Ch 9 FINANCE

Redeeming Qualities of IRR

IRR more popular than NPV, don't need a required return, easy to communicate

Averag Accounting Return

Average Net Income / Average book value accept if AAR is larger than some target return drawback because based on accounting figures rather than economic returns ignores TVM, no discounting one way to calculate benchmark is to find AAR for the whole firm, but no agreed upon way of doing it instead of cash flow and market value, it looks at Net Income and Book Value you won't find the effect on share price of taking an investment only thing is it is easy to calculate and you can always find data for it

The Payback Rule

If there are two payback periods both are technically correct. rapid payback does not necessarily mean a good investment

MIRR vs. IRR

MIRR doesn't suffer from multiple rate of return problem meaningless because neither method is better than the other differences could be huge if cash flows are bigger not clear how to interpret IRR because the data is not from actual cash flows, it's all modified MIRR requires discounting and compounding, so if you have the required rate of return, you could just calculate NPV also, MIRR relies on a separate discount rate, so if isn't really "internal" because it doesn't depend solely on its own cash flows re-investment does not matter --- what the firm does with the cash flows should not affect its profitability

Net Present Value

Something creates value if it is worth more than it costs (sum = worth more than its parts) for example: buy a run down house for 25, pay people to fix it up for 25. worth 60. extra ten is value added. NPV = Differentce in Market Value and cost Always take a positive NPV there is always risk because the estimates might not be accurate

Analyzing the Rule

TVM ignored, does not consider risk (calculated same way regardless of risk). no real way of picking cutoff, number is arbitrarily chosen . by ignoring TVM we may take investments that are worth less than they cost, and ignore projects that are profitable. biased towards short-term investments.

The Profitability Index

benefit-cost ratio PV of future cash flows / initial investment If P-INdex is greater than 1, the NPV is positive it means that for every dollar invested, PI or 1-PI% will result (bang for buck) often measure of performance for non-profit and government. when capital is scarce, allocate to the highest PI. do not compare PI of mutually exclusive or you may pick something with less NPV

Discounted Payback

break-even point in an economic sense. get everything back but also the investment we could have earned elsewhere. if a project ever pays back on a discounted basis, it has positive NPV because NPV = DCF - COST not used in practice because you might as well just use NPV if you have discount rate, it's not simple to calculate. the cutoff still arbitrary, cash flows in the future still ignored. if cutoff is forever, it would be same as NPV rule. just because project has a shorter payback period oesn't mean it has larger NPV

INTRO

capital budgeting is also called strategic asset allocation capital budgeting is most important because fixed assets define a firm (airlines are airlines because the invest in airplanes, regardless of financing)

NPV Profile and IRR continued

graph of NPV (y-axis) vs. IRR (x-axis) IRR is where the curve meets the x-axis (when NPV is 0) decisions in IRR and NPV are the same if and only if: 1. the cash flows are conventional (fist cash flow negative, rest positive) 2. project is independent (accepting the project does not affect the other project)

Problems with IRR

if the conditions aren't met, that's when problems start. if the project cash flows are not conventional, it can be difficult to know a return, and if not independent, IRR can be misleading. sometimes if cash flows are not conventional, you can get multiple rates of return (neither of which are really right) Descartes Rules of Sign, there CAN be as many IRRs as there are sign changes in cash flows (only a maximum not an actual)

MIRR

method 1: discounting Method: discount negative cash flows then find IRR Method 2, Re-Investment Method: compound all cash flows at end, multiply by 1.D% Method 3, combination approach: discount negative cash flows back to present, compound the positive ones at the end

mutually exclusive investments

mutually exclusive if taking on means we can't take the other if not mutually exclusive, independent best one is the one wit larger NPV, but it won't necessarily have the highest return if the cash flow is greater and it has slower payback, NPV will be higher at lower discount rates

Estimating NPV

need to estimate market value e because some things don't have an active market place (fertilizer market vs. real estate market) If NPV is zero, we are indifferent in taking it or not. NPV are estimates! the only way we could truly find out NPV is if we put the investment up for sale preferred in principle though not always in practice

Redeeming parts of the Rule

often used by large and sophisticated companies when making relatively minor decisions many decisions do not warrant a detailed analysis because the cost of analysis would exceed the loss from making a mistake. generally most investments that pay back quickly and have benefits beyond cutoff are probably positive NPV small investments decisions are made every day and at every level payback exercises control on expenditures and limits losses biased towards liquidity: shorter the payback period, the quicker cash can be freed up for other uses important to have liquidity for a smaller business cash flows in the future are uncertain, so it adjusts for risky cash flows by ignoring them altogether cutoff point is break-even point in an accounting sense of the rule, not economically though because TVM is ignored

Internal Rate of Return

try to find a rate of return that summarizes the merits of a project you want it to be only based on cash flows of the investment and not anywhere else investment is acceptable if IRR exceeds required return basically IRR is: for every dollar you invest, you'll get 1.X% back. this investment is is essentially a break-even proposition when NPV is zero because value is not created or destroyed. IRR is break-even discount rate it is discount rate that makes NPV = 0 also called DCF return

The practice of capital budgeting

use multiple methods because the true NPV can never be known, it is only an estimate. so you have to back up your estimate with other methods.

Investing vs. Financing

when project is financing, IRR is the rate you are paying, not receiving so, take only if IRR is LOWER than required return