Chapter 5: Net Present Value and Other Investment Rules - Conceptual

How do you use the profitability index ?

Accept if PI>1 and reject if <1 with independent projects. More difficult to determine with the Mutually exclusive projects because it is a ratio. With capital rationing can help with ranking (see page 154 and 155 in book)

Define the profitability index

A method used to evaluate projects. it is the ration of the present value of the future expected cash flows after initial investment divided by the initial investment.

How do you use the profitability index with the mutually exclusive project

Because it is a ratio, it ignores the larger investment in projects. Has a scale problem.

Define Investing Type Project

Firm initially pays out money and then gets cash flows

Relationship between NPV and IRR

The NPV is positive for discount rates below the IRR and negative for discount rates above the IRR. ONLY for projects with conventional positive cash flows (negative at beginning and positive after)

What must you compare the IRR to in a final decision if that is all that you are using?

The internal discount rate

Define Discounted payback period.

The length of time it takes for a project's discounted cash flows to equal its initial investment.

Define Internal Rate of Return

(IRR) The discount rate at which the net present value of an investment is zero. It is a method of evaluating capital expenditure proposals. You should accept the project if the IRR is greater than the discount rate and reject the project if it is less than the discount rate.

2 Issues with the IRR Approach

1. Investing or Financing: Problem with projects where large expenses are incurred during the project. Cash inflows precede cash outflows. Causes When this happens you ned to accept the project when the IRR is less than the discount rate and reject the project when the IRR is greater than the discount rate. 2. Multiple Rats of Return: Fluctuating cash flows throughout project. Leasing can also cause. So has two IRRs - which do you use?. So IRR cannot be used here

What are 3 attributes of NPV?

1. NPV uses cash flows (dividend payments, other capital budgeting projects or payments of corporate inters). EARNINGS should not be used in assessment. 2. NPV uses all the cash flows of a project. 3. NPV discounts the cash flows properly. (Time value of money)

What are 2 problems specific to mutually exclusive projects?

1. The scale problem. The high percentage on one opporunity is more than the ability to earn at least a decent return on a much bigger investment under Opportunity 2. 2. The timing problem. If cash flows can occur later making a missed opportunity with IRR calculation

3 Issues with Payback Method

1. Timing of cash flows within the payback period. Does not consider the timing of the cash flows within the payback period. 2. Payments after the payback period. Ignores all cash flows after the payback period. Ignores valuable long-term projects (may reject them) 3. Arbitrary Standard for Payback Period. Does not take into account riskiness of project. So payback date may be arbitrary.

Difference between independent and mutually exclusive projects

Independent: One whose acceptance or rejection is independent of the acceptance or rejection of other projects. Mutually exclusive investments: You can accept A only, B only, but you CANNOT accept both

3 Methods of Modified Internal Rate of Return

Method 1: The discounting Approach. Discount all negative cash flows back to the present at the required return and add them to the initial cost. Then calculate the IRR (only one) Method 2: The Reinvestment Approach. Compound all cash flows (positive and negative), except the first Then calculate the IRR. "Reinvesting" cash flows and not taking them out of the project until the very end. Method 3: The Combination Approach. Blends both discounting and reinvestment approach. Negative cash flow are discounted back to present and positive cash flows are compounded at the end of the project. Different discount or compounding rates might be used.

Internal Rate of Return: Project A has an out put of -1000 the first year and Project B has an output of -2000 the first year. The next three years, the cash flows from the two projects are identical. Which of the two projects would have a her IRR? Why?

Project A would have a higher IRR since the initial investment for Project A is less than that of Project B, if the cash flows for the two projects are identical.

Net Present Value: You are evaluating Project A and Project B. Project A has a short period of future cash flows, while Project B has relatively long period of future cash flows. Which project will be more sensitive to changes in the required return? Why?

Project B's NPV would be more sensitive to changes in the discount rate. The reason is the time value of money. Cash flows that occur further out in the future are always more sensitive to changes in the interest rate. This sensitivity is similar to the interest rate risk of a bond.

Internal Rate of Return criterion for accepting or rejecting independent projects

The IRR is the discount rate that causes the NPV of a series of cash flows to be identically zero. IRR can thus be interpreted as a financial break-even rate of return; at the IRR discount rate, the net value of the project is zero. The acceptance and rejection criteria are: If C0 < 0 and all future cash flows are positive, accept the project if the internal rate of return is greater than or equal to the discount rate. If C0 < 0 and all future cash flows are positive, reject the project if the internal rate of return is less than the discount rate. If C0 > 0 and all future cash flows are negative, accept the project if the internal rate of return is less than or equal to the discount rate. If C0 > 0 and all future cash flows are negative, reject the project if the internal rate of return is greater than the discount rate.

Internal Rate of Return: Project A has an out put of -1000 the first year and Project B has an output of -2000 the first year. If C1B = 2CIA C2B=2C2A C3B = 2C3A Then does IRRA = IRRB?

Yes, since both the cash flows as well as the initial investment are twice that of Project B.

Payback and Internal Rate of Return. A project has perpetual cash flows of C per period, a cost of I, and a required return of r. What is the relationship between the projects payback and its IRR? What implications does your answer have for long-lived projects with relatively constant cash flows?

4. For a project with future cash flows that are an annuity: Payback = I/C And the IRR is: 0 = -I + C/IRR Solving the IRR equation for IRR, we get: IRR = C/I Notice this is just the reciprocal of the payback. So: IRR = 1/PB For long-lived projects with relatively constant cash flows, the sooner the project pays back, the greater is the IRR, and the IRR is approximately equal to the reciprocal of the payback period.

Payback Period and Net Present Value: If a project with conventional cash flows has a payback period less than the project's life, can you definitively state the algebraic sign of the NPV? Why or why not? If you know that the discounted payback period is less than the projects life, what can you say about the NPV? Explain

Assuming conventional cash flows, a payback period less than the project's life means that the NPV is positive for a zero discount rate, but nothing more definitive can be said. For discount rates greater than zero, the payback period will still be less than the project's life, but the NPV may be positive, zero, or negative, depending on whether the discount rate is less than, equal to, or greater than the IRR. The discounted payback includes the effect of the relevant discount rate. If a project's discounted payback period is less than the project's life, it must be the case that NPV is positive.

Net Present Value: Suppose a project has conventional cash flows and a positive NPV. What do you know about the payback? Its discounted payback? Its profitability index? Its IRR? Explain.

Assuming conventional cash flows, if a project has a positive NPV for a certain discount rate, then it will also have a positive NPV for a zero discount rate; thus, the payback period must be less than the project life. Since discounted payback is calculated at the same discount rate as is NPV, if NPV is positive, the discounted payback period must be less than the project's life. If NPV is positive, then the present value of future cash inflows is greater than the initial investment cost; thus, PI must be greater than 1. If NPV is positive for a certain discount rate R, then it will be zero for some larger discount rate R*; thus, the IRR must be greater than the required return.

Net Present Value criterion for accepting or rejecting independent projects

NPV is the present value of a project's cash flows, including the initial outlay. NPV specifically measures, after considering the time value of money, the net increase or decrease in firm wealth due to the project. The decision rule is to accept projects that have a positive NPV, and reject projects with a negative NPV. NPV is superior to the other methods of analysis presented in the text because it has no serious flaws. The method unambiguously ranks mutually exclusive projects, and it can differentiate between projects of different scale and with different time horizons. The only drawback to NPV is that it relies on cash flow and discount rate values that are often estimates and thus not certain, but this is a problem shared by the other performance criteria as well. A project with NPV = $2,500 implies that the total shareholder wealth of the firm will increase by $2,500 if the project is accepted.

What are the general rules of IRR?

Only use one IRR if first cash flow is negative and all the remaining are positive. Accept if IRR >r and reject if <r Only use one IRR if first cash flow is positive and all remaining cash flows are negative. Accept if IRR<r and reject if IRR>r May need more than one IRR if some cash flows after first are positive and some are negative. Then there is no valid IRR

Payback period criterion for accepting or rejecting independent projects

Payback period is the accounting break-even point of a series of cash flows. To actually compute the payback period, it is assumed that any cash flow occurring during a given period is realized continuously throughout the period, and not at a single point in time. The payback is then the point in time for the series of cash flows when the initial cash outlays are fully recovered. Given some predetermined cutoff for the payback period, the decision rule is to accept projects that pay back before this cutoff, and reject projects that take longer to pay back. The worst problem associated with the payback period is that it ignores the time value of money. In addition, the selection of a hurdle point for the payback period is an arbitrary exercise that lacks any steadfast rule or method. The payback period is biased towards short-term projects; it fully ignores any cash flows that occur after the cutoff point.

Modified Internal Rate of Return: One of the less flattering interpretations of the acronym MIRR is "Meaningless internal rate of return". Why do you think this term is applied to MIRR?

The MIRR is calculated by finding the present value of all cash outflows, the future value of all cash inflows to the end of the project, and then calculating the IRR of the two cash flows. As a result, the cash flows have been discounted or compounded by one interest rate (the required return), and then the interest rate between the two remaining cash flows is calculated. As such, the MIRR is not a true interest rate. In contrast, consider the IRR. If you take the initial investment, and calculate the future value at the IRR, you can replicate the future cash flows of the project exactly.

Profitability Index criterion for accepting or rejecting independent projects

The profitability index is the present value of cash inflows relative to the project cost. As such, it is a benefit/cost ratio, providing a measure of the relative profitability of a project. The profitability index decision rule is to accept projects with a PI greater than one, and to reject projects with a PI less than one. The profitability index can be expressed as: PI = (NPV + Cost)/Cost = 1 + (NPV/Cost). If a firm has a basket of positive NPV projects and is subject to capital rationing, PI may provide a good ranking measure of the projects, indicating the "bang for the buck" of each particular project.

Net Present Value. The investment in Project A is $1 million, and the investment in Project B is $2 million. Both projects have a unique internal rate of return of 20 percent. is the following statement true or false: For any discount rate from 0 to 20 percent , project B has an NPV twice as great as that of Project A . Explain your answer.

The statement is false. If the cash flows of Project B occur early and the cash flows of Project A occur late, then, for a low discount rate, the NPV of A can exceed the NPV of B. Observe the following example. However, in one particular case, the statement is true for equally risky projects. If the lives of the two projects are equal and the cash flows of Project B are twice the cash flows of Project A in every time period, the NPV of Project B will be twice the NPV of Project A.

International Investment Projects: In March 2020, Ireland-based Kerry Group announced it plans to spend$125 million to expand production at its Georgia plan. The new investment would allow Kerry to double production at the plan, especially in the seafood, poultry and alternative protein markets. Also, in 2020, German auto parts supplier GEDIA automotive Group announced to build an $85 billion plant in Georgia, and Mercedes-Benz announced plans to build a $500 billion plant in South Carolina. What are some of the reasons that for\eign manufacturers of product as diverse as food, auto parts and vans might arrive at the same conclusion to build plants in the U.S.?

There are a number of reasons. Two of the most important have to do with transportation costs and exchange rates. Manufacturing in the U.S. places the finished product much closer to the point of sale, resulting in significant savings in transportation costs. It also reduces inventories because goods spend less time in transit. Higher labor costs tend to offset these savings to some degree, at least compared to other possible manufacturing locations. Of great importance is the fact that manufacturing in the U.S. means that a much higher proportion of the costs are paid in dollars. Since sales are in dollars, the net effect is to immunize profits to a large extent against fluctuations in exchange rates. This issue is discussed in greater detail in the chapter on international finance

Net Present Value versus Profitability Index: Consider the following two mutually exclusive projects available to Global Investments, Inc (see pic) The appropriate discount rates for the projects is 10 percent. Global Investments chose to undertake Project A. At a luncheon for shareholders, the manager of a pension fund that owns a substantial amount of the firm's stock asks you why the firm chose Project A instead of Project B when Project B has a hgigher profitability index. How would you as the CFO, justify your firm's actions? Are there any circumstances under which Global Investments should choose Project B?

Although the profitability index (PI) is higher for Project B than for Project A, Project A should be chosen because it has the greater NPV. Confusion arises because Project B requires a smaller investment than Project A. Since the denominator of the PI ratio is lower for Project B than for Project A, B can have a higher PI yet have a lower NPV. Only in the case of capital rationing could the company's decision have been incorrect.

Capital Budgeting in Not-for-Profit Entities: Are capital budgeting criteria discussed in the last question applicable to not-for-profit corporations? How should such entities make capital budgeting decisions? What about the U.S. government. Should it evaluate spending proposals using these techniques?

Yes, they are. Such entities generally need to allocate available capital efficiently, just as for-profits do. However, it is frequently the case that the "revenues" from not-for-profit ventures are intangible. For example, charitable giving has real opportunity costs, but the benefits are generally hard to measure. To the extent that benefits are measurable, the question of an appropriate required return remains. Payback rules are commonly used in such cases. Finally, realistic cost/benefit analysis along the lines indicated should definitely be used by the U.S. government and would go a long way toward balancing the budget!

Define Financing Type Project

Firm initially receives money from project and then has expenditures

Define Modified Internal Rate of Return (MIRR)

Modify cash flows first and then use an IRR using the modified cash flows.

Capital Budgeting Problems: What are some of the difficulties that might come up in actual applications of the various criteria for NPV and budgeting. Which one would be the easiest to implement in actual applications?

The single biggest difficulty, by far, is coming up with reliable cash flow estimates. Determining an appropriate discount rate is also not a simple task. These issues are discussed in greater depth in the next several chapters. The payback approach is probably the simplest, followed by the AAR, but even these require revenue and cost projections. The discounted cash flow measures (discounted payback, NPV, IRR, and profitability index) are really only slightly more difficult in practice.