Net Present Value and Other Investment Criteria

1
Net Present Value and Other Investment Criteria

• Business 2039

1
K. Hartviksen
2
This Chapter - Topics

• Net Present Value
• Payback Period
• Discounted Payback
• Average Accounting Return
• Internal Rate of Return

• Multiple IRRs
• Mutually Exclusive Investments (NPV vs. IRR)
• Profitability Index
• capital rationing

2
K. Hartviksen
3
Long-Term Investments

• When a firm considers a new project, corporate
  acquisition, plant expansion or asset acquisition
  that will produce income over the course of many
  yearsthis is called capital budgeting.
• It is imperative that in the analysis of such
  projects that we consider the timing, riskiness
  and magnitude of the incremental, after-tax
  cashflows that the project is expected to
  generate for the firm.

4
Payback Method

• This is a simple approach to capital budgeting
  that is designed to tell you how many years it
  will take to recover the initial investment.
• It is often used by financial managers as one of
  a set of investment screens, because it gives the
  manager an intuitive sense of the projects risk.

5
Payback Example
6
Discounted Payback Example
7
Discounted Payback Graphed
NPV
Discounted Payback Point
Years
8
Discounted Payback

• Overcomes the lack of consideration of the time
  value of money
• can help us see the pattern of cashflows beyond
  the payback point.
• If carried to the end of the projects useful
  lifewill tell us the projects NPV (if you are
  using the firms WACC)

9
Net Present Value

• NPV -PV of initial cost PV of incremental
  after-tax benefits
• if greater than 0 - accept
• if equal to 0 - indifferent
• if less than 0 - reject

10
Firms Cost of Capital

• At this point in the course, you will be given
  the firms cost of capital
• the firms cost of capital determines the minimum
  rate of return that would be acceptable for a
  capital project.
• The weighted average cost of capital (WACC) is
  the relevant discount rate for NPV analysis.

11
NPV Example
12
NPV Example
13
NPV Example
14
NPV Example
15
NPV Example
16
NPV Example
17
NPV Example
18
NPV Profile
NPV
IRR
0
Discount Rate
19
NPV Profiles

• The slope of the NPV profile depends on the
  timing and magnitude of cashflows.
• Projects with cashflows that occur late in the
  projects life will have an NPV that is more
  sensitive to discount rate changes.

20
IRR

• The internal rate of return (IRR) is that
  discount rate that causes the NPV of the project
  to equal zero.
• If IRR gt WACC, then the project is acceptable
  because it will return a rate of return on
  invested capital that is likely to be greater
  than the cost of funds used to invest in the
  project.

21
IRR Example
22
IRR Example
23
IRR vs. NPV

• Both methods use the same basic decision inputs.
• The only difference is the assumed discount rate.
• The IRR assumes intermediate cashflows are
  reinvested at IRRNPV assumes they are reinvested
  at WACC

24
NPV Profile
NPV
IRR(B)
IRR(A)
0
Discount Rate
25
Profitability Index

• Uses exactly the same decision inputs as NPV
• simply expresses the relative profitability of
  the projects incremental after-tax cashflow
  benefits as a ratio to the projects initial
  cost.
• PI PV of incremental ATCF benefits
• PV of initial cost of project
• If PIgt1, then we accept because the PV of
  benefits exceeds the PV of costs.

26
Capital Rationing

• The corporate practice of limiting the amount of
  funds dedicated to capital investments in any one
  year.
• Is academically illogical.
• In the long-run could threaten a firms
  continuing existence through erosion of its
  competitive position.