Chapter 8
Five Investment Evaluation Tools
-Net Present Value -Payback Period -Average Accounting Return -Internal Rate of Return -Profitability Index
Average Accounting (AAR)
-This measure is similar to the Return on Assets -If the project earns a sufficient return (so you would need a minimum cutoff), you should accept the project -External level used as the cutoff
Rule for Applying IRR
Accept projects that earn a higher return than required
Rule for Applying NPV
Accept projects that have positive NPVs
The Profitability Index is also called the ___ ratio.
Cost-Benefit
___ is a measure of how much value is created or added by undertaking an investment.
Net Present Value
To Estimate the NPV
1) Estimate the projects cash flows 2) Estimate the return required for the project's level of risk 3) Calculate the PV of cash flows and subtract the initial cost
The PI rule for an independent project is to ___ the project if the PI is greater than 1.
Accept
Rule for Applying Payback:
Accept Projects that payback before some present limit
Rule for Applying AAR
Accept projects that earn a higher return than required
One of the weaknesses of the payback period is that the cutoff date is an ___ standard.
Arbitrary
Capital ___ is the decision-making process for accepting and rejecting projects.
Capital Budgeting
The ___ is best suited for decisions on relatively small, minor projects while ___ is more appropriate for large complex projects.
Payback Period ; NPV
If the IRR is greater than the ___ ___, we should accept the project.
Required Return
Internal rate of return (IRR) must be compared to the ___ in order to determine the acceptability of a project.
Required Return
When calculating NPV, the present value of the nth cash flow is found by dividing the nth cash flow by 1 plus ___ rate raised to the nth power.
The Discount
When comparing NPV to IRR:
The two methods agree for projects that are independent and conventional.
(T/F) Some projects, such as mines, have cash outflows followed by cash inflows and cash outflows again, giving the project multiple internal rates of return.
True
The Average Accounting Return is defined as:
(Average Net Income) / (Average book value)
In general, NPV is ___.
- Negative for discount rates above the IRR -Equal to zero when the discount rate equals the IRR -Positive for discount rates below the IRR
Two important cases where NPV and IRR may disagree
-Nonconventional cash flows -Mutually exclusive projects
The payback period rule ___ a project if it has a payback period that is less than or equal to a particular cutoff date.
Accepts
How does the timing and the size of cash flows affect the payback method? Assume the project does pay back within the project's lifetime.
An increase in the size of the first of the first cash inflow will decrease the payback period, all else held constant.
The present value of the future cash inflows are divided by the __ to calculate the profitability index.
Initial Investment
Capital budgeting is probably the most important of the three key areas of concern to the financial manager because ___.
It defines the business of the firm
The payback period can lead to foolish decisions if it used too literally because:
It ignores cash flows after the cutoff date
Goal of the financial manager:
Maximize shareholder wealth
Higher cash flows earlier in a project's life are ___ valuable than higher cash flows later on.
More Valuable
If a firm is evaluating two possible projects, both of which require the use of the same production facilities, these projects would be considered ___.
Mutually Exclusive
The NPV is ___ if the required return is less than the IRR, and it is ___ if the required return is greater than the IRR.
NPV is Positive if required return is less than IRR NPV is Negative if required return is greater than IRR
Nonconventional cash flow
-Most projects start with an investment (outflow) which are followed by positive cash inflows. -When the cash flows change sign more than once, we call it nonconventional -In general, there can be one IRR for each sign change
Which of the following present problems when using the IRR method?
-Mutually exclusive projects -Non-conventional cash flows
Capital Budgeting in Practice
-NPV and IRR are the most commonly used decision criteria -Payback is often used as a secondary criteria because it is easy to calculate -Profitability Index is useful for raking projects when we have capital rationing
NPV as a decision criteria
-NPV is a good tool to use as it ~ Adjusts for time value of money ~ Adjusts for risk (w/ discount rate) ~Measures how much wealth is being -Use NPV as PRIMARY decision criteria
According to Graham and Harvey's 1999 survey of 392 CFOs (published in 2001), which of the following two capital budgeting methods are widely used by firms in the US and Canada?
-Net Present Value -Internal Rate of Return
Which of the following are methods of calculating the MIRR of a project?
-The Reinvestment Approach -The Discounting Approach -The Combination Approach
Which of the following are weaknesses of the payback method?
-The cutoff date is arbitrary -Time value of money principles are ignored -Cash flows received after the payback period are ignored
Net Present Value (NPV)
-The net present value of a project is the difference between the market value of the project (inflows) and its cost (outflows) -It tells us how much the project will add to the firm's value
Which of the following are reasons why IRR continues to be used in practice?
-It is easier to communicate information about a proposal with an IRR -The IRR of a proposal can be calculated without knowing the appropriate discount rate -Businesspeople refer to talk about rates of return
Payback Period as a decision criteria
-Payback is simple to calculate but has some issues as a decision criteria -Does NOT adjust for time value of money -Adjusts for risk in an ad hoc manner (The farther away in time, the greater uncertainty associated with a particular cash flow. By requiring a short payback period, we are sticking with the most certain cash flows) -Does NOT measure how much wealth is being created (Completely ignores cash flows that occur after payback has been achieved) -Payback is often used as a SECONDARY criteria
The Net Present Value of a conventional project will increase, everything else equal, when:
-The Discount Rate decreases -The project's investment decreases -One or more of the project's cash inflows increase
AAR as a decision criteria
-AAR has some serious drawbacks for use as a way to select investment projects -Does NOT adjust for time value of money -Adjusts for risk in an ad hoc manner (The minimum required return can be set higher for riskier projects but is still an arbitrary figure) -Does NOT measure how much wealth is being created (Because it uses accounting returns instead of cash flows, we do not really know how the value of the firm will be affected just by looking at this measure) -AAR should be AVOIDED if at all possible
The Combination MIRR method is used by the Excel MIRR function and uses which of the following?
-Discounting all negative cash flows to time zero -A financing rate for discounting -A reinvestment rate for compounding -Compounding cash inflows to the end of the project
Questions to Consider when Evaluating Decision Criteria
-Does it adjust for time value of money? -Does it adjust for risk? -Does it provide information about whether we are creating value for the firm?
IRR as a decision criteria
-IRR is a good tool to use to evaluate individual projects -Adjusts for time value of money -Adjusts for risk -Does NOT measure wealth creation directly (Instead it is relative to the size of the investment) -In general, IRR and NPV will give us the same answer to whether we should invest in a project
The basic NPV investment rule is:
-If the NPV is equal to zero, acceptance or rejection of the project is a matter of indifference. -Accept a project if the NPV is greater than zero -Reject a project if its NPV is less than zero
PI as a decision criteria
-PI is a good tool to use to evaluate individual projects -Adjust for time value of money -Adjusts for risk -Does NOT measure wealth creation directly (Instead of being measured in $, it is % of investment) -In general, PI and NPV will give us the same answer to whether we should invest in a -Because PI is scaled by the amount of the initial investment, PI may give a different recommendation for mutually exclusive projects, especially ones of different size
Which of the following is a disadvantage of the Profitability Index?
Cannot rank mutually exclusive projects
Net Present Value is the difference between the market value of a project and its cost. The market value is determined by:
Discounting the project's estimated cash flows at the required rate of return
The profitability index is calculated by dividing the PV of the ___ cash inflows by the initial investment.
Future Cash Flows
An ___ project does not rely on the acceptance or rejection of another project.
Independent
The ___ method evaluates a project by determining the time needed to recoup the initial investment.
Payback Method
(T/F) A project with non-conventional cash flows will produce two or more IRRs
True (An IRR will result for every change in sign in the cash flow stream)
Mutually Exclusive Project Example
Year / Project 1 / Project 2 0 = -$1,000 = -$1,000 1 = $667 = $0 2 = $667 = $1,400 -Issue is that only one of these 2 projects can be accepted -If the required return is 5%, then we can calculate the NPVs of these 2 projects: Project 1: (667/(1.05^1) + (667/(1.05^2) -1000=240.23 Project 2: (0/(1.05^1) + (1400/(1.05^2))-1000=269.84 Project 1 IRR: 21.57% Project 2 IRR: 18.32% -With mutually exclusive projects, the NPV and IRR rules give different recommendations. -Since NPV measures how much value is being created, and our goal is max shareholder wealth, where there is a disagreement, go with the project with the higher NPV --> Accept Project B
Payback Example (Using the cash flows in the example project)
Year 1: -100+50=-50 (still need to recover 50) Year 2: -50+40=-10 (Still need to recover 10) Year 3: -10+40=30 (Payback occurs in Year 3) - Does it take all of Year 3? We needed 10 at the beginning of the year but received 40, so technically we only need a 1/4 Payback = 2.25 Years
Nonconventional NPV Example
Year 1: -1000 Year 2: +6,000 Year 3: -11,000 Year 4: +6,000 -The sign changes 3 times -We can build the NPV profile across a wide range of possible discount rates -There are 3 IRRs: 0%, 100%, and 200% Reject because NPV at 10% is negative
IRR Example (Using Cash flows for the example project)
(50/(1+k)^1) + (40/(1+k)^2)... Solving for k algebraically could be very tedious with trial and error. Use Financial Calculator k=0.1989 or 19.89%
NPV Example (Using the cash flows in the example project)
(50/(1.12)^1) + (40/(1.12)^2) + (40/(1.12)^3) + (15/(1.12^4) - 100 = $14.53 What does this mean? Since this is causing the value of the firm to go up, we should accept
PI Example (same thing as NPV but ignoring outflows)
(50/(1.12^1))+(40/(1.12^2)... =$114.53 -We divide the PV of the inflows by the PV of the outflows (which is the same as the initial investment here) -114.53/100=1.145 Since PI is greater than 1, the project should be accepted
What are the advantages of the payback period method for management?
-It allows lower level managers to make small decisions effectively -The payback period method is easy to use -The payback period method is ideal for minor projects (It does not adjust for discount rate)
If a project has multiple internal rates of return, which of the following methods should be used?
-MIRR -NPV
Payback Period
-This measure looks at how long does it take for a period to recoup its investment -At what point will the cumulative cash flows get back to zero? -If all of the cash inflows generated by a project are equal, you can divide the initial investment by the inflow amount -If the cash flows are unequal, then you go period by period. May need to interpolate the last period
According to the average accounting return rule, a project is acceptable if its average accounting return exceeds:
A target average accounting return
One of the flaws of the payback period method is that cash flows after the cutoff date are ___.
Not considered in the analysis
Profitability Index
-Like IRR, the profitability index is a relative measure of value creation ("bang for the buck") -Helps in ranking projects when there are limited resources to invest -If PI>1, the project's benefits exceeds the project's cost and it will add value to the firm
For each of the following examples we will use the following example:
Year / Cash Flow / Net Income 0 = -$100 = --- 1 = $50 = 10 2 = $40 = 8 3 = $40 = 14 4 = $15 = 6 Avg Book Value of assets: 48 Required Return: 12%
AAR Example (Using cash flows example)
-Lets assume minimum AAR is 25% Avg NI = (10+8+14+6)/4=9.5 AAR= 9.5/48=0.1979 or 19.79% Do NOT accept this project because it is less than 25%
Internal Rate of Return (IRR)
-The IRR is highly related to NPV. In fact, it is defined as the discount rate that makes the NPV to equal to 0 -To calculate, you need only the project's cash flows (no required return) -To use IRR to make an accept/reject decision, you would compare to the required rate of return
Specifying variables in the Excel NPV function differs from the manner in which they are entered in a financial calculator in which of the following ways?
-The Excel NPV function is actually a PV function -The range of cash flows specified in Excel begins with cashflow #1, not cashflow 0 -With the Excel NPV Function, Cashflow #0 must be handled outside the NPV function -The discount rate in Excel is entered as a decimal
