Chapter 5: Net present value and other investment rules Corporate Finance Ross, Westerfield, and Jaffe
Outline 1. Net present value (NPV) 2. The payback period method 3. The discounted payback period method 4. The Internal rate of return (IRR) 5. The profitability index
Capital Budjeting • The capital budgeting process is the process of identifying and evaluating capital projects, that is, projects where the cash How to the firm will be received over a period longer than a year.
Example • Any corporate decisions with an impact on future earnings can be examined using this framework. • Decisions about whether to buy a new machine, expand business in another geographic area, move the corporate headquarters to Cleveland, or replace a delivery truck, to name a few, can be examined using a capital budgeting analysis.
Responsibility of a Financial manger • For a number of good reasons, capital budgeting may be the most important responsibility that a financial manager has. • First, because a capital budgeting decision often involves the purchase of costly long-term assets with lives of many years, the decisions made may determine the future success of the firm.
Responsibility of a Financial manger • Second, the principles underlying the capital budgeting process also apply to other corporate decisions, such as working capital management and making strategic mergers and acquisitions. • Finally, making good capital budgeting decisions is consistent with management's primary goal of maximizing shareholder value.
Basic Principles Of Capital Budgeting • The capital budgeting process involves five key principles: 1. Decisions are based o n cash flows, not accounting income. • The relevant cash flows to consider as part of the capital budgeting process are incremental cash flows, the changes in cash flows that will occur if the project is undertaken.
Basic Principles Of Capital Budgeting • Sunk costs are costs that cannot be avoided, even if the project is not undertaken. • Because these costs are not affected by the accept/reject decision, they should not be included in the analysis. • An example of a sunk cost is a consulting fee paid to a marketing research firm to estimate demand for a new product prior to a decision on the project
Basic Principles Of Capital Budgeting • Externalities are the effects the acceptance of a project may have on other firm cash flows. • The primary one is a negative externality called cannibalization, which occurs when a new project takes sales from an existing product. • When considering externalities, the full implication of the new project (loss in sales of existing products) should be taken into account.
Basic Principles Of Capital Budgeting • An example of cannibalization is when a soft drink company introduces a diet version of an existing beverage. • The analyst should subtract the lost sales of the existing beverage from the expected new sales of the diet version when estimated incremental project cash flows. • A positive externality exists when doing the project would have a positive effect on sales of a firm's other product lines.
Basic Principles Of Capital Budgeting • A project has a conventional cash flow pattern if the sign on the cash flows changes only once, with one or more cash outflows followed by one or more cash inflows. • An unconventional cash flow pattern has more than one sign change. • For example, a project might have an initial investment outflow, a series of cash inflows, and a cash outflow for asset retirement costs at the end of the project's life.
Basic Principles Of Capital Budgeting 2 . Cash flows are based on opportunity costs. • Opportunity costs are cash flows that a firm will lose by undertaking the project under analysis. • These are cash flows generated by an asset the firm already owns that would be forgone if the project under consideration is undertaken. • Opportunity costs should be included in project costs.
Basic Principles Of Capital Budgeting • For example, when building a plant, even if the firm already owns the land, the cost of the land should be charged to the project because it could be sold if not used.
Basic Principles Of Capital Budgeting 3. The timing of cash flows is important. • Capital budgeting decisions account for the time value of money, which means that cash flows received earlier are worth more than cash flows to be received later. 4. Cash flows are analyzed on an after-tax basis. • The impact of taxes must be considered when analyzing all capital budgeting projects. value is based on cash flows they get to keep, not those they send to the government.
Basic Principles Of Capital Budgeting 5 .Financing costs are reflected in the project's required rate of return. • Do not consider financing costs specific to the project when estimating incremental cash flows. • The discount rate used in the capital budgeting analysis takes account of the firm's cost of capital. • Only projects that are expected to return more than the cost of the capital needed to fund them will increase the value of the firm.
Basic Theme • An investment is worth undertaking if it creates value for its owners. • In the most general sense, we create value by identifying an investment worth more in the marketplace than it costs us to acquire. • How can something be worth more than it costs? It’s a case of the whole being worth more than the cost of the parts.
Example • suppose you buy a run-down house for $25,000 and spend another $25,000 on painters, plumbers, and so on to get it fixed up. Your total investment is $50,000. When the work is completed, you place the house back on the market and find that it’s worth $60,000. • The market value ($60,000) exceeds the cost ($50,000) by $10,000. What you have done here is to act as a manager and bring together some fixed assets (a house), some labor (plumbers, carpenters, and others), and some materials (carpeting, paint, and so on). The net result is that you have created $10,000 in value. Put another way, this $10,000 is the value added by management.
NPV • Net present value is a measure of how much value is created or added today by undertaking an investment. • The NPV is the sum of the present values of all the expected incremental cash flows (+/-) if a project is undertaken. • A positive NPV project is expected to increase shareholder wealth, a negative NPV project is expected to decrease shareholder wealth, and a zero NPV project has no expected effect on shareholder wealth.
1st method: the NPV rule • NPV = PV – C0: the difference between the present value of the investment’s future net cash flows, i.e., benefits, and its initial cost. • Ideas: (1) an investment is worth undertaking if it creates value for its owners, and (2) an investment creates value if it worth more than it costs within the time value of money framework (Chapter 4).
Decision rule • If NPV > = 0, accept the project. • If NPV < 0, reject the project. • A positive NPV suggests that the project is expected to add value to the firm, and the project should improve shareholders’ wealth. • Because the goal of financial management is to increase shareholders’ wealth, NPV is a good measure of how well this project will meet this goal.
A proposed project • Your company is looking at a new project that has the following cash flows. • Year 0: initial cost, C0 = $100,000. • Year 1: CF1 = $30,000. • Year 2: CF2 = $50,000. • Year 3: CF3 = $60,000. • The applicable discount rate is 10%.
Judging the NPV rule • Does the NPV rule take the time value of money into consideration? • Does the NPV rule adjust for risk? • Does the NPV rule tell us whether and by how much the project add value to the firm?
Finally, they listen • CFOs are using what academics consider better measures in their capital-budgeting analysis. According to a recent survey, more than 85 percent say they use net present value (NPV) analysis in at least three out of four decisions…."Finance textbooks have taught for years that NPV is superior, but this is the first known survey to show it's the preferred tool," says co-author Patricia A. Ryan, a professor of corporate finance at Colorado State University. • Source: CFO.com.
2nd method: payback period • Payback period: the amount of time required for an investment to generate after-tax cash flows sufficient to recover its initial cost.
Decision rule • An investment is accepted (rejected), if payback period < (>) some specified number of time period. • The cutoff is arbitrarily chosen by the manager or the entrepreneur.
The decision • The payback period is longer than 2 years and shorter than 3 years. • If the cutoff is 2 years, we’d reject the project. • If the cutoff is 3 years, we’d accept the project.
Judging the payback period rule • Does the payback period rule take the time value of money into consideration? • Does the payback period rule adjust for risk? • Does the payback period rule tell us whether and by how much the project add value to the firm?
The good and the bad • Advantage: • Easy to understand and communicate. • Disadvantages: • Ignores the time value of money. • Fail to consider the riskness of the project, no i. • Requires an arbitrary cutoff point.(no economic rationale) • Ignores cash flows beyond the cutoff. • Biased against long-term projects, such as R&Ds.
The good and the bad Analysis • Now that we know how to calculate the payback period on an investment, using the payback period rule for making decisions is straightforward. • A particular cutoff time is selected—say, two years—and all investment projects that have payback periods of two years or less are accepted, whereas any that pay off in more than two years are rejected
The good and the bad Analysis • Now we have a problem. The NPV of the shorter-term investment is actually negative, meaning that taking it diminishes the value of the shareholders’ equity. The opposite is true for the longer-term investment—it increases share value. • Our example illustrates two primary hat shortcomings of the payback period rule. • First, by ignoring time value, we may be led to take investments (like Short) that actually are worthless than they cost. • Second, by ignoring cash flows beyond the cutoff, we may be led to reject profi table long-term investments (like Long). • More generally, using a payback period rule will tend to bias us toward shorter-term investments
3rd method: discounted payback period • Discounted payback period: the length of time required for an investment’s discounted cash flows to equal its initial cost.
Decision rule • An investment is accepted (rejected), if discounted payback period < (>) some specified number of time period. • Again, the cutoff is arbitrarily chosen.
The decision • The discounted payback period is longer than 2 years and shorter than 3 years. • If the cutoff is 2 years, we’d reject the project. • If the cutoff is 3 years, we’d accept the project.
Judging discounted payback period • Does the payback period rule take the time value of money into consideration? • Does the payback period rule adjust for risk? • Does the payback period rule tell us whether and by how much the project add value to the firm?
The good and the bad • Advantage: • Still fairly easy to understand and communicate. • Take TVM into consideration. • Disadvantages: • Requires an arbitrary cutoff point. • Ignores cash flows beyond the cutoff. • Biased against long-term projects, such as R&Ds.
4th method: IRR • IRR: the discounted rate that makes the NPV of an investment zero.
Decision rule • An investment is accepted (rejected), if the IRR > (<) the required rate.
The decision • The computed IRR is 17%, which is higher than the 10% required rate. Thus, we accept the project.
Judging the IRR • Does the IRR rule take the time value of money into consideration? • Does the IRR rule adjust for risk? • Does the IRR rule tell us whether and by how much the project add value to the firm?