, the profitability index (PI) provides a tool for selecting among various project combinations and alternatives

A set of limited resources and projects can yield various combinations.

The highest weighted average PI can indicate which projects to select.


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Profitability Index

121555

162055

2153010

%10@Project 210

C

B

A

NPVCCC

121555

162055

2153010

%10@Project 210

C

B

A

NPVCCC

Cash Flows ($ millions)


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Profitability Index

2.4125C

3.2165B

2.12110A

Indexity Profitabil($) NPV($) InvestmentProject

2.4125C

3.2165B

2.12110A

Indexity Profitabil($) NPV($) InvestmentProject

Cash Flows ($ millions)


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Profitability Index

Example

We only have $300,000 to invest. Which do we select?

Proj NPV Investment PI

A 230,000 200,000 1.15

B 141,250 125,000 1.13

C 194,250 175,000 1.11

D 162,000 150,000 1.08

Investment

NPVIndexity Profitabil


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Profitability Index

Example - continuedProj NPV Investment PIA 230,000 200,000 1.15B 141,250 125,000 1.13C 194,250 175,000 1.11D 162,000 150,000 1.08

Select projects with highest Weighted Avg PIWAPI (BD) = 1.13(125) + 1.08(150) + 0.0 (25) (300) (300) (300) = 1.01


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Profitability Index

Example - continuedProj NPV Investment PIA 230,000 200,000 1.15B 141,250 125,000 1.13C 194,250 175,000 1.11D 162,000 150,000 1.08

Select projects with highest Weighted Avg PIWAPI (BD) = 1.01WAPI (A) = 0.77WAPI (BC) = 1.12


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Linear Programming

Maximize Cash flows or NPV Minimize costs

Example

Max NPV = 21Xn + 16 Xb + 12 Xc + 13 Xd

subject to10Xa + 5Xb + 5Xc + 0Xd <= 10-30Xa - 5Xb - 5Xc + 40Xd <= 12


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Vegetron Case

YEAR1 2 3 4 5

1.Revenue 180 180 180 180 1802. Operating costs 70 70 70 70 703. Depreciation a 80 80 80 80 804. Net income 30 30 30 30 305. Start-of-year book value 400 320 240 160 80

Book rate of return 7.50% 9.40% 12.50% 18.75% 37.50%(4÷5)

Table 5.2


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Vegetron Case

Table 5.3

YEAR1 2 3 4 5 6 7

1.Reyenue 140 140 140 140 140 140 1402. Operating costs 55 55 55 55 55 55 553. Depreciation a 57 57 57 57 57 57 574. Net income 28 28 28 28 28 28 285. Start-of-year book value 400 343 286 229 171 114 57

6. Book rate of return 7.00% 8.20% 9.80% 12.20% 16.40% 24.60% 49.10% (4÷5)


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Web Resources

www.invest-faq.com/articles/analy-int-rate-return.html

www.rebuild.org/lawson/irr.asp

www.unix.mcs.anl.gov/otc/Guide/faq/linear-programming-faq.html

www.faqs.org/faqs/linear-programming-faq/

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Chapter 5 Principles of Corporate Finance Eighth Edition Why Net Present Value Leads to Better Investment Decisions Than Other Criteria Slides by Matthew