Net Present Value Other Investment Criteria FIL 240 Prepared by Keldon Bauer 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 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 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 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 NPV Example 1 0 1 2 3 4 5 450 460 470 480 490 9 1 500 412 84 387 17 362 93 340 04 318 47 321 45 Net Present Value NPV Example 2 0 1 2 3 755 855 955 9 3 000 692 66 719 64 737 44 746 68 747 42 643 83 Net Present Value 4 5 1 054 1 150 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 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 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 Payback Period Steps 1 2 3 4 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 P a y b a c k P e r io d A CF CF A A 1 Payback Period Example 1 0 1 2 3 4 5 1 500 450 460 470 480 490 Step 2 1 500 1 050 590 120 360 850 Cumulative Step 1 Step 3 Step 4 Last negative year is 3 P A CF CF A A 1 3 120 480 3 2 5 y e a r s Payback Period Example 2 0 1 2 3 4 5 3 000 755 855 955 1 054 1 150 1 390 435 619 Step 1 Step 2 3 000 2 245 Step 3 Step 4 Last negative year is 3 P A CF CF A A 1 3 1 769 Cumulative 435 1 0 5 4 3 4 1 y e a r s 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 Advantages and Disadvantages of Payback 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 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 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 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 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 IRR Example 1 0 1 500 1 2 3 4 5 450 460 470 480 490 IRR 16 82 IRR Example 2 0 3 000 1 2 3 4 5 755 855 955 1 054 1 150 IRR 16 37 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 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 Multiple IRRs Example Since the IRR is defined as the discount rate which yields an NPV of zero 2 5 0 0 0 2 5 0 0 0 N P V 4 0 0 0 0 2 1 k 1 k 25 25 4 1 k 1 k 2 0 Multiple IRRs Example Multiplying both sides by 1 k 2 yields 4 1 2 k k 2 25 25k 25 0 4 17k 4k 2 0 Factoring the above polynomial 4 k 1 k 4 0 k IRR 25 or 400 Multiple IRRs Example 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 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 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 …