Session 6

Why net present value leads to better investment decisions

6049 Corporate Finance Lecture Slides, Academic Year 2010/2011

Session 6: Why Net Present Value Leads to Better Investment Decisions than Other Criteria Hannes Wagner g

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Corporate Finance

Session 6

Why net present value leads to better investment decisions

Topics

• • • •

NPV and alternatives The payback rule The IRR rule Choosing projects with capital rationing

Expectations: › You should have no pproblems with this material Literature: › BMA Chapter p 6

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Corporate Finance

Session 6

Why net present value leads to better investment decisions

NPV and Cash Transfers Every possible method for evaluating projects impacts the flow of cash about the company as follows. Cash

Investment opportunity (real asset)

Firm

Invest

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Shareholder

Alternative: pay dividend to shareholders h h ld -3-

Investment opportunities (financial assets) Shareholders invest for themselves Corporate Finance

Session 6

Why net present value leads to better investment decisions

CFO D Decision i i TTools l Survey Data on CFO Use of Investment Evaluation Techniques

SOURCE: Graham and Harvey, “The Theory and Practice of Finance: Evidence from the Field,” Journal of Financial Economics 61 (2001), pp. 187-243.

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Corporate Finance

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Why net present value leads to better investment decisions

Book Rate of Return Book Rate of Return - Average income divided by average book value over project life. Also called accounting rate of return.

book income Book rate of return  b k assets book Managers g rarelyy use this measurement to make decisions. The components reflect tax and accounting figures, not market values or cash flows. 6049

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Corporate Finance

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Why net present value leads to better investment decisions

Pa back Payback

• The payback period of a project is the number of years it takes before the cumulative forecasted cash flow equals l the th initial i iti l outlay. tl

• The payback rule says only accept projects that “payback” in the desired time frame.

• This method is flawed, primarily because it ignores later year cash flows and the present value of future cash flows. 6049

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Corporate Finance

Session 6

Why net present value leads to better investment decisions

Pa back Payback Example Examine the three projects and note the mistake we would make if we insisted on only taking projects with a payback period of 2 years or less. l

Project

C0

C1

C2

C3

Payback P b k Period

A

-2000 2000

500

500

5000

___

2, 2 624

B

-2000

500

1800

0

___

58

C

-2000 2000 1800

500

0

___

50

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NPV@ 10%

Corporate Finance

Session 6

Why net present value leads to better investment decisions

Impro ement discounted payback Improvement: pa back rule

NPV at 10%

Q: How manyy yyears does the pproject j have to last in order for it to make sense in terms of net present value? Do not use payback to judge investment decisions! 6049

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Corporate Finance

Session 6

Why net present value leads to better investment decisions

Internal Rate of Return Example You can purchase a turbo powered machine tool gadget for $4,000. The investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment? Answer:

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Corporate Finance

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Why net present value leads to better investment decisions

Internal Rate of Return The IRR rule – accept any investment project of the opportunity cost of capital is less than the internal rate of return.

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Why net present value leads to better investment decisions

Internal Rate of Return Pitfall 1 - Lending or Borrowing? • With some cashh flows fl ( noted (as t d below) b l ) the th NPV off the th project j t increases i as the th discount rate increases.

•

This is contrary to the normal relationship between NPV and discount rates. rates

Project A B

C0  1, 000  1, 000

C1  1,500  1,500

IRR  50 %  50 %

NPV @ 10 %  364  364

1500 1500 0r   1  0.5 05 1 r 1000 1500 1500 B : 1000  0r   1  0.5 05 1 r 1000 A : 1000 

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Corporate Finance

Session 6

Why net present value leads to better investment decisions

Internal Rate of Return Pitfall 2 - Multiple Rates of Return • Certain cash flows can generate NPV=0 at two different discount rates. • The following cash flow generates NPV=0 at both IRR% of ((-44%)) and +11.6%. • Reason is the double change in sign of the cashflows • There can be as manyy IRRs as there are sign g NPV changes 600 • Large end-of investment negative cashflows are not rare – examples? IRR=11 6% IRR=11.6% 300

Discount Rate

0 -30 -600

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IRR=-44%

Cash Flows in millions

C0  600

C 1 ...... - 12 - 120

...... C 9 120

C 10  150

Corporate Finance

Session 6

Why net present value leads to better investment decisions

Internal Rate of Return Pitfall 2 - Multiple Rates of Return

•

It is possible to have NO IRR and a positive NPV Project j C

•

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C0

C1

C2

IRR

1, 000 3, 000 2,500 None

NPV @10% @ 339

Q: How does the NPV function look like here?

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Why net present value leads to better investment decisions

Internal Rate of Return Pitfall i f ll 3 - Mutually ll Exclusive l i Projects j • IRR sometimes ignores the magnitude of the project. • The following two projects illustrate that problem.

Project C0 C1 IRR D 10, 000 20, 000 100% E

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20, 000 35, 000 75%

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NPV @10% 8,182 11,818

Corporate Finance

Session 6

Why net present value leads to better investment decisions

We can save the IRR rule by looking at incremental CFs in this case

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Why net present value leads to better investment decisions

...but but what hat about these projects?

Assume cost of capital is 10%

• •

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Note that project G generates 1,800 in perpetuity. If you compare F and G, which project do you choose?

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Corporate Finance

Session 6

Why net present value leads to better investment decisions

Internal Rate of Return Pitfall 3 - Mutually Exclusive Projects

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Corporate Finance

Session 6

Why net present value leads to better investment decisions

Internal Rate of Return Pitfall 4 - Term Structure Assumption • Wee assu assumee tthat at ddiscount scou t rates ates aaree stable du during g tthee term of the project. • This assumption implies that all funds are reinvested at the IRR. • This is a false assumption. assumption • How to resolve this?

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Corporate Finance

Session 6

Why net present value leads to better investment decisions

Profitabilit Index Profitability Inde

• When resources are limited, the profitability index • •

(PI) provides a tool for selecting among various project j t combinations bi ti andd alternatives lt ti A set of limited resources and projects can yield various i combinations. bi ti The highest weighted average PI can indicate which projects j t to t select. l t NVP Profitability index= investment

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Corporate Finance

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Why net present value leads to better investment decisions

P fit bilit IIndex Profitability d

The simple case with one constraint works…

…but but not one with more than one constraint:

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Corporate Finance

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Why net present value leads to better investment decisions

BMA Quiz Qui 1

a) What is the payback period on each of the following projects? b) Given that you wish to use the payback rule with a cutoff period of two years, which projects would you accept? c) If you use a cutoff period of three years, which projects would you accept? t? d) If the cost of capital is 10%, which projects have positive NPV? 6049

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Corporate Finance

Session 6

Why net present value leads to better investment decisions

BMA Quiz Qui 1

e) „If a firm uses a single cutoff period for all projects, it is likely to accept too many short-lived projects.“ True or false? f) If the firm uses the discounted payback rule, will it accept any negative-NPV ti NPV projects? j t ? Will it turn t d down positive-NPV iti NPV projects? j t? Explain!

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Corporate Finance

Session 6

Why net present value leads to better investment decisions

Re ie material Review

• • • •

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BMA summary pp. 134-135 Selected BMA problems Homework assignment BMA quiz questions, online at www.mhhe.com/bma9e

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Corporate Finance