FIN 331: Chapter 9 - Net Present Value & Other Investment Criteria

If NPV is positive

The effect on share share value will be favorable.

What is the PI for a project with an initial cash outflow of $30 and a subsequent cash inflows of $80 in Year 1 and $20 in Year 2 if the discount rate is 12%?

$2.91

Payback rule shortcomings

1. We calculate the payback period by adding up the future cash flows. NO DISCOUNTING INVOLVED TIME VALUE OF MONEY IGNORED FAILS TO CONSIDER ANY DIFFERENCES COMING UP WITH THE RIGHT CUTOFF PERIOD. 2. By ignoring time value, may be led to take investments that are worth less than they cost. 3. Ignoring cash flows beyond cutoff, may be led to reject profitable LT investments.

Payback period tells the time it takes to break even in an ____ sense. Discounted payback period tells the time it takes to break even in an ____ or financial sense.

Accounting; economic

A particular cutoff time is selected and all investment projects that have payback periods within that time (or less) are accepted.

So any projects that pay off in more than the cutoff time are rejected.

Mutually exclusive investment decisions

a situation in which taking one investment prevents the taking of another

Discounted Payback Period

length of time until the sum of the discounted cash flows is equal to the initial investment

Advantages of AAR

1. Easy to calculate 2. Needed info will usually be available.

Saxon Company is considering a project that will generate net income of $50,000 in Year 1, $75,000 in Year 2, and $90,000 in Year 3. The cost of the project is $700,000, and this cost will be depreciated to zero in the three years of the investment. What is their average accounting return?

20.48% Average net income is (50k+75k+90k)/3=71667. Average book value of the investment is (700000+0)/2 = $350k. AAR = 71667/350k = 20.48%

NPV ______ cash flows properly

Discounts

The point at which the NPV profile crosses the horizontal axis is the:

IRR

Multiple rates of return

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

Each alternative way of assessing profitability is flawed in some key way

True **NPV is preferred approach in principle

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:

Zero

Payback period

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

What will the PI be for a positive NPV investment?

Bigger than 1

According to Graham and Harvey's 1999 survey of 392 CFOs, which of the following two capital budgeting methods are most used by firms in the US?

1 IRR 2. NPV

A(n) ____ project does not rely on the acceptance or rejection of another project.

Independent

In capital budgeting, the net _________ determines the value of a project to the company.

Present value

IRR must be compared to the ____ in order to determine the acceptability of a project.

Required return

Disadvantages of AAR

1. Not a true rate of return; time value of money is ignored 2. Uses an arbitrary benchmark cutoff rate 3. Based on accounting net income and book values, not cash flows and market values.

The IRR on an investment is:

The required return that results in a zero NPV when it is used as the discount rate.

Advantages of Payback Period Rule

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

Advantages of Discounted Payback Period Rule

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

When cash flows are conventional, NPV is:

1. Positive for discount rates below the IRR 2. Negative for discount rates above the IRR. 3. Equal to zero when the discount rate equals the IRR.

Advantages of IRR

1. closely related to NPV, often leading to identical decisions 2. easy to understand and communicate

T/F: The MIRR function eliminates multiple IRRs and should replace NPV

False

IRR continues to be very popular in practice, partly because:

It gives a rate of return rather than a dollar value.

Small investment decisions are:

Made by hundreds every day in large organizations. Made at all levels.

The _____ method differs from NPV because it evaluates a project by determining the time needed to recoup the initial investment.

Payback

Profitability Index (PI)

Aka benefit-cost ratio. It's (NPV - initial investment)/initial investment

Which of the following are mutually exclusive investments?

1. A restaurant or a gas station on the same piece of land and; 2. Two different choices for the assembly lines that will make the same product.

What is the IRR for a project with an initial investment of $250 and subsequent cash inflows of $100 per year for 3 years?

9.70%

NPV

A measure of how much value is created or added today by undertaking an investment.

A project should be ____________ if its NPV is greater than zero.

Accepted

Net present value rule

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

Average accounting return (AAR)

An investment's average net income divided by its average book value. Some measure of average accounting profit/ some measure of average accounting value.

IRR rule

Based on the IRR rule, an investment is acceptable if the IRR exceeds the required return. It should be rejected otherwise.

Average accounting return rule

Based on the average accounting return rule, a project is acceptable if its average accounting return exceeds a target average accounting return.

Discounted payback rule

Based on the discounted payback rule, an investment is acceptable if its discounted payback is less than some prespecified number of years.

Payback period rule

Based on the payback rule, an investment is acceptable if its calculated payback period is less than some prespecified number of years.

Payback period rule will tend to:

Bias us toward ST investments.

T/F: Investing more money in a project will always lead to greater profits.

False

The PI is calculated by dividing the PV of the _____ cash flows by the initial investment.

Future

The most important alternative to NPV is the ___ method

Internal rate of return (IRR)

Which of the following are advantages of AAR?

Is easy to compute Needed info is usually available.

An investment is worth undertaking if....

It creates value for its owners.

What is the NPV of a project with an initial investment of $95, a cash flow in one year of $107, and a discount rate of 6%?

NPV = -$95+ ($107/1.06) = $5.94

If a project has multiple internal rates of return, which of the following methods should be used?

NPV and MIRR

This capital budgeting method allows lower management to make smaller, everyday financial decisions effectively.

Payback method

The amount of time needed for the cash flows from an investment to pay for its initial cost is:

Payback period

In which of the following scenarios would IRR always recommend the wrong decision?

Starting flow: 1000 Ending flow: -2000

If a project has a positive NPV, then

The PV of the future cash flows must be bigger than the initial investment.

If NPV is negative

The effect on share value will be unfavorable

How to Estimate NPV

To see how we might go about estimating NPV, suppose we believe the cash revenues from our fertilizer business will be $20,000 per year, assuming everything goes as expected. Cash costs (including taxes) will be $14,000 per year. We will wind down the business in eight years. The plant, property, and equipment will be worth $2,000 as salvage at that time. The project costs $30,000 to launch. We use a 15 percent discount rate on new projects such as this one. Is this a good investment? If there are 1,000 shares of stock outstanding, what will be the effect on the price per share of taking this investment? 1. Calculate the PV of the future cash flows at 15%. - Net cash inflow will be $20K cash incomes - $14K in costs per year for 8 years. **8 year annuity of $20k-$14k = $6k per year. Single lump sum inflow of $2k in 8 years (from PPE) 2. Calculate PV: PV = $6k * [1-(1/1.15^8)]/.15+(2000/1.15^8) =(6000*4.4873) + (2000/3.0590) =$26924+$654 =$27578 ***When compared to the $30K estimated cost, we see: NPV = -$30k + $27578 = -$2,422 NOT A GOOD INVESTMENT *Decrease total value of stock by $2422. *With 1k shares outstanding, our best estimate of the impact of taking this project is a loss of value of $2422/1000= $2.42 per share.

(T/F) Some projects, such as mines, have cash outflows followed by cash inflows and cash outflows again, giving the project multiple internal rates of return.

True

T/F: Based on the discounted payback rule, an investment is acceptable if its discounted payback is less than some prespecified number of years.

True

T/F: IRR approach may lead to incorrect decisions in comparison of two mutually exclusively projects.

True

T/F: The crossover rate is the rate at which the NPVs of two projects are equal.

True

The IRR is the discount rate that makes the NPV of a project equal to

zero

Calculating payback period

Year 1 $100 Year 2 $200 Year 3 $500 This project costs $500. The initial cost is $500. After the first two years, the cash flows total $300. After the third year, the total cash flow is $800, so the payback period is sometime between Year 2 and Year 3. 1. B/c the first two years accumulated cash flows of $300, we only need $200 from third year.. 2. The third year cash flow is $500, so we will have to wait $200/$500 = .4 years to do this. *** Payback period is 2.4 years, or about two years and five months.

Net present value profile

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

The IRR rule can lead to bad decisions when ____ or ______

Cash flows are not conventional and projects are mutually exclusive.

Problems with IRR

Come about when one or both conditions are not met.

Capital budgeting is:

Decision-making between accepting or rejecting projects.

To see how we might calculate the discounted payback period, suppose we require a 12.5% return on new investments. We have an investment that costs $300 and has cash flows of $100 per year for 5 years.

To get the discounted payback, we have to discount each cash flow at 12.5% and then start adding them.

What procedure is used to estimate the present value of cash values?

Discounted cash flow (DCF) valuation

Payback period rule _____ a project if it has a payback period that is less than or equal to a particular cutoff date

Suggests accepting

As long as we use straight-line depreciation:

The average investment will always be 1/2 of the initial investment.

When cash flows are conventional, NPV is _____ if the discount rate is above the IRR.

Negative

IRR is sometimes called

Discounts cash flow (DCF) return.

Discounted payback is

The time it takes to break even in an economic or financial sense. It includes time value of money.

Disadvantages of IRR

1) may result in multiple answers with nonconventional cash flows 2) may lead to incorrect decisions in comparisons of mutually exclusive investments

Arrange the steps involved in the discounted payback period in order starting with the first step.

1. Discount the cash flows using the discount rate. 2. Add the discounted cash flows. 3. Accept if the discounted payback period is less than some pre-specified number of years.

Disadvantages of Discounted Payback Period Rule

1. May reject positive NPV investments. 2. Requires an arbitrary cutoff point. 3. Ignores cash flows beyond the cutoff date. 4. Biased against LT projects, such as research and development, and new projects 5. Loss of simplicity as compared to the payback method.

The PI rule for an independent project is to ______ the project if the PI is greater than 1.

Accept

A project has a total up-front cost of $435.44. The cash flows are $100 in the first year, $200 in the second year, and $300 in the third year. What's the IRR? If we require an 18 percent return, should we take this investment?

NPV is 0 at 15%, so 15% is the IRR. **If we require an 18$ return, we shouldn't take this investment.

IRR and NPV rules always lead to identical decisions when:

1. Project's cash flows must be conventional, meaning that the first cash flow (initial investment) is negative and all the rest are positive. 2. Project must be independent, meaning that the decision to accept/reject this project does not affect the decision to accept/reject any other. **First of these conditions typically met, second is often not.

According to the average account return rule, a project is acceptable if its average accounting return exceeds:

A target average accounting return

How does the timing and the size of cash flows affect the payback method? Assume the project does pay back within the project's lifetime.

An increase in the size of the first cash inflow will decrease the payback period, all else held constant.

Redeeming qualities of IRR

Despite flaws, the IRR is very popular in practice - more so than even the NPV.

Net present value of investment

Difference between an investment's market value and its cost.

Modified IRR (MIRR)

Method 1 - The Discounting Approach. *Discount all negative cash flows back to the present at the required return and add the to the initial cost. THEN calculate IRR. Method 2 - The reinvestment approach. ** Compound all cash flows (+ and -) except the first out to the end of the project's life and then calculate the IRR. Method 3 - The Combination Approach. *Blends first two methods. Negative cash flows discounted back to present and positive cash flows are compounded to the end of the project.

Project Alpha's NPV profile crosses the vertical axis at $230,000. Project Beta's NPV profile crosses the vertical axis at $150,000. If Projects Alpha and Beta have conventional cash flows, are mutually exclusive and the NPV profiles cross at 15% (where the NPVs are positive), which of the projects has a higher internal rate of return?

Project Beta; The two projects have a crossover point above the horizontal axis, and Project Alpha crosses the vertical axis above Project Beta. B/c cash flows are conventional, their NPV profiles cross only once, so Alpha must have a steeper NPV profile, and Beta must have a higher IRR.

MIRRs are controversial.

TRUE Some say MIRR should stand for "meaningless internal rate of return" NO clear reason to say one method is better than the next. Too many ways to calculate MIRR.