ECON366 - KONSTANTINOS KANELLOPOULOS
CHAPTER 9
METHODS FOR ACCEPTANCE/REJECTION OF INVESTMENT PROPOSALS
▪ The net present value (NPV) method of evaluating investment proposals is a discounted cash flow (DCF) technique that considers the time value of all project cash flows.
o To implement the NPV, proceed as follows: (a) Find the present value of each future cash flow, discounted at the firm’s required rate of return, (b) subtract the project’s initial investment to find the net benefit the firm will realize from investing in the project, and (c) accept the project if the NPV is positive.
o The NPV is defined as follows:
▪ NPV = [pic]
o Here, CFt is the expected net cash flow at Period t, and k is the firm’s required rate of return to invest in this project. Cash outflows are treated as negative cash flows.
o If the NPV is positive, the project should be accepted; if negative, it should be rejected. If two projects are mutually exclusive (that is, only one can be accepted), the one with the higher NPV should be chosen, assuming that the NPV is positive. If both projects have negative NPVs, neither should be chosen.
o An NPV of zero signifies that the project’s cash flows are just sufficient to repay the invested capital and to provide the required rate of return on that capital.
o If a project has a positive NPV, then it generates a return that is greater than is needed to pay for funds provided by investors, and this excess return accrues solely to the firm’s stockholders.
▪ The internal rate of return (IRR) is defined as the discount rate that equates the present value of a project’s expected cash inflows to the investment outlay, or initial cost.
▪ The equation for calculating the IRR is shown below:
▪ [pic]
▪ This equation has one unknown, the IRR, and we can solve for the value of the IRR that will make the equation equal to zero. The solution value of IRR is defined as the internal rate of return.
▪ The IRR formula is simply the NPV formula solved for the particular discount rate that causes the NPV to equal zero.
▪ As long as the rate of return expected from a project, its IRR, is greater than the firm’s required rate of return, or the hurdle rate, for such an investment, the project is acceptable.
▪ The IRR can be found by trial and error, but most financial calculators and computers with financial analysis software can easily calculate IRRs and NPVs.
▪ Taking on a project whose IRR exceeds its required rate of return, or cost of funds, increases shareholders’ wealth.
COMPARISON BETWEEN NPV AND IRR THROUGH THE NET PRESENT VALUE (NPV) PROFILE: INDIVIDUAL AND INDEPENDENT PROJECTS
• A net present value (NPV) profile is a graph that shows the relationship between a project’s NPV and various discount rates (required rates of return).
• The NPV profile crosses the Y-axis at the undiscounted NPV (k = 0), while it crosses the X-axis at the IRR.
• The crossover rate is the discount rate at which the NPV profiles of two projects cross and, thus, at which the projects’ NPVs are equal.
• If two projects are independent, then the NPV and IRR criteria always lead to the same accept/reject decision.
• If a project’s NPV is positive, its IRR will exceed k, while if NPV is negative, k will exceed the IRR.
COMPARISON BETWEEN NPV AND IRR THROUGH THE NET PRESENT VALUE (NPV) PROFILE: MUTUALLY EXCLUSIVE PROJECTS
▪ If two mutually exclusive projects have NPV profiles that intersect, then there may be a conflict between the NPV and IRR methods. Two basic conditions can lead to conflicts between NPV and IRR:
▪ Project size (or scale) differences exist; that is, the cost of one project is larger than that of the other.
▪ Timing differences exist such that cash flows from one project come in early years and most of the cash flows from the other project come in later years.
▪ The NPV method implicitly assumes that project cash flows are reinvested at the required rate of return.
-----------------------
wj(j
................
................
In order to avoid copyright disputes, this page is only a partial summary.
To fulfill the demand for quickly locating and searching documents.
It is intelligent file search solution for home and business.