CHAPTER Some Alternative Investment Rules Chapter Outline 6.1 ...

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2005 The McGraw-Hill Companies, Inc. All Rights Reserved. CHAPTER. 6. Some Alternative. Investment Rules. 6-1. McGraw-Hill/Irwin. Corporate Finance, 7/e.
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Chapter Outline CHAPTER

6

Some Alternative Investment Rules McGraw-Hill/Irwin Corporate Finance, 7/e

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6.1 Why Use Net Present Value? 6.2 The Payback Period Rule 6.3 The Discounted Payback Period Rule 6.4 The Average Accounting Return 6.5 The Internal Rate of Return 6.6 Problems with the IRR Approach 6.7 The Profitability Index 6.8 The Practice of Capital Budgeting 6.9 Summary and Conclusions McGraw-Hill/Irwin Corporate Finance, 7/e

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6.1 Why Use Net Present Value?

The Net Present Value (NPV) Rule Net Present Value (NPV) = Total PV of future CF’s + Initial Investment

Accepting positive NPV projects benefits shareholders. 9 NPV uses cash flows 9 NPV uses all the cash flows of the project 9 NPV discounts the cash flows properly

Estimating NPV: 1. Estimate future cash flows: how much? and when? 2. Estimate discount rate 3. Estimate initial costs

Minimum Acceptance Criteria: Accept if NPV > 0 Ranking Criteria: Choose the highest NPV McGraw-Hill/Irwin Corporate Finance, 7/e

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Good Attributes of the NPV Rule 1. Uses cash flows 2. Uses ALL cash flows of the project 3. Discounts ALL cash flows properly Reinvestment assumption: the NPV rule assumes that all cash flows can be reinvested at the discount rate.

6.2 The Payback Period Rule How long does it take the project to “pay back” its initial investment? Payback Period = number of years to recover initial costs Minimum Acceptance Criteria: set by management

Ranking Criteria: set by management

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The Payback Period Rule (continued)

6.5 The Internal Rate of Return (IRR) Rule

Disadvantages:

IRR: the discount that sets NPV to zero Minimum Acceptance Criteria:

Ignores the time value of money Ignores cash flows after the payback period Biased against long-term projects Requires an arbitrary acceptance criteria A project accepted based on the payback criteria may not have a positive NPV

Accept if the IRR exceeds the required return.

Ranking Criteria: Select alternative with the highest IRR

Reinvestment assumption: All future cash flows assumed reinvested at the IRR.

Disadvantages: Does not distinguish between investing and borrowing. IRR may not exist or there may be multiple IRR Problems with mutually exclusive investments

Advantages:

Advantages:

Easy to understand Biased toward liquidity McGraw-Hill/Irwin Corporate Finance, 7/e

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Easy to understand and communicate

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Multiple IRRs

6.6 Problems with the IRR Approach

There are two IRRs for this project: $200

Multiple IRRs. Are We Borrowing or Lending? The Scale Problem The Timing Problem

NPV

0 -$200

$800

1

2

Which one should we use?

3 - $800

$100.00

100% = IRR2

$50.00 $0.00 -50% 0% ($50.00)

50%

100%

150%

0% = IRR1

200%

Discount rate

($100.00) ($150.00) McGraw-Hill/Irwin Corporate Finance, 7/e

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The Scale Problem Would you rather make 100% or 50% on your investments? What if the 100% return is on a $1 investment while the 50% return is on a $1,000 investment?

The Timing Problem $10,000

$1,000

$1,000

Project A 0

1

-$10,000

2 $1,000

3 $1,000

$12,000

Project B 0

1

2

3

-$10,000 The preferred project in this case depends on the discount rate, not the IRR. McGraw-Hill/Irwin Corporate Finance, 7/e

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Mutually Exclusive vs. Independent Project

The Timing Problem $5,000.00

Mutually Exclusive Projects: only ONE of several potential projects can be chosen, e.g. acquiring an accounting system.

$4,000.00

Project A

$3,000.00

Project B 10.55% = crossover rate

NPV

$2,000.00 $1,000.00

RANK all alternatives and select the best one.

$0.00 ($1,000.00) 0%

10%

20%

30%

40%

Independent Projects: accepting or rejecting one project does not affect the decision of the other projects.

($2,000.00) ($3,000.00) ($4,000.00)

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12.94% = IRRB 16.04% = IRRA Discount rate © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

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Must exceed a MINIMUM acceptance criteria. McGraw-Hill/Irwin Corporate Finance, 7/e

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6.7 The Profitability Index (PI) Rule

6.8 The Practice of Capital Budgeting

Total PV of Future Cash Flows PI = Initial Investent

Varies by industry: Some firms use payback, others use accounting rate of return.

Minimum Acceptance Criteria: Accept if PI > 1

Ranking Criteria:

The most frequently used technique for large corporations is IRR or NPV.

Select alternative with highest PI

Disadvantages: Problems with mutually exclusive investments

Advantages: May be useful when available investment funds are limited Easy to understand and communicate Correct decision when evaluating independent projects McGraw-Hill/Irwin Corporate Finance, 7/e

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Example of Investment Rules Compute the IRR, NPV, PI, and payback period for the following two projects. Assume the required return is 10%. Year 0 1 2 3 McGraw-Hill/Irwin Corporate Finance, 7/e

Project A -$200 $200 $800 -$800

Project B -$150 $50 $100 $150 © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

Example of Investment Rules CF0 PV0 of CF1-3 NPV = IRR = PI = McGraw-Hill/Irwin Corporate Finance, 7/e

Project A -$200.00 $241.92

Project B -$150.00 $240.80

$41.92 0%, 100% 1.2096

$90.80 36.19% 1.6053

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Relationship Between NPV and IRR

Example of Investment Rules Payback Period: Project A Project B Time CF Cum. CF CF Cum. CF 0 -200 -200 -150 -150 1 200 0 50 -100 2 800 800 100 0 3 -800 0 150 150 Payback period for project B = 2 years. Payback period for project A = 1 or 3 years? McGraw-Hill/Irwin Corporate Finance, 7/e

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Discount rate NPV for A -10% -87.52 0% 0.00 20% 59.26 40% 59.48 60% 42.19 80% 20.85 100% 0.00 120% -18.93 McGraw-Hill/Irwin Corporate Finance, 7/e

NPV for B 234.77 150.00 47.92 -8.60 -43.07 -65.64 -81.25 -92.52

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NPV

NPV Profiles

6.9 Summary and Conclusions

$400 $300

IRR 1(A)

IRR (B)

This chapter evaluates the most popular alternatives to NPV:

IRR 2(A)

$200 $100 $0 -15%

0%

15%

30%

45%

70%

100% 130% 160% 190%

($100) ($200)

Cross-over Rate McGraw-Hill/Irwin Corporate Finance, 7/e

Discount rates

Project A Project B

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Payback period Accounting rate of return Internal rate of return Profitability index

When it is all said and done, they are not the NPV rule; for those of us in finance, it makes them decidedly second-rate. McGraw-Hill/Irwin Corporate Finance, 7/e

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