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Chapter Seven : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-1 Chapter Seven Net Present Value and Other Investment Criteria

Chapter Organisation : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-2 7.1 Net Present Value 7.2 The Payback Rule 7.3 The Discounted Payback Rule 7.4 The Accounting Rate of Return 7.5 The Internal Rate of Return 7.6 The Present Value Index 7.7 The Practice of Capital Budgeting 7.8 Summary and Conclusions Chapter Organisation

Chapter Objectives : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-3 Chapter Objectives Discuss the various investment evaluation techniques, including their advantages and disadvantages. Apply these techniques to the evaluation of projects. Interpret the results of the application of these techniques in accordance with their respective decision rules. Understand the importance of net present value.

Net Present Value (NPV) : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-4 Net Present Value (NPV) Net present value is the difference between an investment’s market value (in today’s dollars) and its cost (also in today’s dollars). Net present value is a measure of how much value is created by undertaking an investment. Estimation of the future cash flows and the discount rate are important in the calculation of the NPV.

Net Present Value : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-5 Net Present Value Steps in calculating NPV: 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.

NPV Illustrated : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-6 NPV Illustrated 0 1 2 Initial outlay ($1100) Revenues $1000 Expenses 500 Cash flow $500 Revenues $2000 Expenses 1000 Cash flow $1000 – $1100.00 +454.55 +826.45 +$ 181.00 1 $500 x 1.10 1 $1000 x 1.10 2 NPV

NPV : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-7 NPV An investment should be accepted if the NPV is positive and rejected if it is negative. NPV is a direct measure of how well the investment meets the goal of financial management—to increase owners’ wealth. A positive NPV means that the investment is expected to add value to the firm.

Payback Period : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-8 Payback Period The amount of time required for an investment to generate cash flows to recover its initial cost. Estimate the cash flows. Accumulate the future cash flows until they equal the initial investment. The length of time for this to happen is the payback period. An investment is acceptable if its calculated payback is less than some prescribed number of years.

Payback Period Illustrated : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-9 Payback Period Illustrated Initial investment = –$1000 Year Cash flow 1 $200 2 400 3 600 Accumulated Year Cash flow 1 $200 2 600 3 1200 Payback period = 2 2/3 years

Advantages of Payback Period : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-10 Advantages of Payback Period Easy to understand. Adjusts for uncertainty of later cash flows. Biased towards liquidity.

Disadvantages of Payback Period : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-11 Disadvantages of Payback Period Time value of money and risk ignored. Arbitrary determination of acceptable payback period. Ignores cash flows beyond the cut-off date. Biased against long-term and new projects.

Discounted Payback Period : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-12 Discounted Payback Period The length of time required for an investment’s discounted cash flows to equal its initial cost. Takes into account the time value of money. More difficult to calculate. An investment is acceptable if its discounted payback is less than some prescribed number of years.

Example—Discounted Payback : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-13 Example—Discounted Payback Initial investment = —$1000 R = 10% PV of Year Cash flow Cash flow 1 $200 $182 2 400 331 3 700 526 4 300 205

Example—Discounted Payback (continued) : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-14 Example—Discounted Payback (continued) Accumulated Year discounted cash flow 1 $182 2 513 3 1039 4 1244 Discounted payback period is just under three years

Ordinary and Discounted Payback : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-15 Ordinary and Discounted Payback Initial investment = –$300 R = 12.5% Ordinary payback? Discounted payback?

Advantages and Disadvantages of Discounted Payback : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-16 Advantages and Disadvantages of Discounted Payback Advantages - Includes time value of money - Easy to understand - Does not accept negative estimated NPV investments - Biased towards liquidity Disadvantages May reject positive NPV investments Arbitrary determination of acceptable payback period Ignores cash flows beyond the cutoff date Biased against long-term and new products

Accounting Rate of Return (ARR) : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-17 Accounting Rate of Return (ARR) Measure of an investment’s profitability. A project is accepted if ARR > target average accounting return.

Example—ARR : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-18 Example—ARR Year 1 2 3 Sales $440 $240 $160 Expenses 220 120 80 Gross profit 220 120 80 Depreciation 80 80 80 Taxable income 140 40 0 Taxes (25%) 35 10 0 Net profit $105 $30 $0 Assume initial investment = $240

Example—ARR (continued) : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-19 Example—ARR (continued)

Example—ARR (continued) : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-20 Example—ARR (continued)

Disadvantages of ARR : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-21 Disadvantages of ARR The measure is not a ‘true’ reflection of return. Time value is ignored. Arbitrary determination of target average return. Uses profit and book value instead of cash flow and market value.

Advantages of ARR : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-22 Advantages of ARR Easy to calculate and understand. Accounting information almost always available.

Internal Rate of Return (IRR) : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-23 Internal Rate of Return (IRR) The discount rate that equates the present value of the future cash flows with the initial cost. Generally found by trial and error. A project is accepted if its IRR is > the required rate of return. The IRR on an investment is the required return that results in a zero NPV when it is used as the discount rate.

Example—IRR : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-24 Example—IRR Initial investment = –$200 Year Cash flow 1 $ 50 2 100 3 150 n Find the IRR such that NPV = 0 50 100 150 0 = –200 + + + (1+IRR) 1 (1+IRR) 2 (1+IRR) 3 50 100 150 200 = + + (1+IRR) 1 (1+IRR) 2 (1+IRR) 3

Example—IRR (continued) : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-25 Example—IRR (continued) Trial and Error Discount rates NPV 0% $100 5% 68 10% 41 15% 18 20% –2 IRR is just under 20%—about 19.44%

NPV Profile : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-26 NPV Profile Year Cash flow 0 – $275 1 100 2 100 3 100 4 100 Discount rate 2% 6% 10% 14% 18% 120 100 80 60 40 20 Net present value 0 – 20 – 40 22% IRR

Problems with IRR : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-27 Problems with IRR More than one negative cash flow  multiple rates of return. Project is not independent  mutually exclusive investments. Highest IRR does not indicate the best project. Advantages of IRR Popular in practice Does not require a discount rate

Multiple Rates of Return : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-28 Multiple Rates of Return Assume you are considering a project for which the cash flows are as follows: Year Cash flows 0 –$252 1 1431 2 –3035 3 2850 4 –1000

Multiple Rates of Return : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-29 Multiple Rates of Return n What’s the IRR? Find the rate at which the computed NPV = 0: at 25.00%: NPV = 0 at 33.33%: NPV = 0 at 42.86%: NPV = 0 at 66.67%: NPV = 0 n Two questions: u 1. What’s going on here? u 2. How many IRRs can there be?

Multiple Rates of Return : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-30 Multiple Rates of Return $0.06 $0.04 $0.02 $0.00 ($0.02) NPV ($0.04) ($0.06) ($0.08) 0.2 0.28 0.36 0.44 0.52 0.6 0.68 IRR = 25% IRR = 33.33% IRR = 42.86% IRR = 66.67% Discount rate

IRR and Non-conventional Cash Flows : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-31 IRR and Non-conventional 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, you cannot use any of them to make your decision.

IRR, NPV and Mutually-exclusive Projects : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-32 IRR, NPV and Mutually-exclusive Projects Discount rate 2% 6% 10% 14% 18% 60 40 20 0 – 20 – 40 Net present value – 60 – 80 – 100 22% IRR A IRR B 0 140 120 100 80 160 Year 0 1 2 3 4 Project A: – $350 50 100 150 200 Project B: – $250 125 100 75 50 26% Crossover Point

Present Value Index (PVI) : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-33 Present Value Index (PVI) Expresses a project’s benefits relative to its initial cost. Accept a project with a PVI > 1.0.

Example—PVI : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-34 Example—PVI Assume you have the following information on Project X: Initial investment = –$1100 Required return = 10% Annual cash revenues and expenses are as follows: Year Revenues Expenses 1 $1000 $500 2 2000 1000

Example—PVI (continued) : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-35 Example—PVI (continued) Net Present Value Index = 181 1100 = 0.1645

Example—PVI (continued) : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-36 Example—PVI (continued) Is this a good project? If so, why? This is a good project because the present value of the inflows exceeds the outlay. Each dollar invested generates $1.1645 in value or $0.1645 in NPV.

Advantages and Disadvantages of PVI (and NPVI) : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-37 Advantages and Disadvantages of PVI (and NPVI) Advantages - Closely related to NPV, generally leading to identical decisions. - Easy to understand. - May be useful when available investment funds are limited. Disadvantages - May lead to incorrect decisions in comparisons of mutually exclusive investments.

Capital Budgeting in Practice : 

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 7-38 Capital Budgeting in Practice We should consider several investment criteria when making decisions. NPV and IRR are the most commonly used primary investment criteria. Payback is a commonly used secondary investment criteria.