Ch 9: Net Present Value and Other Investment Criteria
Disadvantages of the Internal Rate of Return (IRR)
*May result in multiple answers or not deal with nonconventional cash flows. *May lead to incorrect decisions in comparisons of mutually exclusive investments.
Based on the average accounting rule, a project is acceptible if its average accounting return
exceeds a target average accounting return AAR = Avg net income / Avg book value
What is the IRR for a project with an inital investment of $250 and subsequent cash inflows of $100 per year for 3 years?
9.7%
If a project has multiple internal rates of return, which methods should be used
MIRR (Modified Internal Rate of Return) or NPV (Net Present Valu) *the possibility that more than one discount rate will make the NPV of an investment zero
Capital Corp is considering a project whose internal rate of return is 14%. If Capital's required return is 14%, the project's NPV is:
NPV = 0
*inital investment of $95 *cash flow in one year of $107 *discount rate of 6% What is the NPV?
NPV = PV of Inflows - PV of Outflows NPV = (PV of Inflows / (1+ R) -PV of Outflows NPV = $107/1.06) -$95 = $5.94
internal rate of return (IRR)
The discount rate that makes the NPV of an investment zero, which is the point at which the profice crosses the horizontal axis. *sometimes called discounted cash flow or DCF, return
Discounted payback period
The length of time required for an investment's discounted cash flows to equal its initial cost.
The internal rate of return is a function of
a project's cash flows
Internal Rate of Return (IRR)
the discount rate (or required return) that will bring all of the cash flows into present value time and total the exact value of the cost of the project. *the discount rate or return that will yield a NPV = $0 *when IRR < R, NPV < 0 (Reject) *when IRR = R, NPV = 0 (accept or reject) *when IRR > R, NPV > 0 (accept)
The present value of all cash flows (after the inital investment) is divded by the
inital investment to calculate the profitability index PI = cash inflow /(1+R)∧1 + cash inflow /(1+R)∧2 / inital investment PI = present value of future cash flows / the intital investment
The point at which the NPV profile crosses the horizontal axis is the:
internal rate of return
If a projects NPV is greater than zero,
the project should be accepted
Weaknesses of the discounted payback period
*May reject positive NPV investments. *Requires an arbitrary cutoff point *Ignores cash flows beyond the cutoff date *Biased against long-term projects, such as research and development, and new projects. *Time value of money principals are ignored
profitability index (PI)
*also called bennefit-cost ratio PI = present value of future cash flows / the intital investment
The IRR rule can lead to bad decisions when
*cash flows are not conventinal *projects are mutually exclusive
Profitability Index Advantages
*closely related to NPV, generally leading to identical decisions *easy to understand and communicate *may be useful when available investment funds are limited
Advantages of NPV
*considers all of the cash flows in the computation *uses the time value of money *provides the answer in dollar terms, easy to understand *usually similar answers to the IRR computation
What are the advantages of the dicounted payback period method for management?
*the payback period method is ideal for short projects *It allows lower level managers to make small decisions effectively *The payback period method is easy to use *Adjusts for uncertainty of later cash flows *Biased toward liquidity.
The three attributes of NPV are that it:
*uses all the cash flow of the project *uses cash flows *discounts the cash flows properly
Nonconvential Cash Flows such as mines:
1. Initial investment 2. Cash inflow 3. Cash outflow for maintainence 4. Cash inflow *cash outflows, followed by cash inflows, followed by cash outflows, giving the project multiple rates of return
net present value profile
A graphical representation of the relationship between an investment's NPVs and various discount rates.
A project will generate net income of, $50,000 in yr 1, $75,000 in yr 2, and $90,000 in yr 3. The cost of the project is $700,000 and will be depreciated to zero in the project's 3 years of investment. What is their average accounting return?
AAR = Avg net income / Avg book value Avg net income = (50,000 + 75,000 + 90,000) / 3 yrs = 71666.67 Avg book value = (700,000+0) / 2 = 350,000 AAR =71666.67 / 350,000 = 20.48%
If the average accounting return is required to be at least 20%, select the projects that are acceptible.
AAR = Avg net income / Avg book value Book store: 140,000/600,000 = .23 Restaurant: 450,000/2,180,000 = .206
To calculate an NPV, future cash flows are
discounted to the present
The PI rule for an independent project is to accept the project
if the PI is greater than 1
AAR (Average Accounting Return) Advantages
*Easy to calculate *Needed information is usually available
Capital budgeting decision method finds the present value of each cash flow before calculating a payback period
Discounted payback period
When cash flows are convential, NPV is
*negagive for discount rates above the IRR *equal to zero when the discount rate equals the IRR *positive for discount rates below the IRR
According to Graham and Harvey's 1999 survey of 392 CFO's, which two capital budgeting methondds are most used by firms in the U.S. and Cananda?
*Internal rate of return *Net present value
Payback method of Capital Budgeting
Allows lower mangagement to make smaller, everyday financial decisions effectively
When a project pays back within the project's lifetime, how does timing and size of cash flows affect the payback method?
An increase in the size of the first cash inflow will decrease the payback period, all else held constant
IRR rule
An investment is acceptable if the IRR exceeds the required return Reject a project if the IRR is less than the required return
Decision-making process for accepting and rejecting projects
Capital Budgeting
Payback period tells the time it takes to break even in an Accounting sense.
Discounted payback period tells the time it takes to break even in an Economic or financial sense.
What is the PI for a project with an inital cash outflow of $30 and subsequent cash inflows of $80 in Year 1 and $20 Year 2 if the diescount rate is 12%?
PI = cash inflow /(1+R)∧1 + cash inflow /(1+R)∧2 / inital investment PI = present value of future cash flows / the intital investment PI=80/1.12 + 20/1.12∧2 / 30 PI=2.91
A: profile crosses the vertical axis at $230,000 B: profile crosses the vertical axis at $150,000 A & B have, *conventional cash flows * are mutually exclusive *NPV profiles cross at 15% (positive) Which project has a higher IRR?
Project B: the two projects have a crossover point above the horizontal axis and project A crosses the vertical above project B. Because the cash flows are conventional, their NPV profiles cross only once, so A must have a steeper NPV profile, and B must have a higer IRR.
multiple rate of return
The possibility that more than one discount rate will make the NPV of an investment zero.
mutually exclusive investment decisions
The present value of an investment's future cash flows divided by its initial cost. Also called the benefit-cost ratio. *i.e., * Two different choices for the assembly lines that will make the same product * A restaurant or a gas station on a piece of land
In capital budgeting, the net present value (NPV)
determines the value of a project to the company
Modified Internal Rate of Return (MIRR)
differentiates itself from IRR in that the reinvestment rate from the cash flows is determined by the evaluator. It is the interest rate that compares the future value of the cash flows with the cost of the project.
According to the payback period rule, an investment is acceptable if tits calculated payback period is
less than some prespecified number of years
When cash flows are convential, NPV is
negative if the discount rate is above the IRR.
IRR continues to be a preferred methond of financial analisys beacuse,
provides a rate of return rather than a dollar value
The point at whicgh the NPV profile crosses the verical axis is the:
sum of the cash flows of the project. *Because the vertical axis crosses the horizontal axis where the discount rate is zero, the NPV profile crosses the vertical axis at the sum of the cash flows (or the pv of the cash flows with a discount rate of 0)
The crossover rate
the rate at which the NPVs of two project are equal