Corporate Finance Chapter 9

• May reject positive NPV investments • Requires an arbitrary cutoff point • Ignores cash flows beyond the cutoff point • Biased against long-term projects, such as R&D and new products

Advantages of Discounted Payback

1. Easy to understand. 2. Adjusts for uncertainty of later cash flows. 3. Biased toward liquidity.

Advantages of Discounted Payback Period

• Knowing a return is intuitively appealing • It is a simple way to communicate the value of a project to someone who doesn't know all the estimation details

Advantages of IRR

• 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 PI

Easy to understand Adjusts for uncertainty of later cash flows Biased toward liquidity

Advantages of Payback Method

1. Closely related to NPV, generally leading to identical decisions. 2. Easy to understand and communicate. 3. May be useful when available investment funds are limited.

Advantages of Profitability Index

1. Ignores the time value of money. 2. Requires an arbitrary cutoff point. 3. Ignores cash flows beyond the cutoff date. 4. Biased against long-term projects, such as research and development, and new projects.

Disadvantages of Discounted Payback Period

1. May result in multiple answers or not deal with nonconventional cash flows. 2. Can not resolve mutually exclusive projects

Disadvantages of IRR

• May lead to incorrect decisions in comparisons of mutually exclusive investments

Disadvantages of PI

We need to ask ourselves the following questions when evaluating capital budgeting decision rules:

Does the decision rule adjust for the time value of money? Does the decision rule adjust for risk? Does the decision rule provide information on whether we are creating value for the firm?

You receive cash up front, then pay expenses later.

Financing Type Cash Flows

When the cash flows change sign more than once, there is more than one

IRR

• This is the most important alternative to NPV • It is often used in practice and is intuitively appealing • It is based entirely on the estimated cash flows and is independent of interest rates found elsewhere

IRR

Section 9.5

Internal Rate of Return

When you pay upfront expenses and then receive cash flows.

Investment Type Cash Flows

We calculate the payback period by simply adding up the future cash flows. There is no discounting involved, so the time value of money is completely ignored. The payback rule also fails to consider any risk differences. The payback would be calculated the same way for both very risky and very safe projects. Perhaps the biggest problem with the payback period rule is coming up with the right cutoff period: We don't really have an objective basis for choosing a particular number.

Issues with Payback Method

The possibility that more than one discount rate will make the NPV of an investment zero.

Multiple Rates of Return

A situation in which taking one investment prevents the taking of another.

Mutually Exclusive Investment Decisions

You are reviewing a new project and have estimated the following cash flows: • Year 0:CF0 = -165,000 • Year 1:CF1 = 63,120 • Year 2:CF2 = 70,800 • Year 3:CF3 = 91,080 • Your required return for assets of this risk level is R=12%.

NPV = $12,627 Accept Project because there is a positive NPV.

An investment should be accepted if the net present value is positive and rejected if it is negative.

The Net Present Value Rule

Section 9.2

The Payback Rule

IRR is the return that makes the NPV =

0

More generally, if a project has a positive NPV, then the present value of the future cash flows must be bigger than the initial investment. The profitability index would thus be bigger than # for a positive NPV investment and less than # for a negative NPV investment.

1

1. Includes time value of money. 2. Easy to understand. 3. Does not accept negative estimated NPV investments. 4. Biased toward liquidity.

Advantages of Discounted Payback

• Includes time value of money • Easy to understand • Does not accept negative estimated NPV investments when all future cash flows are positive • Biased towards liquidity

Advantages of Discounted Payback

1. Closely related to NPV, often leading to identical decisions. 2. Easy to understand and communicate.

Advantages of IRR

1. May reject positive NPV investments. 2. Requires an arbitrary cutoff point 3. Ignores cash flows beyond the cutoff date. 4. Biased against long-term projects, such as research and development, and new projects.

Disadvantages of Discounted Payback

• Suppose an investment will cost $90,000 initially and will generate the following cash flows: • Year 1: 132,000 • Year 2: 100,000 • Year 3: -150,000 • The required return is 15%. • Should we accept or reject the project?

NPV = $1,769.54 NPV says yes because it is positive. IRR = 10.11 IRR say no because the IRR is less than the required rate of return (15%). WE GO WITH THE NPV ANSWER THOUGH! The reason the answers are different is because the cash flows are non-conventional.

Section 9.3

The Discounted Payback

The discount rate that makes the NPV of an investment zero.

internal rate of return (IRR).

We now come to the most important alternative to NPV, the

internal rate of return (IRR).

If you are using financing type cash flows, then you are going to want to accept the project if the IRR is (higher/lower) than the required rate of return.

lower. Because the lower the rate, the less you are paying. The required rate of return is thus stating how much you are willing to pay.

Accept if the payback period is less than some

preset limit.

Accept the project if the IRR is greater than the

required rate of return.

Based on the IRR rule, an investment is acceptable if the IRR exceeds the

required rate of return. Should be rejected if otherwise.

Based on the discounted payback rule, an investment is acceptable if its discounted payback is less than

some presepcified number of years.

You may be wondering if the IRR and NPV rules always lead to identical decisions. The answer is yes, as long as two very important conditions are met. First, the project's cash flows must be conventional, meaning that the first cash flow (the initial investment) is negative and all the rest are positive. Second, the project must be independent, meaning that the decision to accept or reject this project does not affect the decision to accept or reject any other.

This would be wise to understand. 1. Conventional Cash Flows 2. Independent Projects (Not mutually exclusive)

NPV and IRR will generally give us the same decision T or F?

True Exceptions: • Nonconventional cash flows - cash flow signs change more than once • Mutually exclusive projects

Does the NPV rule account for the time value of money? • Does the NPV rule account for the risk of the cash flows? • Does the NPV rule provide an indication about the increase in value? • Should we consider the NPV rule for our primary decision rule?

Yes to all of these questions.

If the NPV is positive,

accept the project. A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners

The IRR on an investment is the required return that results in a zero NPV when it is used as the

discount rate.

Section 9.1

Net Present Value

The difference between the market value of a project and its cost

Net Present Value

The difference between an investment's market value and its cost.

Net Present Value (NPV)

A graphical representation of the relationship between an investment's NPVs and various discount rates.

Net Present Value Profile

Chapter 9

Net Present Value and Other Investment Criteria

Section 9.7

Net Present Value and Other Investment Criteria

Assume we will accept the project if it pays back within two years. • Year 1: 165,000 - 63,120 = 101,880 still to recover • Year 2: 101,880 - 70,800 = 31,080 still to recover • Year 3: 31,080 - 91,080 = -60,000 project pays back in year 3

Payback = 2 + 31080/91080 = 2.34 years We accept the project if 2.34 years is less than our required payback period.

The amount of time required for an investment to generate cash flows sufficient to recover its initial cost.

Payback Period

An investment is acceptable if its calculated payback period is less than some prespecified number of years.

Payback Rule

Measures the benefit per unit cost, based on the time value of money

Profitability Index

Section 9.6

Profitability Index

The present value of an investment's future cash flows divided by its initial cost. Also called the benefit-cost ratio.

Profitability Index (PI)

A discounted payback period rule has a couple of other significant drawbacks. The biggest one is that the cutoff still has to be arbitrarily set, and cash flows beyond that point are ignored.3 As a result, a project with a positive NPV may be found unacceptable because the cutoff is too short. Also, just because one project has a shorter discounted payback than another does not mean it has a larger NPV.

Significant Issue with discounted payback

The process of capital budgeting could thus be given a more descriptive (not to mention impressive) name:

Strategic Asset Allocation

An investment is worth undertaking if it creates value for its owners. In the most general sense, we create value by identifying an investment worth more in the marketplace than it

costs us to acquire.

The crossover rate, by definition, is the discount rate that makes the NPVs of two projects

equal.

If the NPV is zero, then...

we would be indifferent between accepting the project.

• Ignores the time value of money • 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

Disadvantages of Payback Method

1. May lead to incorrect decisions in comparisons of mutually exclusive investments.

Disadvantages of Profitability Index

The process of valuing an investment by discounting its future cash flows.

Discounted Cash Flow (DCF) Valuation

Assume we will accept the project if it pays back on a discounted basis in 2.5 years. • Compute the PV for each cash flow and determine the payback period using discounted cash flows • Year 1: 165,000 - 63,120/1.121 = 108,643 • Year 2: 108,643 - 70,800/1.122 = 52,202 • Year 3: 52,202 - 91,080/1.123 = -12,627 project pays back in year 3

Discounted Payback = 2 + 52202/64829 = 2.81 We do not accept the project based off of the discounted payback period.

The length of time required for an investment's discounted cash flows to equal its initial cost.

Discounted Payback Period (Payback period adjusted for time value of money)