Chapter 9 Net Present Value Other Investment Criteria Net Present Value capital budgeting is probably the most important issue in corporate finance how a firm chooses to finance its operations how it manages its short term operating activities the financial manager must examine a potential investment in light of its likely effect on the price of the firm s shares an investment is worth taking if it creates value for its owners We create value by identifying an investment worth more in the market place than it costs us to acquire it the real challenge is to somehow identify value ahead of time net present value NPV difference between an investment s market value and costs o measure of how much value is created today by undertaking an investment First estimate future cash flows Second apply discounted cash flows to estimate PV Discounted cash flow DCF valuation process of valuing an investment by discounting its future cash flows Npv required rate of return initial investment CF1 CF2 If NPV is negative REJECT investment if NPV is positive ACCEPT investment The Payback Rule investment payback is the length of time it takes to recover an initial investment How many years do we have to wait until the accumulated cash flows from this investment equal exceed the cost of the Payback period amount of time required for an investment to generate cash flows sufficient to recover its initial cost Payback rule an investment is ACCEPTABLE if its payback period is less than the prespecified number of years REJECT investment is payback period is more than prespecified number of years Advantages Disadvantages of the Payback Period Rule Disadvantages Advantages 1 Easy to understand 2 Adjusts for uncertainty of later cash flows 3 Biased towards liquidity computation of payback period 1 2 3 ignores time value of money requires an arbitrary cutoff point ignores cash flows outside cutoff point estimate cash flows subtract future cash flows from initial cost UNTIL investment has been recovered o o o number of subtractions payback period o compare computed number of years to prespecified number The Discounted Payback discounted payback period length of time required for an investment s discounted cash flows to equal its initial cost an investment is ACCEPTABLE if its discounted payback is less than the prespecified number of years REJECT if payback is more than prespecified number of years If a project even pays back on a discounted basis then it must have a positive NPV therefore we won t accidentally take any projects with an estimated negative NPV Advantages 1 2 Easy to understand 3 Does not accept negative NPV investments Includes time value of money The Internal Rate of Return IRR Advantages Disadvantages of the Discounted Payback Period Rule Disadvantages 1 May reject positive NPV investments 2 Requires an arbitrary cutoff point IRR discount rate that makes the NPV of an investment zero o IRR initial investment CF1 CF2 leave out R IRR Rule an investment is ACCEPTABLE if the IRR Required return REJECT is IRR R With the IRR we try to find a single rate that summarizes the merits of a project We want this rate to be an internal rate in the sense that it depends only on the cash flows of a particular investment To find break even discount rate we set NPV 0 and solve for R The IRR is sometimes called the counted cash flow return NPV Profile graphical representation of relationship between NPVs and discount rates NPV on y axis Discount rate on x axis NPV and IRR Rules come to the same conclusions IF cash flows are conventional first is negative the rest are positive o o Project is independent decision to accept reject does not depend on another project Multiple rates of return possibility that more than one discount rate will make NPV 0 nonconventional cash flows o Npv R NI CF1 CF2 accept if NPV is positive o Accept if discount rate is between 2 calculated rates on NPV profile o IRR NI CF1 CF2 accept if IRR is greater than R Mutually exclusive investment decisions taking one investment prevents taking another When comparing investments to determine which is best we need to look at relative NPVs the option with the higher NPV is preferred Advantages 1 Closely related to NPV 2 Easy to understand or communicate The Modified Internal Rate of Return MIRR 1 The Discounting Approach Advantages Disadvantages of the IRR Disadvantages 1 May result in multiple answers 2 May lead to incorrect decision regarding mutually exclusive investments a Discount all negative cash flows back to the present at the required return b Add them to the initial cost c Calculate IRR 2 The Reinvestment Approach a Compound all cash flows except the first out to the end of the project s life b Calculate IRR 3 The Combination Approach a Negative cash flows are discounted back to the present b Positive cash flows are compounded to the read of the project The Profitability Index profitability index present value of an investment s future cash flows divided by its initial cost benefit cost ratio ACCEPT investment if PI 1 REJECT is PI 1 PI cannot be used to rank mutually exclusive projects