CHAPTER 9

Net Present Value and Other Investment Criteria

The difference between the market value of a project

and its cost

Estimating NPV: (DCF)

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.

Net Present Value

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.

NPV – Decision Rule

The amount of time required for an

investment to generate cash flows sufficient

to recover its initial cost.

An investment is accepted if its

calculated period is less than some

prespecified number of years

Payback Period

E D C B A Year

-50$ -200$ -200$ -200$ -100 $ 0

100 100 40 40 30 1

-50,000,000 100 20 20 40 2

-200 10 10 50 3

200 130 60 4

Example

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 rule?

Analyzing the rule

short Long Year

-250$ -250$ 0

100 100 1

200 100 2

0 100 3

0 100 4

Example

Advantages Easy to understand Adjusts for uncertainty of later cash flows Biased toward liquidity

Advantages and Disadvantages of Payback

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

The 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 some

prespecified number of years

Discounted Payback Period

Accumulated cash flow

Cash flow

discounted undiscounted

discounted undiscounted

year

89 100 89$ 100$ 1

168 200 79 100 2

238 300 70 100 3

300 400 62 100 4

355 500 55 100 5

Example

Does the discounted payback rule account for the

time value of money?

Does the discounted payback rule account for the

risk of the cash flows?

Does the discounted payback rule provide an

indication about the increase in value?

Should we consider the discounted payback rule for

our primary decision rule?

Decision Criteria Test – Discounted Payback

Advantages Includes time value of money Easy to understand Does not accept negative estimated NPV investments when all future cash flows are positive Biased towards liquidity

Advantages and Disadvantages of Discounted Payback

Disadvantages May reject positive

NPV investments Requires an

arbitrary cutoff point

Ignores cash flows beyond the cutoff point

Biased against long-term projects, such as R&D and new products

Cash flow year

-34,000$ 0

16,000 1

18,000 2

15,000 3

Ex 8 Page 293

Suppose the firm uses the NPV decision rule. At a

required return of 11 percent, should the firm accept

the project? What of the required return was 30

percent?

Cash flow year

-19,500$ 0

9,800 1

10,300 2

8,600 3

Ex 11 Page 294

What is the NPV at a discount rate of zero percent?

What is the payback period for the following

set of cash flows?

Ex 1 Page 292

Cash flow year

-6,400$ 0

1,600 1

1,900 2

2,300 3

1,400 4

An investment project provides cash inflows

of 765$ per year for eight years. What is the

project payback period if the initial cost is

2,400$?

Ex 2 Page 293

An investment project has annual cash

inflows of 4,200$ , 5,300$ , 6,100$ and

7,400$, and a discount rate of 14 percent.

What is the discounted payback period for

these cash flows if the initial cost is 13,000?

Ex 4 Page 293

An investment’s average net income divided

by its average book value

A project is acceptable if its average

accounting return exceeds a target

average accounting return

Average Accounting Return

Suppose we are deciding whether to open a

store in anew shopping mall. The required

investment in improvements is 500,000$.

The store would have a five-year life. The

required investment would be 100 percent

depreciated. The tax rate is 25 percent. Net

income for the five years as follow:

Example

NI year

100,000 1

150,000 2

50,000 3

0 4

-50,000 5

Does the AAR rule account for the time value of money?

Does the AAR rule account for the risk of the cash

flows?

Does the AAR rule provide an indication about the

increase in value?

Should we consider the AAR rule for our primary

decision rule?

Decision Criteria Test - AAR

Advantages

Easy to calculate

Needed information

will usually be available

Advantages and Disadvantages of AAR

Disadvantages

Not a true rate of

return; time value

of money is ignored

Based on

accounting net

income and book

values, not cash

flows and market

values

The discounted rate that makes the NPV of

an investment zero

This is the most important alternative to NPV

An investment is acceptable if the IRR

exceeds the required return

Internal Rate of Return

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?

Decision Criteria Test - IRR

Advantageous

o Closely related to NPV leading to identical

decisions

o Easy to understand and communicate

Advantages and Disadvantages of IRR

NPV directly measures the increase in value

to the firm

Whenever there is a conflict between NPV

and another decision rule, you should

always use NPV

Conflicts Between NPV and IRR

A firm evaluates all of its projects by

applying the IRR. If the required return is 16

percent, should the firm accept the following

project?

Ex 7 Page 293

CF year

-$34,000 0

16,000 1

18,000 2

15,000 3

A project that provides annual cash flows of

28,500$ for nine years costs 138,000$ today.

Is this a good project if the required rate of

return is 20 percent? At what discount rate

would you be indifferent between accepting

the project and rejecting it?

Ex 9 Page 293

The present value of an investment’s future

value cash flows divided by its initial cost.

This measure can be very useful in situations

in which we have limited capital

Profitability Index

Advantages Closely related to NPV, generally leading to

identical decisions Easy to understand and communicate May be useful when available investment

funds are limited

Advantages of Profitability Index

What is the profitability index for the

following set of cash flows if the relevant

discount rate is 22 percent?

Ex 15 Page 294

CF year

-14,000$ 0

7,300 1

6,900 2

5,700 3

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

Capital Budgeting In Practice

An investment project has the following cash flows:

CF0 = -1,000,000; C01 – C08 = 200,000 each

If the required rate of return is 12%, what decision

should be made using NPV?

How would the IRR decision rule be used for this

project, and what decision would be reached?

Comprehensive Problem