Net Present Value & Other Investment Criteria

1. Net Present Value & Other Investment Criteria FIL 240 Prepared by Keldon Bauer

2. Good Decision Criteria • We need to ask ourselves the following questions when evaluating decision criteria • Does the decision rule adjust for the time value of money? • Does the decision rule adjust for risk? • Does the decision rule provide information on whether we are creating value for the firm?

3. Discounted Payback - Example • As the Chief Financial Officer of Spamway, Corp., you have been presented with the following two potential projects.Assume a 9% discount rate.

4. Net Present Value • The philosophy behind the net present value (NPV) is how much should adoption of the project have on the overall value of the firm. • NPV is the sum of all outlays in present value terms. • Since outlays are negative, and inflows are positive, the net represents addition to value of the firm.

5. Net Present Value • How much value is created from undertaking an investment? • The first step is to estimate the expected future cash flows. • The second step is to estimate the required return for projects of this risk level. • The third step is to find the present value of the cash flows and subtract the initial investment.

6. -$1,500 $412.84 2 3 4 5 0 1 9% $387.17 $362.93 $340.04 $450 $460 $470 $480 $490 $318.47 NPV - Example 1 $ 321.45 = Net Present Value

7. 9% -$3,000 $755 $855 $955 $1,054 $1,150 $692.66 2 3 4 5 0 1 $719.64 $737.44 $746.68 $747.42 NPV - Example 2 $ 643.83 = Net Present Value

8. NPV Decision Rule • If the NPV is positive, accept the project • A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners. • Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal.

9. Decision Criteria Test - NPV • Does the NPV rule account for the time value of money? • Does the NPV rule account for the risk of the cash flows? • Does the NPV rule provide an indication about the increase in value? • Should we consider the NPV rule for our primary decision criteria?

10. Payback Period • Meant to measure the time it takes to recoup the initial investment (ignoring the time value of money). • The quicker the payback period (smaller the number), the better! • To calculate payback period follow the following 4 steps:

11. Payback Period - Steps • Create cash flow time line. • Add a line for cumulative cash flow. • Identify the last year that cumulative cash flow is negative, we will call it A. • Payback period is calculated as follows:

12. Step 1 -1,500 450 460 470 480 490 Cumulative 2 3 4 5 0 1 Step 2 -1,500 -1,050 -590 -120 360 850 Step 4 Payback Period - Example 1 Step 3 Last negative year is 3 È

13. Step 1 -3,000 755 855 955 1,054 1,150 Step 2 -3,000 -2,245 -1,390 -435 619 1,769 Cumulative 2 3 4 5 0 1 Step 4 Payback Period - Example 2 Step 3 Last negative year is 3 È

14. Decision Criteria Test - Payback • Does the payback rule account for the time value of money? • Does the payback rule account for the risk of the cash flows? • Does the payback rule provide an indication about the increase in value? • Should we consider the payback rule for our primary decision criteria?

15. Advantages Easy to understand Adjusts for uncertainty of later cash flows Biased towards liquidity Disadvantages Ignores the time value of money Requires an arbitrary cutoff point Ignores cash flows beyond the cutoff date Biased against long-term projects, such as research and development, and new projects Advantages and Disadvantages of Payback

16. Internal Rate of Return • This is the most important alternative to NPV • It is often used in practice and is intuitively appealing • It is based entirely on the estimated cash flows and is independent of interest rates found elsewhere

17. IRR – Definition and Decision Rule • Definition: IRR is the return that makes the NPV = 0 • Decision Rule: Accept the project if the IRR is greater than the required return • The internal rate of return (IRR) represents the effective interest earned on the investment.

18. Computing IRR For The Project • If you do not have a financial calculator, then this becomes a trial and error process • Calculator • Enter the cash flows as you did with NPV • Press IRR and then CPT • IRR = 16.13% > 12% required return • Do we accept or reject the project?

19. Discounted Payback - Example • As the Chief Financial Officer of Spamway, Corp., you have been presented with the following two potential projects.Assume a 9% required return.

20. -1,500 450 460 470 480 490 2 3 4 5 0 1 IRR - Example 1 ? IRR = 16.82%

21. -3,000 755 855 955 1,054 1,150 2 3 4 5 0 1 IRR - Example 2 ? IRR = 16.37%

22. IRR Problems • IRR has two major problems. • First, it assumes that all cash inflows will earn the IRR rate instead of the much more likely discount rate. • Second, depending on the cash flow streams there can be more than one IRR.

23. Multiple IRRs • As an example of more than one IRR, let’s assume you have a project that will return a net $4,000 in year zero (salvage of old machine, and financing, etc.), nets a negative $25,000 in year one, and finishes with a positive $25,000 in year three.

24. Multiple IRRs - Example • Since the IRR is defined as the discount rate which yields an NPV of zero:

25. Multiple IRRs - Example • Multiplying both sides by (1+k)2 yields: Factoring the above polynomial: k = IRR = 25% or 400%

26. Multiple IRRs - Example

27. Decision Criteria Test - IRR • Does the IRR rule account for the time value of money? • Does the IRR rule account for the risk of the cash flows? • Does the IRR rule provide an indication about the increase in value? • Should we consider the IRR rule for our primary decision criteria?

28. Advantages of IRR • Knowing a return is intuitively appealing • It is a simple way to communicate the value of a project to someone who doesn’t know all the estimation details • If the IRR is high enough, you may not need to estimate a required return, which is often a difficult task

29. NPV vs. IRR • NPV and IRR will generally give us the same decision • Exceptions • Non-conventional cash flows – cash flow signs change more than once • Mutually exclusive projects • Initial investments are substantially different • Timing of cash flows is substantially different

30. IRR and Nonconventional Cash Flows • When the cash flows change sign more than once, there is more than one IRR • When you solve for IRR you are solving for the root of an equation and when you cross the x-axis more than once, there will be more than one return that solves the equation • If you have more than one IRR, which one do you use to make your decision?

31. Conflicts Between NPV and IRR • NPV directly measures the increase in value to the firm • Whenever there is a conflict between NPV and another decision rule, you should always use NPV • IRR is unreliable in the following situations • Non-conventional cash flows • Mutually exclusive projects

32. Modified Internal Rate of Return • IRR has some problems that MIRR rectifies. • There is only one MIRR for all projects. • Reinvestment is assumed to be at k. • MIRR can be seen as a more realistic return on invested capital. • To calculate MIRR, you should follow 4 steps:

33. Modified Internal Rate of Return • Create cash flow time line. • Sum the present value of all cash outlays. • Sum the future value of all cash inflows in the project’s final period. • Using only the present value from 2 and the future value from 3, calculate the interest rate.

34. MIRR - Example • As the Chief Financial Officer of Spamway, Corp., you have been presented with the following two potential projects. Assume a 9% discount rate.

35. -$1,500 2 3 4 5 0 1 9% $450 $460 $470 $480 $490 MIRR - Example 1- Steps 1 & 2 Because all outflows are already in present value, no adjustments are needed.

36. -$1,500 $523.20 2 3 4 5 0 1 $558.41 9% $595.71 $635.21 $450 $460 $470 $480 $490 MIRR - Example 1 - Step 3 Future Value = $2,802.53

37. ? -$1,500 $2,802.53 2 3 4 5 0 1 MIRR - Example 1 - Step 4 MIRR = 13.32%

38. 9% -$3,000 $755 $855 $955 $1,054 $1,150 2 3 4 5 0 1 MIRR - Example 2 - Steps 1 & 2 Because all outflows are already in present value, no adjustments are needed.

39. 9% -$3,000 $755 $855 $955 $1,054 $1,150 $1,148.86 2 3 4 5 0 1 $1,134.64 $1,107.25 $1,065.74 MIRR - Example - Step 3 Future Value = $5,606.49

40. ? -$3,000 $5,606.49 2 3 4 5 0 1 MIRR - Example - Step 4 MIRR = 13.32%

41. NPV Profiles • To create an NPV profile, plot NPV on the Y axis and the discount rate on the X axis. • Since the discount rate should be sensitive to changes in project risk, the NPV profile will show how sensitive the projected NPV is to the appropriate discount rate.

42. Crossover Rate 8.1% NPV Profiles - Figure 8-3

43. NPV Profiles • The crossover rate is the rate at which both projects have the same NPV. • If one knows the crossover rate, then one can assess the probability of the discount rate being that low (high), and can better rank the priority of potential projects.

44. NPV Profiles • The slope of the lines in an NPV profile measures the sensitivity of NPV to the discount rate chosen. • In the book’s example the L represents a longer payback and S a shorter payback. • The longer the payback the more sensitive the NPV will be to the discount rate.

45. Independent Projects • If two projects are independent, then adopting one does not affect the firm’s ability to adopt the other. • If two projects are independent, all projects with positive NPV and/or IRR and MIRR greater than the discount rate should be adopted.

46. Independent Projects • All projects with positive NPV add value to the firm. • All projects where IRR or MIRR are greater than the discount rate will bring more return than their cost of capital.

47. Mutually Exclusive Projects • If two projects are mutually exclusive, then the firm can only adopt one of the two projects. • So which of the techniques should be used to decide which project to adopt?

48. Profitability Index • Measures the benefit per unit cost, based on the time value of money • A profitability index of 1.1 implies that for every $1 of investment, we create an additional $0.10 in value • This measure can be very useful in situations where we have limited capital

49. Profitability Index - Example • As the Chief Financial Officer of Spamway, Corp., you have been presented with the following two potential projects. Assume a 9% discount rate.

50. Profitability Index - Example • Step 1 – Calculate the present value of all future cash flows: • PV of G = 1,821.45 • PV of Y = 3,643.83 • Step 2 – Divide the present value from step 1 by the initial outlay: