FIN 301 Chapter 9 - Net Present Value & Investment Criteria PDF

CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA  LEARNING OBJECTIVES After studying this chapter, you should understand: LO1 The reasons why the net present value criterion is the best way to evaluate proposed investments. LO2 The payback rule and some of its shortcomings. LO3 T...

CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA  LEARNING OBJECTIVES After studying this chapter, you should understand: LO1 The reasons why the net present value criterion is the best way to evaluate proposed investments. LO2 The payback rule and some of its shortcomings. LO3 The discounted payback rule and some of its shortcomings. LO4 Accounting rates of return and some of the problems with them. LO5 The internal rate of return criterion and its strengths and weaknesses. LO6 The modified internal rate of return. Capital budgeting involves evaluating long-term investments, like Tesla's $2 billion battery factory or Southern Co.'s $14 billion nuclear reactors. These decisions involve significant expenditures and risks, requiring careful analysis to determine if the investments will increase the firm's value.  9.1 Net Present Value  Net present value is a measure of how much value is created or added today by undertaking an investment  NPV = The difference between an investment’s market value and its cost.  NPV Example; Organic Fertilizer Business  Goal: Decide if starting a fertilizer business is a good investment based on its NPV.  Key Question: Does the value of the business exceed the start-up costs (i.e., EXAMPLE OF NET PRESENT VALUE (NPV): HOUSE INVESTMENT Initial investment: $50,000 ($25,000 to buy the house + $25,000 for repairs). After renovations, the market value of the house is $60,000. The value created: $60,000 - $50,000 = $10,000. Management brought together fixed assets, labor, and materials to add $10,000 in value. The challenge in capital budgeting is predicting ahead of time whether an investment will create value, as seen in this example where the project turned out profitable. ESTIMATING NET PRESENT VALUE Steps to Determine NPV: Estimate start-up costs: Known and predictable. Estimate future cash flows: Project revenues and expenses of the business over time. Discount future cash flows: Use a discounted cash flow (DCF) as learnt in chapter 5 approach to calculate the present value of future cash flows. Calculate NPV: Subtract start-up costs from the present value of future cash flows. If NPV > 0, the investment is worthwhile; if NPV < 0, it’s not. CALCULATING NPVS WITH A SPREADSHEET; ISSUES THAT MAY ARISE You can get a freeware NPV calculator at www.wheatworks.com. Issue: Many capital budgeting decisions are based on incorrect use of spreadsheet functions. Problem: The "NPV" function in most spreadsheets is actually a Present Value (PV) function, not a true NPV function. Consequences: This mistake can lead to incorrect project evaluations. Always understand the underlying formula, not just rely on tools like calculators or spreadsheets. In this case, 9.2 The Payback Rule DEFINING THE RULE Payback period; The amount of time required for an investment to generate cash flows sufficient to recover its initial cost. Based on the payback rule, an investment is acceptable if its calculated payback period is less than some prespecified number of years. CALCULATING PAYBACK Cash Flows After 2 years: $300 After 3 years: $800 (total) Calculation: Need to recover $200 in Year 3. Year 3 cash flow = $500. Fractional payback: $200 / $500 = 0.4 year. Payback Period: 2.4 years (or 2 years and 5 months). This shows how to calculate payback when cash flows ANALYZING THE RULE & IT’S SHORTCOMINGS No Discounting: The payback rule adds up future cash flows without discounting. Problem: Ignores the time value of money. No Risk Consideration: The rule calculates payback the same way for both risky and safe projects. Problem: Fails to account for risk differences. Arbitrary Cutoff: Choosing a payback period is subjective and arbitrary. Problem: No economic rationale for selecting a specific cutoff. REDEEMING QUALITIES OF THE RULE; Why Payback Period Rule is Still Used; Simplicity: Quick and easy to apply, especially for small decisions. Practicality: Detailed analysis for minor decisions may not be cost-effective. Example: Companies may require a 2-year payback for investments under $10,000. Advantages: Short-Term Focus: Biases decisions toward projects that free up cash quickly, promoting liquidity.  LIMITATIONS AND REALITIES OF THE PAYBACK RULE Limits Possible Losses: While imperfect, the payback rule provides some control over spending. Illusion of Simplicity: Cash flow estimation is still required, which can be challenging. Key Insights: Liquidity Focus: Important for small businesses, less so for large corporations. Adjusting for Risk: Later cash flows are often more uncertain, and the payback rule addresses this by ignoring them—though this is an oversimplification. 9.3 The Discounted Payback The discounted payback period is the length of time until the sum of the discounted cash flows is equal to the initial investment. We saw that one shortcoming of the payback period rule was that it ignored time value. A variation of the payback period, the discounted payback period, fixes this particular problem. ORDINARY AND DISCOUNTED PAYBACK The figure above Illustrates another interesting feature of the discounted payback period. If a project ever pays back on a discounted basis, then it must have a positive NPV. This is true because, by definition, the NPV is zero when the sum of the discounted cash flows equals the initial investment.  Future Value of Project Cash Flows These figure illustrates this idea by comparing the future value at 12.5% of the $300 investment to the future value of the$100 annual cash flows at 12.5%. Notice that the two lines cross at exactly four years. This tells us that the value of the project’s cash flows catches up and then passes the original ADVANTAGES AND DISADVANTAGES OF THE DISCOUNTED PAYBACK PERIOD Advantages RULE Disadvantages Includes time value of May reject positive NVP money statements Easy to understand Requires an arbitrary cut off Does not accept point. negative estimated NPV Ignores cash flows beyond investments the cutoff date Biased towards liquidity Biased against long term projects, such as research and  9.4 The Average Accounting Return Another attractive, but flawed, approach to making capital budgeting decisions involves the average accounting return (AAR). There are many different definitions of the AAR. However, in one form or another, the AAR is always defined as: Average accounting return (AAR); An investment’s average net income divided by its average book value. ADVANTAGES AND DISADVANTAGES OF USING AAR ADVANTAGES DISADVANTAGES Easy to calculate Not a true rate of return; time value of money is Needed information will ignored usually be available Uses an arbitrary benchmark cut off rate. Based on accounting (book) values, not cash flows and market values 9.5 The Internal Rate of Return Definition: The IRR is the discount rate that makes the Net Present Value (NPV) of an investment zero. Basic Concept:  For a project costing $100 today and paying $110 in one year, the return is 10% because $110 / $100 = 1.10 or 10% return.  If the IRR exceeds the required return, the investment is acceptable; otherwise, it should be rejected. Calculating IRR: For a single-period investment, IRR is easy to calculate. For more complex investments with multiple cash flows, IRR can be calculated using trial and error or financial calculators/spreadsheets. Example: For a project with cash flows of $60 each year for two years and an initial cost of $100, the IRR is approximately 13.1%. NPV Profile: The NPV profile is a graph showing the relationship between NPV and discount rates. The IRR is the discount rate where the NPV curve intersects the x-axis. Example: Given cash flows of $100 in year one, $200 in year two, and $300 in year three, with an initial cost of $435.44, the IRR is 15%. If the required return is 18%, the investment is not acceptable. PROBLEMS WITH IRR: 1. Non-Conventional Cash Flows: Cash flows that alternate between negative and positive can result in multiple IRRs, making it unclear which IRR to use. Example: A project requiring an initial investment of $60 and yielding $155 in the first year, but needing $100 in the second year, may have multiple IRRs. 2. Mutually Exclusive Investments:  IRR can be misleading when comparing mutually exclusive investments (where choosing one excludes the other). The IRR might suggest a different ranking than the NPV.  Example: Two projects with different NPVs at varying discount rates can result in conflicting rankings based on IRR alone. 3. Investing vs. Financing Cash Flows:  Projects with cash inflows before outflows (financing- type) might give misleading IRR values. For such projects, a lower IRR might be preferable if it indicates cheaper financing. 9.6 Modified Internal Rate of Return (MIRR): Purpose: To address IRR’s limitations by providing a single rate of return and handling unconventional cash flows more accurately. Methods to Calculate MIRR:  Discounting Approach: Discount all negative cash flows to the present, add them to the initial cost, and calculate IRR.  Reinvestment Approach: Compound all cash flows to the end of the project and calculate IRR.  Combination Approach: Blend discounting and compounding for negative and positive cash flows Example Calculations: For a project with cash flows of -$60, +$155, - $100: Discounting Approach: MIRR ≈ 19.74% Reinvestment Approach: MIRR ≈ 19.72% Combination Approach: MIRR ≈ 19.87% 9.7 Profitability Index (PI) Definition: The Profitability Index (PI), also known as the benefit–cost ratio, measures the present value of future cash flows divided by the initial investment. Formula: Example: If an investment costs $200 and the present value of future cash flows is $220, then: Interpretation: A PI greater than 1 indicates a positive NPV (the investment is expected to generate more value than its cost). A PI less than 1 indicates a negative NPV (the investment is expected to generate less value than its cost). Advantages: Measures the value created per dollar invested. Useful for performance evaluation in not-for-profit contexts or when capital is limited. Limitations: It can be misleading when comparing mutually exclusive projects. For example, an investment with a higher PI might have a lower total NPV compared to another project with a lower PI. 9.8.Capital Budgeting Procedures Common Procedures: 1.Net Present Value (NPV) 2.Internal Rate of Return (IRR) 3.Payback Period 4.Accounting Rate of Return (ARR) 5.Discounted Payback Period 6.Profitability Index (PI) SUMMARY Why Multiple Measures?  PI and other measures can offer additional insights or be easier to communicate.  NPV provides a direct estimate of value added but requires accurate cash flow projections.  Multiple criteria help assess investment reliability, especially under uncertainty, and align with different decision-making needs. Practical Use: Firms often use a combination of methods to ensure a comprehensive evaluation and manage uncertainty effectively.