Chapter 9: Net Present Value & Other Investment Criteria

Net Present Value (NPV)
a measure of the difference between the market value of an investment and its cost; while cost is often relatively straight forward, finding the market value of assets or their benefits can be tricky
-the principle is to find the market price of comparables or substitutes
Discounted Cash Flow Valuation
finding the market value of assets or their benefits by taking the present value of future cash flows, i.e. by estimating what the future cash flows would trade for in today’s dollars
NPV Rule
an investment should be accepted if the NPV is positive and rejected if it is negative
-in other words, if the market value of the benefits is larger than the cost, an investment will increase value
Payback Period
the length of time until the accumulated cash flows equal or exceed the original investment
Payback Period Rule
states that an investment is acceptable if its calculated payback is less than some pre-specified number of years
Analyzing the Payback Period Rule
-no discounting involved
-doesn’t consider risk differences
-bias for short-term investments
-How to determine the cutoff point?
Redeeming Qualities
-simple to use (mostly by ignoring long-term)
-bias for short-term promotes liquidity
Discounted Payback Period
the length of time until accumulated discounted cash flows equal or exceed the initial investment
-this technique entails all the work of NPV and yet it is arbitrary
-a redeeming feature is if the project ever pays back on a discounted basis, then it must have a non-negative NPV
-you need cash flow estimates and a discount rate to compute the discounted payback; you might as well go ahead and figure out the NPV and know what you’re getting
Average Accounting Return
Average Net Income/Average Book Value
AAR decision rule
a project is acceptable if its average accounting return exceeds the target return
Analyzing the AAR Method
-Since it involves accounting figures rather than cash, it is not comparable to returns in capital markets
-it treats money in all periods as having the same value
-there is not objective to find the cut-off point
IRR
the rate that makes the present value of the future cash flows equal to the initial cost or investments
-the discount rate that give a project a zero NPV
-expected return on the project
IRR decision rule
acceptable it the required return is less than the IRR, otherwise it should be rejected
NO ranking conflict
The NPV and the IRR method will have NO ranking conflict when analyzing a single conventional project
ranking conflict
existence of discrepancy between two capital budgeting techniques, i.e. NPV and IRR method, in terms of accepting or rejecting a project
Independent projects
the accept/reject decision does not have any impact on the accept/ reject decision of other projects
-NO ranking conflict!
Mutually Exclusive Projects
the acceptance of one project eliminates the others from consideration
-there is a ranking conflict when r is less than the crossover rate
negative
NEVER accept a project if NPV is _________.
Unconventional Cash Flows
if of loan type, meaning money in at first and cash out later, the IRR is really a borrowing rate and lower is better
Multiple Rates of Return
If cash flows alternate back and forth between positive and negative (in and out), more than one IRR is possible and we resort to the NPV rule
Ranking Conflicts for Mutually Exclusive Investment Decisions
the project with the highest IRR may not be the one with the highest NPV
Crossover rate
discount rate that makes the NPV of two projects the same (assuming, of course, they cross)
-find the crossover rate by taking the difference in the project’s cash flows and calculating the IRR
Redeeming Qualities of the IRR
-people seem to prefer talking about rates of return to dollars of value
-unlike the NPV, which requires a market discount rate, IRR relies only upon the project cash flows, which , if the IRR is high enough, may be all that is needed to accept or reject as a practical matter
Profitability Index decision rule
accept the project if PI > 1
If a project has a positive NPV,
then the PI will be greater than 1
When PI=1
NPV=0
Profitability Index
has a ranking problem similar to the IRR when dealing with mutually exclusive
-i.e., we’re not necessarily looking for the biggest return per dollar, but the project that adds the greatest value
Conceptual Comparison of Capital budgeting Techniques
Capital Budgeting Techniques are required to meet at least the following criteria
-consider all the cash flows
-consider the time value of money
-discount at the opportunity cost of capital, e.g., the required rate of return if any cash flows are to be discounted