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Week 4: Net Present Value and Other Investment Criteria Readings: Chapter 7
Agenda
Last Week Net Present Value and Other Inv. Criteria
Key Concepts and Skills
Next Week
Last Lecture
Bonds
Bond value = PV coupons (annuity) + PV of par Inverse relationship between yield & prices Premium and Discount bonds
Shares
Zero growth dividends are equal perpetuity Constant growth dividends increase DGM Supernormal growth combination of different growth rates & DGM discount each cash flow
Chapter 7
2. Time Value of Money 9. Return, Risk & the Security Market Line
11. Financial Leverage & Capital Structure Policy 12. Dividends & Dividend Policy
You are looking at a new project and you have estimated the following cash flows:
Year 0: CF = -$165,000 (investment outlay/costs) Year 1: CF = $63,120; NI = $13,620 Year 2: CF = $70,800; NI = $3,300 Year 3: CF = $91,080; NI = $29,100 Average Book Value = $72,000
Decision Rule:
Accept if the payback period is less than some preset limit.
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Computing Payback
Assume we will accept the project if it pays back within 2 years.
Year 0: -$165,000 initial outlay Year 1: $165,000 Year 2: $101,880 Year 3: $31,080
Year 0 1 2 3 Cash flow -$165,000 $63,120 $70,800 $91,080 Cumulative -$165,000 -$101,880 -$31,080 +$60,000
The project pays back in year 3 (2 + 31,080/91,080 = 2.34 years) Do we accept or reject the project?
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Disadvantages
Ignores the time value of money. Requires an arbitrary cutoff point. Ignores cash flows beyond the cutoff date. Biased against long-term projects, such as research and development.
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Decision Rule:
Accept the project if it pays back on a discounted basis within the specified time.
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Disadvantages
May reject positive NPV investments. Requires an arbitrary cutoff point. Ignores cash flows beyond the cutoff point. Biased against long-term projects, such as R&D and new products.
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Computing AAR
Computing AAR for the Project:
Assume we require an average accounting return of 25% Average Net Income: (13,620 + 3,300 + 29,100) / 3 = 15,340 Average Book value: 72,000
AAR = Average net income / Average book value. AAR = 15,340 / 72,000 = 0.213 = 21.3%
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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.
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Decision Rule:
Accept the project if the IRR is greater than the required return (hurdle rate).
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Computing IRR
Computing IRR for the project: Trial & Error
63,120 70,800 91,080 NPV 0 165,000 2 (1 IRR) (1 IRR) (1 IRR)3
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IRR = 16.13%
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NPV Profile
IRR = 10.11%
$4,000.00 $2,000.00 $0.00
and
42.66%
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
NPV 90,000
We should accept the project if the required return is between 10.11% and 42.66%
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The required return for both projects is 10%. Which project should you accept and why?
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NPV Profiles
$160.00 $140.00 $120.00 $100.00 NPV $80.00 $60.00 $40.00
IRR for A = 19.43% IRR for B = 22.17% Crossover Point = 11.8% Hurdle rate = 10%
A B
$20.00
$0.00 ($20.00) 0% ($40.00) Discount Rate 5% 10% 15% 20% 25% 30%
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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.
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A present value 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.
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Disadvantages
May lead to incorrect decisions in comparisons of mutually exclusive investments.
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Source: http://articles.moneycentral.msn.com/CollegeAndFamily/SavingForCollege/IsYourDegreeWorth1million.aspx
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Bachelor's degree
Average $308,588 Business $349,028
Master's degree
Average $180,010 Business $375,780
Professional degree
Average (incl. Business) $716,927 Law $748,865 Medicine $977,601 The magic PV $1m mark!
Source: http://articles.moneycentral.msn.com/CollegeAndFamily/SavingForCollege/IsYourDegreeWorth1million.aspx
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Next Week
Next week we investigate further capital budgeting techniques by looking closer at how cash flows are derived and special cases of cash flow analysis.
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