finance chapter 9
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 project's life, what can you say about the NPV?
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.
concerning AAR: what are the problems associated with using the AAR to evaluate a project's cash flows? what underlying feature of AAR is most troubling to you from a financial perspective? does the AAR have any redeeming qualities?
AAR is not a measure of cash flows and market value, but a measure of financial statement accounts that often bear little resemblance to the relevant value of a project. In addition, the selection of a cutoff is arbitrary, and the time value of money is ignored. For a financial manager, both the reliance on accounting numbers rather than relevant market data and the exclusion of time value of money considerations are troubling. Despite these problems, AAR continues to be used in practice because (1) the accounting information is usually available, (2) analysts often use accounting ratios to analyze firm performance, and (3) managerial compensation is often tied to the attainment of certain target accounting ratio goals.
concerning payback: what are the advantages of using the payback period to evaluate cash flows? Are there any circumstances under which using payback might be appropriate? explain
Despite its shortcomings, payback is often used because (1) the analysis is straightforward and simple and (2) accounting numbers and estimates are readily available. Materiality considerations often warrant a payback analysis as sufficient; maintenance projects are another example where the detailed analysis of other methods is often not needed. Since payback is biased towards liquidity, it may be a useful and appropriate analysis method for short-term projects where cash management is most important.
concerning discounted payback: what conceptual advantage does the discounted payback method have over the regular payback method? can the discounted payback ever be longer than the regular payback? explain
Discounted payback is an improvement on regular payback because it takes into account the time value of money. For conventional cash flows and strictly positive discount rates, the discounted payback will always be greater than the regular payback period.
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 project's payback and its IRR? what implications does your answer have for long-lived projects with relatively constant cash flows?
For long-lived projects with relatively constant cash flows, the sooner the project pays back, the greater is the IRR.
concerning IRR: despite its shortcomings in some situations, why do most financial managers use IRR along with NPV when evaluating projects? can you think of a situation in which IRR might be a more appropriate measure to use than NPV? explain
IRR is frequently used because it is easier for many financial managers and analysts to rate performance in relative terms, such as "12%", than in absolute terms, such as "$46,000." IRR may be a preferred method to NPV in situations where an appropriate discount rate is unknown are uncertain; in this situation, IRR would provide more information about the project than would NPV.
concerning IRR: what is the relationship between IRR and NPV? are there any situations in which you might prefer one method over the other? explain
IRR is the interest rate that causes NPV for a series of cash flows to be zero. NPV is preferred in all situations to IRR; IRR can lead to ambiguous results if there are non-conventional cash flows, and it also ambiguously ranks some mutually exclusive projects. However, for stand-alone projects with conventional cash flows, IRR and NPV are interchangeable techniques.
concerning NPV: describe how NPV is calculated, and describe the information this measure provides about a sequence of cash flows. What is the NPV criterion decision rule?
NPV is simply the present value of a project's cash flows. 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.
concerning NPV: why is NPV considered a superior method of evaluating the cash flows from a project? suppose the NPV for a project's cash flows is computed to be $2,500. what does this number represent with respect to the firm's shareholders?
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 can differentiate between projects of different scale and time horizon. The only drawback to NPV is that it relies on cash flow and discount rate values that are often estimates and 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.
concerning the profitability index: what is the relationship between the profitability index and NPV? are there any situations in which you might prefer one method over the other? explain
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.
concerning payback: describe how the payback period is calculated, and describe the information this measure provides about a sequence of cash flows. what is the payback criterion decision rule?
Payback period is simply 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 payback before this cutoff, and reject projects that take longer to payback.
concerning IRR: describe how the IRR is calculated, and describe the information this measure provides about a sequence of cash flows. what is the IRR criterion decision rule?
The IRR is the discount rate that causes the NPV of a series of cash flows to be exactly zero. IRR can thus be interpreted as a financial break-even rate of return; at the IRR, the net value of the project is zero. The IRR decision rule is to accept projects with IRRs greater than the discount rate, and to reject projects with IRRs less than the discount rate.
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.
concerning AAR: describe how the average accounting return is usually calculated, and describe the information this measure provides about a sequence of cash flows. What is the AAR criterion decision rule?
The average accounting return is interpreted as an average measure of the accounting performance of a project over time, computed as some average profit measure attributable to the project divided by some average balance sheet value for the project. This text computes AAR as average net income with respect to average (total) book value. Given some predetermined cutoff for AAR, the decision rule is to accept projects with an AAR in excess of the target measure, and reject all other projects.
concerning discounted payback: describe how the discounted payback period is calculated, and describe the information this measure provides about a sequence of cash flows. What is the discounted payback criterion decision rule?
The discounted payback is calculated the same as is regular payback, with the exception that each cash flow in the series is first converted to its present value. Thus discounted payback provides a measure of financial/economic break-even because of this discounting, just as regular payback provides a measure of accounting break-even because it does not discount the cash flows. Given some predetermined cutoff for the discounted payback period, the decision rule is to accept projects whose discounted cash flows payback before this cutoff period, and to reject all other projects.
concerning discounted payback: what are the problems associated with using the discounted payback period to evaluate cash flows?
The primary disadvantage to using the discounted payback method is that it ignores all cash flows that occur after the cutoff date, thus biasing this criterion towards short-term projects. As a result, the method may reject projects that in fact have positive NPVs, or it may accept projects with large future cash outlays resulting in negative NPVs. In addition, the selection of a cutoff point is again an arbitrary exercise.
concerning the profitability index: describe how the profitability index is calculated, and describe the information this measure provides about a sequence of cash flows. what is the profitability index decision rule?
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.
what difficulties might come up in actual applications of the various criteria we discussed in this chapter? which one would be the easiest to implement in actual applications? the most difficult?
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.
concerning payback: what are the problems associated with using the payback period to evaluate cash flows?
The worst problem associated with payback period is that it ignores the time value of money. In addition, the selection of a hurdle point for 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.
in march 2014, automobile manufacturer BMW announced plans to invest $1 billion to increase production at its south carolina plant by 50 percent. BMW apparently felt that it would be better able to compete and create value with US-based facilities. Other companies such as fuji film and swiss chemical company lonza have reached similar conclusions and taken similar actions. what are some of the reasons that foreign manufacturers of products as diverse as automobiles, film, and chemicals might arrive at this same conclusion?
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.
are the capital budgeting criteria we discussed applicable to not-for-profit corporations? how should such entities make capital budgeting decisions? what about the US 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 not tangible. 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 net present value profile
a graphical representation of the relationship between an investment's NPV and various discount rates
define mutually exclusive investment decisions
a situation in which taking one investment prevents the taking of another
average accounting return (AAR)
an investment's average net income divided by its average book value
suppose a project has conventional cash flows and a positive NPV. what do you know about its payback? its discounted payback? its IRR?
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.
discounted payback period
the length of time required for an investment's discounted cash flows to equal its initial cost
define multiple rates of return
the possibility that more than one discount rate will make the NPV of an investment zero
define profitability index
the present value of an investment's future cash flows divided by its initial cost. also called the benefit-cost ratio
define discounted cash flow (DCF) valuation
the process of valuing an investment by discounting its future cash flows
T/F: NPV says nothing about the reinvestment of intermediate cash flows
true
define payback period
the amount of time required for an investment to generate cash flows sufficient to recover its initial cost
define net present value (NPV)
the difference between an investment's market value and its cost
define internal rate of return
the discount rate that makes the NPV of an investment zero
