Transcript Slide 1
Principles of Corporate Finance Chapter 5 Why Net Present Value Leads to Better Investment Decisions Than Other Criteria McGraw-Hill/Irwin Eighth Edition Slides by Matthew Will Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 2 Topics Covered A Review of The Basics – NPV and its Competitors The Payback Period – The Book Rate of Return Internal Rate of Return Capital Rationing McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 3 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 McGraw-Hill/Irwin Shareholder Alternative: pay dividend to shareholders Investment opportunities (financial assets) Shareholders invest for themselves Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 4 CFO Decision Tools Survey Data on CFO Use of Investment Evaluation Techniques NPV, 75% IRR, 76% Payback, 57% Book rate of return, 20% Profitability Index, 12% 0% 20% 40% 60% 80% 100% SOURCE: Graham and Harvey, “The Theory and Practice of Finance: Evidence from the Field,” Journal of Financial Economics 61 (2001), pp. 187-243. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 5 Net Present Value (NPV) NPV = The difference between an investment’s market value (=present value) and its cost An investment should be accepted if the NPV is positive, and rejected otherwise McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 6 NPV Example Your company is worth three million, 1 million in cash and 2 million in other assets There are 500.000 shares outstanding, the expected return on these stock is 12 % You are offered an investment costing one million and offering cash flows of 300.000 per year for five years. Should you accept the offer? McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 7 NPV Example cont. PV = 300.000(1/0.12 – 1/0.12(1.12)5) = 1.081.432 NPV = -1.000.000 + 1.081,432 = 81,432 Accept because NPV > 0 Rationale: – Share price will increase by 16 cents: • from 6,00 euros to 6,16 euros What if required return were 17%? – NPV = -40.196 – Share price would decrease by 8 cents McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 8 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 book assets Managers rarely use this measurement to make decisions. The components reflect tax and accounting figures, not market values or cash flows. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 9 Payback The payback period of a project is the number of years it takes before the cumulative forecasted cash flow equals the initial outlay. 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 the present value of future cash flows. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 10 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. Project C0 C1 A B - 2000 - 2000 500 500 C - 2000 1800 McGraw-Hill/Irwin C2 C3 Payback Period NPV@ 10% 500 5000 1800 0 500 0 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 11 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. Payback C2 C3 Period 500 5000 3 1800 0 2 Project C0 C1 A B - 2000 - 2000 500 500 C - 2000 1800 McGraw-Hill/Irwin 500 0 2 NPV@ 10% 2,624 - 58 50 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 12 Internal Rate of Return The discount rate that makes NPV zero Accept the project, if Internal Rate of Return is greater than the Required return, IRR > r McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 13 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? McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 14 Internal Rate of Return Example You can purchase a turbo powered machine tool gadget for $4,000. The investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment? 2,000 4,000 NPV 4,000 0 1 2 (1 IRR ) (1 IRR ) IRR 28.08% McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 15 Internal Rate of Return 2500 2000 IRR=28% 1000 500 10 0 90 80 70 60 50 40 30 -500 20 0 10 NPV (,000s) 1500 -1000 -1500 -2000 Discount rate (%) McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 16 Internal Rate of Return Pitfall 1 - Lending or Borrowing? With some cash flows (as noted below) the NPV of the project increases s the discount rate increases. This is contrary to the normal relationship between NPV and discount rates. Project C0 C1 IRR NPV @10% A 1,000 1,500 50% 364 B 1,000 1,500 50% 364 McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 17 Internal Rate of Return Pitfall 2 - Multiple Rates of Return Certain cash flows can generate NPV=0 at two different discount rates. The following cash flow generates NPV=$A 3.3 million at both IRR% of (-44%) and +11.6%. Cash Flows (millions of Australian dollars) C0 60 McGraw-Hill/Irwin C1...... ......C9 12 12 C10 15 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 18 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=$A 3.3 million at both IRR% of (-44%) and +11.6%. NPV 600 IRR=11.6% 300 Discount Rate 0 -30 IRR=-44% -600 McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 19 Internal Rate of Return Pitfall 2 - Multiple Rates of Return It is possible to have no IRR and a positive NPV – (NPV is positive at all discount rates) Project C0 C1 C2 IRR NPV @10% C 1,000 3,000 2,500 None 339 McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 20 Internal Rate of Return Pitfall 3 - Mutually Exclusive Projects IRR sometimes ignores the magnitude of the project. The following two projects illustrate that problem. Project C0 C1 IRR NPV @10% D 10,000 20,000 100% 8,182 E 20,000 30,000 75% 11,818 McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 21 Internal Rate of Return Pitfall 3 - Mutually Exclusive Projects McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 22 Internal Rate of Return Pitfall 4 - Term Structure Assumption We assume that discount rates are stable during the term of the project. This assumption implies that all funds are reinvested at the IRR. This is a false assumption. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 23 Profitability Index When resources are limited, the profitability index (PI) provides a tool for selecting among various project combinations and alternatives A set of limited resources and projects can yield various combinations. The highest weighted average PI can indicate which projects to select. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 24 Profitability Index Cash Flows ($ millions) Project C0 C1 A 10 30 B C 5 5 5 5 C2 5 NPV @ 10% 21 20 15 16 12 Suppose you only have 10 to invest. Choose (A) or (B and C)? McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 25 Profitability Index Cash Flows ($ millions) NPV Profitabil ity Index Investment Project Investment($) NPV ($) Profitability Index A 10 21 2.1 B C McGraw-Hill/Irwin 5 5 16 12 3.2 2.4 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 26 Web Resources Click to access web sites Internet connection required www.invest-faq.com/articles/analy-int-rate-return.html www.rebuild.org/lawson/irr.asp www.hud.gov/offices/cpd/affordablehousing/training/ener gy/cost/payback.cfm www.unix.mcs.anl.gov/otc/Guide/faq/linear-programmingfaq.html www.faqs.org/faqs/linear-programming-faq/ McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved