Transcript Critique of NPV 04/29/08 Ch. 6 Merits and Flaws of NPV  We will examine issues that are sometimes problematic for NPV        Project Interactions –

Critique of NPV
04/29/08
Ch. 6
Merits and Flaws of NPV
 We will examine issues that are sometimes
problematic for NPV
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Project Interactions – Mutually Exclusive
Unequal Lives
Replacement Decisions
Capital Rationing
Side Costs
Synergy
Embedded Options
 But it is still the best model…
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Project Interactions
 Mutually Exclusive Projects
 Definition: Accepting one project means rejecting
another project
 Example: When two projects require the same scare
resource
 Scare resource, plot of land
 Projects, build restaurant or build service station
 Assumes you can not acquire a similar scarce
resource, another plot of land
 Assumes you can not have a dual use of the
land…Taco Bell Express at a Service Station
 NPV does a nice job of picking the right project but
IRR may not...diagram to explain…
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Unequal Lives
 If two or more projects have different lives, the NPV
model favors the longer lived project
 Can you correct for this bias?
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Extend shorter project to match life of longer project
 Assumptions are that you can “invest” at the
termination of the short-term project in a very similar
project, the cost of capital has not changed and you
do not have access to additional capital at start of the
project
 Compute NPV for the short project and the extension
 Compute Equivalent Annuities
 Equivalent Annuity = NPV x (r / [1-(1+r)-n]
 Problem 3, Heating System for a Building
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Unequal Lives – Equivalent Annuity
 Problem 3
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Solar Heating, Cost $12,000 with annual costs of $500,
infinite life
Gas Heating, Cost $5,000 with annual costs of $1,000, and
will last twenty years
Oil Heating, Cost $3,500 with annual costs of $1,200 and will
last fifteen years
 Compute present value of costs at 10% cost of capital
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(1) Solar $17,000 (2) Gas $13,514 (3) Oil $12,627
 Compute Equivalent Annuities
 (1) Solar $1,700 (2) Gas $1,587 (3) Oil $1,659
 Pick the lowest equivalent annuity…Gas
 Issues with this approach?
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Replacement Decision
 Fits Mutually Exclusive as we only want one choice…either
keep current system, immediately replace current system, or
wait and replace later (which is keep current system)
 Issues that are important - Salvage Value
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Let’s re-examine this and how we deal with salvage value
Example…replace delivery truck with new delivery truck
Old truck (five years old)…original cost $38,000
New truck (expected life is eight years) …cost of $64,000
Old truck depreciation life was five year life (MACRS), book
value is 5.76% x $38,000 = $2,189
What if “blue book” is $1,200 for old truck
 What if “blue book” is $2,189 for old truck
 What if “blue book” is $4,800 for old truck
 Does replacement lower future costs? Does replacement
increase future revenues? Why replace now?
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Solutions to Salvage Value
 Book Value of Truck is 38,000 x 0.0576 = $2,189
 At sales price of $1,200
Loss on Disposal is $1,200 - $2,189 = $989
 Tax Credit (40% tax rate) $989 x 0.40 = $396
 Cash Flow at Disposal = $1,200 + $396 = $1,596
 At sales price of $2189
 No loss or gain
 Cash Flow at Disposal = $2,189
 At sales price of $4,800
 Gain on Disposal is $4,800 - $2,189 = $2,611
 Tax (40% tax rate) $989 x 0.40 = $1,044
 Cash Flow at Disposal = $4,800 - $1,044 = $3,756
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Profitability Index Example
 Problem #1 ($150 million max on spending)
Project
Initial Inv.
NPV
PI
A
$25
$10
0.40
B
$30
$25
0.83
C
$40
$20
0.50
D
$10
$10
1.00
E
$15
$10
0.67
F
$60
$20
0.33
G
$20
$10
0.50
H
$25
$20
0.80
I
$35
$10
0.28
J
$15
$ 5
0.33
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Ranking by NPV vs PI
Outlay $
Rank by NPV
$ 30
B
$ 65
C & H*
$ 45
D, G & E
$140
* Can’t pick F as it puts
you over the $150
Outlay $
$ 10
$ 30
$ 25
$ 15
$ 60
$140
Rank by PI
D
B
H
E
C and G
Total NPV
$95
$95
With a portfolio approach both give the same answer!
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Problems with PI
 Assumes capital rationing applies to the
current period only and that projects can only
be done during current period…
 Assumes all investment is up front
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Projects with cash outflow in future periods will
be overstated with PI
Future cash outflow will constrain future
periods
 PI may not spend all current capital – so other
combinations may produce higher NPV
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Side Costs and Sunk Costs
 Should be included as part of the incremental costs
of a project but may be difficult to quantify
 Opportunity costs
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Project must “carry” the lost revenues of other uses
People – taken for new project
Resources – taken for new project
 Sunk Costs
 Do not include if truly sunk costs
 Erosion – Substitute Products
 Include if truly eroding other products
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Synergy, 2+2 = 5
 When adding new projects in the whole is
greater than the parts, you get synergies
 Often used for mergers
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Firm A Value + Firm B Value < Firm (A+B)
Value
 Where does synergy come from?
 Reduction in duplicate costs
 Using excess capacity
 Complementary Products
 Timing of synergy…immediate or much later?
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Embedded Options
 Not a problem with NPV…
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But, difficulty to quantify and properly add into
the expected future cash flow
There is an element of probability here…the
probability that this project will lead to
additional projects
 Option to delay…projects always compete
with themselves over time…again, just need
to find the NPV today versus the NPV
tomorrow
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Embedded Options
 Expansion
 Once a project has been completed additional
projects become available
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How do you incorporate this into the original NPV
decision of the initial project?
What happens if you do not take on the additional
projects?
 Abandonment
 Is this an option for every project?
 How do you incorporate abandonment value in
the future cash flow of a project?
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NPV remains the Best
 The problem with NPV is not in theory but in
practice
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Problems with finding the right WACC for the
project
Problems with finding the right future cash
flows for the project
Usually the only comfortable number in cash
flow is the initial outflow
 Other models all have these same cash flow
estimation problems…plus other issues
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Weekly Homework for Thursday
 Problem 4 – Replacement, unequal lives
 Problem 5 – Unequal lives
 Problem 7 – Salvage Value
 Problem 15 – Capital Rationing
 Problem 16 – Opportunity costs
 Problem 18 – Lease option
 Problem 21 – Opportunity cost
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