CHAPTER FIVE - University of Windsor



CHAPTER 7

NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA

CHAPTER IN PERSPECTIVE

This chapter continues the valuation theme, but shifts to an internal, managerial focus oriented to the discussion and evaluation of several investment decision criteria. The net present value and internal rate of return decision criteria are consistent with shareholder wealth maximization, for they focus on expected cash flows, when the flow occurs, and the riskiness of the cash flow. The professor must help the student make a transition from the former section and chapters related to valuation in a macroeconomic setting to this microeconomic setting related to making decisions within the business. Managers must assess the expected value added contributions of new investment projects. The net present value measures each project’s expected contribution to shareholder wealth. Help your student to continue the valuation theme from the last chapter into this and future chapters. Tying chapters together with a continuous theme, such as valuation, keep students from getting lost in specific formulas and enables them to see their managerial finance course from an overall perspective and how it relates to other areas of study in their business curriculum.

CHAPTER OUTLINE

7.1 NET PRESENT VALUE

A Comment on Risk and Present Value

Valuing Long-Lived Projects

7.2 OTHER INVESTMENT CRITERIA:

Payback

Discounted Payback

Internal Rate of Return

A Closer Look at the Rate of Return Rule

Calculating the Rate of Return for Long-Lived Projects

A Word of Caution

Some Pitfalls of the IRR Rule

Book Rate of Return

7.3 MUTUALLY EXCLUSIVE PROJECTS

Investment Timing

Long- versus Short-Lived Equipment

Replacing an Old Machine

Mutually Exclusive Projects and the IRR Rule

7.4 CAPITAL RATIONING

Soft Rationing

Hard Rationing

Pitfalls of the Profitability Index

7.5 A Last Look

7.6 Summary

TOPIC OUTLINE, KEY LECTURE CONCEPTS, AND TERMS

7.1 NET PRESENT VALUE

A. Net present value measures each project’s contribution to shareholder wealth.

B. While there are several long-term investment decision criteria, the net present value method is favored because it tends to focus on building shareholder value and has the fewest limiting assumptions.

A Review of the Basics

A. Capital budgeting decisions, the process of choosing investment projects, are important because they usually involve large cash outlays with cash flow return over a long period of time. The four steps in the capital budgeting decision process are:

1. Forecast the future project cash flows, noting when the flow occurs.

2. Estimate the opportunity cost of capital. The opportunity cost of capital is the expected rate of return given up by investing in the project under review.

3. Calculate the present value of the future cash flows discounted at the opportunity cost of capital rate. The present value of the cash flows represents the maximum amount that investors would pay for the investment.

4. NPV Decision Rule: The present value sum of the future cash flows minus the investment outlay is the net present value. If the net present value is positive (greater than zero), make the investment. If the net present value is negative, forgo the investment. If the present value is the maximum amount one would pay for the investment relative to the cost, the NPV represents the added value of the investment.

B. The expected net present value of a project is the added shareholders’ wealth provided by the project.

Valuing Long-Lived Projects

A. Added net present values generated by investments are represented in higher stock prices.

B. The net present value method is a proxy for financial market investor,

analysis of business investments.

C. Projects that are expected to generate negative net present values will reduce shareholders’ wealth by the expected negative NPV.

7.2 OTHER INVESTMENT CRITERIA

Payback

A. A popular and relatively simple cash flow investment decision criteria is the payback defined as the time until cash flows recover the initial investment of the project.

B. The payback rule states that the investment should proceed if the payback period exceeds a specified period.

C. While cash flows are considered, the timing of the cash flows and the cash flows beyond the payback period are not considered. The payback method ignores the risk of the project cash flows and the opportunity rate of return of investors.

D. The payback method is a popular, simple evaluation method for short-lived projects.

Discounted Payback

A. Sometimes managers calculate the discounted payback period. This is the number of periods before the present value of prospective cash flows equals or exceeds the initial investment. This surmounts the objection that equal weight is given to all cash flows before the cutoff date. However, the discounted payback rule still takes no account of any cash flows after the cutoff date.

B. The discounted payback does offer one important advantage over the normal payback criterion. It improves upon the payback period to the extent that equal weight is no longer given to all cash flows before the cutoff date.

C. Also, it is useful to know that If a project meets a discounted payback cutoff, it must have a positive NPV, because the cash flows that accrue up to the discounted payback period are (by definition) just sufficient to provide a present value equal to the initial investment. Any cash flows that come after that date tip the balance and ensure positive NPV.

D. However, the discounted payback still ignores all cash flows occurring after the arbitrary cut off date and therefore will incorrectly reject some positive NPV opportunities. Also, It is no easier to use than the NPV rule, because it requires determination of both project cash flows and an appropriate discount rate.

Book Rate of Return

A. Another decision criterion, book rate of return (accounting rate of return) or the average accounting income per period divided by the book value of the investment.

B. The book rate of return does not consider cash flows, the timing of the cash flows, or the investors’ opportunity rate of return.

A. An alternative to the NPV method is the internal rate of return, which is the discount rate that, having discounted the expected cash flows, will produce a present value equal to the cost of the project. In this case, a discount rate that will generate an NPV of zero.

B. The rate of return decision rule—invest in any project offering a rate of return higher than the opportunity cost of capital.

A Closer Look at the Rate of Return Rule

A. The rate of return, or the internal rate of return, or IRR, or the discounted cash flow (DCF) rate of return, is the discount rate at which NPV equals zero.

B. If the rate of return is greater than the opportunity cost of capital, the NPV of the project is greater than zero.

C. If the NPV of a project is less than zero (negative) the rate of return is less than the opportunity cost of capital.

D. The rate of return rule and the NPV rule are equivalent.

Calculating the Rate of Return for Long-Lived Projects

A. The IRR of a single future cash flow (PV) or an annuity flow (PV of annuity) may be determined easily and arithmetically as the discount rate that equates the cost of the project with the present value of the future cash flows.

B. The IRR of a multiple, uneven cash flow stream involves more than one unknown and is not easily solved arithmetically. One must iterate, often several times, selecting an expected IRR and discounting the cash flows until the NPV of the project is zero.

C. The rate of return rule will give the same decision as the NPV rule as long as the NPV of a project declines smoothly as the discount rate increases. See Figure 7.3 reproduced below.

A Word of Caution

A. Do not confuse the IRR with the opportunity cost of capital. The IRR is the rate of return on the cash flows of the investment.

B. The opportunity cost of capital is the minimum IRR acceptable to the firm. The opportunity rate of return is an estimate of the minimum acceptable rate of return demanded by investors in financial markets on similar risk investments.

Figure 7.3

Pitfalls of the Rate of Return Rule

A. While the IRR is easier to understand than the NPV, the NPV should be used as a final decision criterion for an investment.

B. The IRR method has a number of theoretical pitfalls that encourages the use of the NPV method:

1. Pitfall 1: mutually exclusive projects. Where mutually exclusive projects are facing the financial manager, one must be selected and the other deferred or passed by. In cases where competing projects serve the same purpose, select the project with the highest expected NPV. The IRR may give a conflicting choice relative to the NPV, which focuses more accurately on shareholder value. Analysis of the IRR on incremental basis will give decisions consistent with the NPV.

2. Pitfall 1a: mutually exclusive projects involving different outlays, same lives. Small projects may be erroneously selected over larger projects using the IRR. When NPV is higher as the discount rate increases, a project is acceptable only if its internal rate of return is less than the opportunity cost of capital.

3. Pitfall 2: lending or borrowing. The IRR does not distinguish between a lending (investing) or a borrowing (borrow and invest) situation, whereas the NPV clearly points out the negative aspects of the borrowing strategy.

4. Pitfall 3: multiple rates of return. Any change in sign (+,-) in period cash flows produces as many IRR’s as there are changes in the cash flow directions of the investment. Many investments, such as oil or gas wells, entail added outlays after several periods of positive cash flows, producing the arithmetical possibility of multiple IRR’s. Use the NPV, offsetting the discounted negative cash flows against the positive cash flows.

7.3 PROJECT INTERACTIONS

The capital budgeting decision analyses, to this point in the chapter, have considered mutually exclusive alternatives. In either Project A or Project B, the proper decision rule was to select the project with the higher NPV. There are other mutually exclusive decision analysis considerations that occur frequently that complicate our simple NPV rule. Three situations are discussed below.

Investment Timing

A. When to make an investment is a difficult decision in a dynamic world, where new cost-saving technology is always improving and NPV’s are greater if delayed until later.

B. The right time to purchase an ever-increasing NPV investment is indicated by the highest present value of future NPV’s, found by discounting the estimated NPV’s of projects made in future periods by the opportunity cost of capital. See Table 7.3.

Long-Lived versus Short-Lived Equipment

A. When comparing mutually exclusive projects that have unequal project lives, one must analyze the costs of the projects, the outlays and the annual costs of the projects.

B. Calculate the equivalent annual cost of both machines. Decision Rule: Accept the project with the lowest equivalent annual cost.

C. The equivalent annual cost is the annual (annuity or payment) project cost that equates the present value cost of the project (outlay and annual costs) at the opportunity rate of return. The equivalent annual cost is the level annual charge or cost necessary to recover the present value of investment outlays and operating costs.

Replacing an Old Machine

A. Most equipment is replaced before the end of its useful economic life or its depreciable life. Replacement decisions most often involve replacing old with new with different useful cash-flow lives.

B. Calculate the equivalent cost, annuity payment which equates the PV cost at the opportunity rate of return, of the new project’s costs compared to the period cost of the old project.

C. If the equivalent period cost of the new project is less than the period cost of the old project, accept the new; if greater, delay the replacement and review later.

7.4 CAPITAL RATIONING

A. A business maximizes shareholders’ wealth by accepting every project with a positive NPV.

B. The above statement assumes that only negative NPV’s establish a limit on the capital budget of a business and that any financing needed can be raised in financial markets.

C. Capital rationing exists if there is a limit on the amount of funds available for investment. There are two forms of capital rationing: soft rationing and hard rationing.

Soft Rationing

A. Soft rationing exists if businesses themselves, or their senior managers, place limits on the size of the capital budget.

B. Soft rationing limits can be relaxed if added NPV investments are available; financing is provided easily by financial markets.

Hard Rationing

A. Hard rationing or limits on the capital budget are set by financial markets (investors).

B. With funding constraints, positive NPV projects are forgone.

C. With hard rationing, the firm must choose projects, to the limit of its financing ability, from among a list of projects with positive NPV’s.

D. Within a hard rationing constraint, choose the projects with the highest profitability index to the limit of the financing budget. The profitability index is the ratio of the sum of present values of the project divided by the initial cost of the investment. It is a relative measure of the value (present value) of a project compared to its cost. The higher profitability index projects have higher PV’s relative to the scarce capital invested.

Pitfalls of the Profitability Index

A. Using the profitability index decision rule in situations without capital rationing may give erroneous choices, similar to the IRR.

B. Using the profitability index without capital rationing wrongly favors small, short-lived projects over large, long-lived projects with higher NPV’s.

Further Points Regarding the Investment Criteria Discussed Above:

A. NPV, IRR, and profitability index, with some limitations, are preferred investment decision criteria because they consider three variables:

1. Estimated future cash flows of the investment.

2. The timing of the cash flows—present value analysis.

3. The opportunity rate of return of shareholders, considering the project riskiness relative to other, alternative investor opportunities.

4. The Payback and discounted payback period and Book Rate of Return are also popular decision criteria, but each has important shortcomings.

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