Alternative Investment Appraisal Rules Lecture 8 PDF

Alternative Investment Appraisal Rules Lecture 8 1 1.Payback Payback period: number of years to recover initial investment through accumulated future cash flows x-year payback  accept all projects recovering their initial outlay within x years Example: Payback period New investment costs £10,000 an...

Alternative Investment Appraisal Rules Lecture 8 1 1.Payback Payback period: number of years to recover initial investment through accumulated future cash flows x-year payback  accept all projects recovering their initial outlay within x years Example: Payback period New investment costs £10,000 and promises future cash flows of £3,000 for the first three years, £4,000 for the next two years, and £6,000 in year 6. Investors require a 14% return. The firm uses a 3-year payback period. Payback period = 31/4 years  reject. Note: NPV is £4,144 > 0. 2 Advantages of payback (a) easy to compute and understand – useful as a coarse screening device (b) encourages cash generation (c) values early cash flows over late cash flows Disadvantages of payback (a) (b) (c) (d) (e) adds cash flows ignoring the time value of money choice of cut off period is arbitrary ignores cash flows after the cut off period biased towards rejecting long-lived projects possibly with + NPVs biased towards accepting short-lived projects possibly with - NPVs 3 Discounted Payback Payback period: number of years to recover initial investment through DISCOUNTED accumulated future cash flows Example: Same CF; Investors require a 14% return. The firm uses a 3-year discounted payback period. Time t=0 t=1 t=2 t=3 t=4 t=5 t=6 CF 3,000 3,000 3,000 4,000 4,000 6,000 -10,000 3,000 3,000 3,000 − 10,000 + + + = −3,035.10 2 3 1.14 1.14 1.14 Solves: Time value, bias against short lived projects with -NPV Note: NPV is £4,144 > 0 4 2. The internal rate of return (IRR) IRR: the return that gives a zero NPV using DCF Example: Yr Calculating IRR 0 CF (£000) -10 1 2 3 4 5 3 3 3 4 6 4 6 -10 + __3__ + __3__ + __3__ + __4__ + __4__ + __6__ = 0 (1 + IRR) (1+IRR)2 (1+IRR)3 (1+IRR)4 (1+IRR)5 (1+IRR)6 IRR=26.46% > 14% Decision rule: accept if IRR so Accept! > required return 5 Net Present Value Profile NPV Cut-off r* =14% r(%) r* =14% IRR< r* Reject IRR=26.46% IRR> r* Accept 6 Conventional investment project: initial negative cash outflow followed by positive cash inflows If cut-off rate of return is r* then accept if IRR >r*  rule  DCF-NPV but it does not give the NPV, the increase to the value of the firm Problems: 1. non-conventional cash flows 2. mutually exclusive projects Example: Multiple IRRs Year t=0 t=1 Cash flow –4,500 6,000 IRR? t=2 6,000 t=3 –8,000 7 You can check that the NPVs of these cash flows are zero at both 15.47% and 33.3% NPV Cut-off r = 14% r(%) 0 15.47 33.3 -500 On either side of the two IRRs, the NPV is negative. Focussing on NPV curve to the left of 15.47%, if we used a cut-off of 14%, we will accept the project though NPV is –ve. 8 Mutually exclusive projects Example : Consider two projects: (1) Project A : £1 m investment, promising 20% return next period 20% IRR (2) Project B : £3 m investment, promising 15% return next period 15% IRR If market required return is 12% we have NPV (Project A) = -1 + 1.2 = £71,429 1.12 NPV (Project B) = -3 + 3.45 = £80,357 1.12 9 NPV Net Present Value Profile 12.5% is the crossover rate Non constant discount rates 20 12.5 15 r(%) Project A Project B Cut-off r =12% 10 3. Accounting rate of return (ARR) Also referred to as – average accounting return – book rate of return ARR =Investment’s average accounting profits each year average book value of assets invested each year 11 Example (£000s) Initial inv. in assets Deprecn. Closing BV Of assets Revs. Less Op. Exps. Depn. Earnings Before tax Taxes (33%) Earned For ordinary t=0 50 50 t=1 t=2 t=3 t=4 5 45 20 5 15 4.95 10.05 10 35 19 10 9 2.97 6.03 15 20 20 0 18.5 21 15 20 3.5 1 1.155 0.33 2.345 0.67 Average profit = 10.05 + 6.03 + 2.345 + 0.67 = 4.77375 (X 1000) 4 Average BV = 50 + 45 + 35 + 20 = 37.500 (X 1000) = 37500 4 ARR = 4773.75 = 12.73% 37500 target ARR = 12%  accept target ARR = 13%  reject 12 Advantages of ARR (a) easy to compute because the firm collects the accounting information anyway (for budgeting and planning purposes) Disadvantages of ARR (a) ignores the timevalue of money (b) choice of target ARR is arbitrary (c) based on earnings not cash flows uses accounting depreciation tax charge based on accounting earnings (d) no standard calculation method (e) not a true return on investment 13 4.Profitability index PI= PV of future cash flows Initial investment Accept if PI>1 Mutually exclusive investments? 14 Summary 1. payback period is the number of years to repay the initial investment 2. payback has several disadvantages 3. discounted payback eliminates some of these disadvantages 4. IRR comes close to the NPV rule 5. IRR has problems with non-conventional cash flows and mutually exclusive investments 6. ARR = average profit/average investment 7. ARR has several disadvantages 8. PI shares some problems with IRR 15