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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
Chapter Outline
Net Present Value The Payback Rule The Discounted Payback The Average Accounting Return The Internal Rate of Return The Profitability Index The Practice of Capital Budgeting
P ro fit = -5 0 +
60 1 .1 0
$ 4 .5 5
$4.55 $50 Added Value Initial Investment
Example - continued
$16,000 $16,000 2 3
$450,000
$16,000
Present Value
14,953
14,953
380,395 $409,323
1 6 ,0 0 0 ( 1 .0 7 )
2
4 6 6 ,0 0 0 ( 1 .0 7 )
3
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
Payback Method
Example The three project below are available. The company accepts all projects with a 2 year or less payback period. Show how this decision will impact our decision. Cash Flows Project C0 C1 C2 C3 A -2000 +1000 +1000 +10000 B -2000 +1000 +1000 0 C -2000 0 +2000 0
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
Disadvantages
May reject positive NPV investments Requires an arbitrary cutoff point Ignores cash flows beyond the cutoff point Biased against longterm projects, such as R&D and new products
Need to have a target cutoff rate Decision Rule: Accept the project if the AAR is greater than a preset rate.
Disadvantages
Not a true rate of return; time value of money is ignored Uses an arbitrary benchmark cutoff rate Based on accounting net income and book values, not cash flows and market values
IRR = 16.13%
NPV
30,000 20,000 10,000 0 -10,000 0 -20,000 Discount Rate 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22
IRR=12.96%
NPV (,000s)
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
NPV Profile
$4,000.00 $2,000.00 $0.00
NPV
0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55
Discount Rate
2
IRR NPV
325
19.43 % 64.05
200
22.17 % 60.74
NPV Profiles
$160.00 $140.00 $120.00 $100.00
NPV
$80.00 $60.00 $40.00 $20.00 $0.00 ($20.00) 0 ($40.00) Discount Rate 0.05 0.1 0.15 0.2 0.25 0.3
16 (1 IRR )
1
16 (1 IRR )
2
466 (1 IRR )
3
400 (1 IRR )
1
C1 400 16
C2 16
C3 466
NPV $, 1,000s
40
Revised proposal
IRR= 12.96%
30
20 10
IRR= 14.29%
Initial proposal
0
-10 -20 8 10
IRR= 12.26%
12 Discount rate, %
14
16
Project Interactions
When you need to choose between mutually exclusive projects, the decision rule is simple. Calculate the NPV of each project, and, from those options that have a positive NPV, choose the one whose NPV is highest.
Investment Timing
Sometimes you have the ability to defer an investment and select a time that is more ideal at which to make the investment decision. A common example involves a tree farm. You may defer the harvesting of trees. By doing so, you defer the receipt of the cash flow, yet increase the cash flow.
Investment Timing
Example You may purchase a computer anytime within the next five years. While the computer will save your company money, the cost of computers continues to decline. If your cost of capital is 10% and given the data listed below, when should you purchase the computer?
Investment Timing
Example You may purchase a computer anytime within the next five years. While the computer will save your company money, the cost of computers continues to decline. If your cost of capital is 10% and given the data listed below, when should you purchase the computer? Year Cost PV Savings NPV at Purchase NPV Today
0 1 2 3 4 5
50 45 40 36 33 31
70 70 70 70 70 70
20 25 30 34 37 39
Equivalent
annual
annuity
present va
annuity
3 -4
2.82 2.78
.87 1.10
Capital Rationing
Capital Rationing - Limit set on the amount of funds available for investment.
Soft Rationing - Limits on available funds imposed by management. Hard Rationing - Limits on available funds imposed by the unavailability of funds in the capital market.
Profitability Index
Project J K L M N PV 4 6 10 8 5 Investment 3 5 7 6 4 NPV 1 1 3 2 1 Profitability Index 1/3 = .33 1/5 = .20 3/7 = .43 2/6 = .33 1/4 = .25
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
Disadvantages
May lead to incorrect decisions in comparisons of mutually exclusive investments
Profitability Index
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?
Comprehensive Problem
An investment project has the following cash flows: CF0 = -1,000,000; C01 C08 = 200,000 each If the required rate of return is 12%, what decision should be made using NPV? How would the IRR decision rule be used for this project, and what decision would be reached? How are the above two decisions related?