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
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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
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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.
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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
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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?
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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
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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.
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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.
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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
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C2
C3
Payback
Period
NPV@ 10%
500 5000
1800
0
500
0
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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
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500
0
2
NPV@ 10%
 2,624
- 58
 50
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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
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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?
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Internal Rate of Return
Example
You can purchase a turbo powered machine tool gadget for $4,000.
The investment will generate $2,000 and $4,000 in cash flows for two
years, respectively. What is the IRR on this investment?
2,000
4,000
NPV  4,000 

0
1
2
(1  IRR ) (1  IRR )
IRR  28.08%
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Internal Rate of Return
2500
2000
IRR=28%
1000
500
10
0
90
80
70
60
50
40
30
-500
20
0
10
NPV (,000s)
1500
-1000
-1500
-2000
Discount rate (%)
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Internal Rate of Return
Pitfall 1 - Lending or Borrowing?
 With some cash flows (as noted below) the NPV of the project
increases s the discount rate increases.
 This is contrary to the normal relationship between NPV and
discount rates.
Project
C0
C1
IRR NPV @10%
A
 1,000  1,500  50%
 364
B
 1,000  1,500  50%
 364
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Internal Rate of Return
Pitfall 2 - Multiple Rates of Return
 Certain cash flows can generate NPV=0 at two different discount rates.
 The following cash flow generates NPV=$A 3.3 million at both IRR%
of (-44%) and +11.6%.
Cash Flows (millions of Australian dollars)
C0
 60
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C1...... ......C9
12
12
C10
 15
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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=$A 3.3 million at both IRR% of
(-44%) and +11.6%.
NPV
600
IRR=11.6%
300
Discount
Rate
0
-30
IRR=-44%
-600
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Internal Rate of Return
Pitfall 2 - Multiple Rates of Return
 It is possible to have no IRR and a positive NPV
– (NPV is positive at all discount rates)
Project
C0
C1
C2
IRR NPV @10%
C
 1,000  3,000  2,500 None
 339
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Internal Rate of Return
Pitfall 3 - Mutually Exclusive Projects
 IRR sometimes ignores the magnitude of the project.
 The following two projects illustrate that problem.
Project
C0
C1
IRR NPV @10%
D
 10,000  20,000 100%
 8,182
E
 20,000  30,000  75%
 11,818
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Internal Rate of Return
Pitfall 3 - Mutually Exclusive Projects
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Internal Rate of Return
Pitfall 4 - Term Structure Assumption
 We assume that discount rates are stable during
the term of the project.
 This assumption implies that all funds are
reinvested at the IRR.
 This is a false assumption.
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Profitability Index
 When resources are limited, the profitability index
(PI) provides a tool for selecting among various
project combinations and alternatives
 A set of limited resources and projects can yield
various combinations.
 The highest weighted average PI can indicate
which projects to select.
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Profitability Index
Cash Flows ($ 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)?
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Profitability Index
Cash Flows ($ millions)
NPV
Profitabil ity Index 
Investment
Project Investment($) NPV ($) Profitability Index
A
10
21
2.1
B
C
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5
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3.2
2.4
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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/
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