Chapter 6: Net present value and other investment rules

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Chapter 6 Net present value and other investment
rules

• Corporate Finance
• Ross, Westerfield, and Jaffe

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Outline

• 6.1 Net present value (NPV)
• 6.2 The payback period method
• 6.3 The discounted payback period method
• 6.4 The Internal rate of return (IRR)
• 6.5 The profitability index

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Announcement

• Your group needs to submit a typed report for
  mini-case Bullock Gold Mining, p. 196, after we
  finish this chapter.

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Good decision criteria

• Does the rule take the time value of money into
  consideration?
• Does the rule adjust for risk?
• Does the rule tell us whether and by how much the
  project add value to the firm?

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A proposed project

• Your company is looking at a new project that has
  the following cash flows.
• Year 0 initial cost, C0 100,000.
• Year 1 CF1 30,000.
• Year 2 CF2 50,000.
• Year 3 CF3 60,000.
• The applicable discount rate is 10.

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1st method the NPV rule

• NPV PV C0 the difference between the present
  value of the investments future net cash flows,
  i.e., benefits, and its initial cost.
• Ideas (1) an investment is worth undertaking if
  it creates value for its owners, and (2) an
  investment creates value if it worth more than it
  costs within the time value of money framework
  (Chapter 4).

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Decision rule

• If NPV gt 0, accept the project.
• If NPV lt 0, reject the project.
• A positive NPV suggests that the project is
  expected to add value to the firm, and the
  project should improve shareholders wealth.
• Because the goal of financial management is to
  increase shareholders wealth, NPV is a good
  measure of how well this project will meet this
  goal.

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Project NPV
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Judging the NPV rule

• Does the NPV rule take the time value of money
  into consideration?
• Does the NPV rule adjust for risk?
• Does the NPV rule tell us whether and by how much
  the project add value to the firm?

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Finally, they listen

• CFOs are using what academics consider better
  measures in their capital-budgeting analysis.
  According to a recent survey, more than 85
  percent say they use net present value (NPV)
  analysis in at least three out of four
  decisions."Finance textbooks have taught for
  years that NPV is superior, but this is the first
  known survey to show it's the preferred tool,"
  says co-author Patricia A. Ryan, a professor of
  corporate finance at Colorado State University.
• Source CFO.com.

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2nd method payback period

• Payback period the amount of time required for
  an investment to generate after-tax cash flows
  sufficient to recover its initial cost.

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Decision rule

• An investment is accepted (rejected), if payback
  period lt (gt) some specified number of time
  period.
• The cutoff is arbitrarily chosen by the manager
  or the entrepreneur.

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Project payback period
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The decision

• The payback period is longer than 2 years and
  shorter than 3 years.
• If the cutoff is 2 years, wed reject the
  project.
• If the cutoff is 3 years, wed accept the project.

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Judging the payback period rule

• Does the payback period rule take the time value
  of money into consideration?
• Does the payback period rule adjust for risk?
• Does the payback period rule tell us whether and
  by how much the project add value to the firm?

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The good and the bad

• Advantage
• Easy to understand and communicate.
• Disadvantages
• Ignores the time value of money.
• Fail to consider the riskness of the project, no
  i.
• Requires an arbitrary cutoff point.
• Ignores cash flows beyond the cutoff.
• Biased against long-term projects, such as RDs.

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3rd method discounted payback period

• Discounted payback period the length of time
  required for an investments discounted cash
  flows to equal its initial cost.

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Decision rule

• An investment is accepted (rejected), if
  discounted payback period lt (gt) some specified
  number of time period.
• Again, the cutoff is arbitrarily chosen.

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Project discounted payback period
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The decision

• The discounted payback period is longer than 2
  years and shorter than 3 years.
• If the cutoff is 2 years, wed reject the
  project.
• If the cutoff is 3 years, wed accept the
  project.

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Judging discounted payback period

• Does the payback period rule take the time value
  of money into consideration?
• Does the payback period rule adjust for risk?
• Does the payback period rule tell us whether and
  by how much the project add value to the firm?

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The good and the bad

• Advantage
• Still fairly easy to understand and communicate.
• Take TVM into consideration.
• Disadvantages
• Requires an arbitrary cutoff point.
• Ignores cash flows beyond the cutoff.
• Biased against long-term projects, such as RDs.

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4th method IRR

• IRR the discounted rate that makes the NPV of an
  investment zero.

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Decision rule

• An investment is accepted (rejected), if the IRR
  gt (lt) the required rate.

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Project IRR
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The decision

• The computed IRR is 17, which is higher than the
  10 required rate. Thus, we accept the project.

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Judging the IRR

• Does the IRR rule take the time value of money
  into consideration?
• Does the IRR rule adjust for risk?
• Does the IRR rule tell us whether and by how much
  the project add value to the firm?

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NPV vs. IRR

• For most projects, NPV and IRR lead to the same
  conclusion.
• Practitioners really like to use IRR because this
  measure gives practitioners a good idea about at
  what rate they are able to earn. Knowing a return
  is intuitively appealing.
• IRR provides a measure about the value of a
  project to someone who doesnt know all the
  estimation details.
• If the IRR is high enough, one may not need to
  estimate the required return at all.

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A warning

• Typical IRR calculations build in reinvestment
  assumptions.
• This makes projects look better than they
  actually are.

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But, non-unique IRR solutions
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Lesson

• Before you use your IRR estimate, always verify
  the result with the NPV result.
• In real life, NPV and IRR are the 2 most popular
  decision rules used by modern (big) U.S.
  corporations. And, they tend to be used together.

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5th method the profitability index

• Profitability index (PI) PV / C0.
• Often used for government or other non-for-profit
  investments.
• Measures the benefit per unit cost, based on the
  time value of money.
• A profitability index of 1.2 suggests that for
  every 1 of initial investment, we create an
  additional 0.20 in value.

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Decision rule

• For a project, we accept the project only if PI gt
  1.
• For mutually exclusive projects, practitioners
  sometimes choose the project with the highest PI.
  However, this approach is problematic.
• If there is no capital constraint, one should
  choose the project with the highest NPV from the
  mutually exclusive pool.

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Project PI
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The good and the bad

• Advantages
• Related to NPV, generally leading to identical
  decisions.
• Easy to understand and communicate.
• Disadvantage
• Should not be used for making mutually exclusive
  decisions.

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Real options

• So far, you know that NPV is the best criterion
  IRR is another almost equally good and important
  one.
• But these analyses mainly address independent
  projects whose acceptance or rejection has no
  implications on the acceptance or rejection of
  other projects.
• When projects have (real) options, NPV and IRR
  may perform poorly.

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An example timing option

• Suppose that the NPV for a developer to built a
  building on a vacant land now is positive. The
  simple version of the NPV rule would lead to the
  conclusion that the developer should build the
  building now.
• In real life, the developer may choose to wait.
  For instance, the developer may believe that this
  is not the best timing (although the NPV is
  positive). The developer may want to wait for
  another few years when the real estate market is
  stronger to realize a even larger NPV at that
  time.

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More real options

• In real life, there are several more types of
  real options that will make capital budgeting a
  even more complex task.
• Chapter 8, pp. 241-245 has an introduction to
  another two types of real options (1) the option
  to expand, and (2) the option to abandon.
• I bet these will be treated in your intermediate
  corporate finance course.

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Mini-case report due

• Please submit your report for mini-case Bullock
  Gold Mining, p. 196, in 1 week.
• For task 1, please calculate (1) the payback
  period, (2) the discounted payback period, (3)
  NPV, and (4) IRR. Ignore modified IRR.
• Ignore task 3 i.e., do not need to write a VBA
  script.