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Investment Decisions: Firms Decision To Invest Most Effectively
Investment Decisions: Firms Decision To Invest Most Effectively
Investment Decisions: Firms Decision To Invest Most Effectively
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Mutually Exclusive Projects: only ONE of several
potential projects can be chosen, e.g., acquiring an
accounting system.
◦ RANK all alternatives, and select the best one.
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How long does it take the project to “pay back” its
initial investment?
Payback Period = number of years to recover initial
costs
Minimum Acceptance Criteria:
◦ Set by management based on predetermined standard payback
Ranking Criteria:
◦ Set by management – highest (one) rank to the project with
shortest payback
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Disadvantages:
◦ Ignores the time value of money
◦ Ignores cash flows after the payback period
◦ Biased against long-term projects
◦ Requires an arbitrary acceptance criteria
◦ A project accepted based on the payback criteria may not
have a positive NPV
Advantages:
◦ Easy to understand
◦ Biased toward liquidity
- C0 C1 C2 C3 C4
A -4000 3000 1000 2000 1000
B -4000 0 4000 1000 1000
How long does it take the project to “pay back” its initial
investment, taking the time value of money into account?
Decision rule: Accept the project if it pays back on a
discounted basis within the specified time set by management .
Ranking Criteria:
◦ Set by management – highest (one) rank to the project with
shortest discounted payback
By the time you have discounted the cash flows, you might as
well calculate the NPV.
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Also known as return on investment, uses accounting
information as revealed by financial statement to measure
the profitability of an investment.
Example: A project will cost 40000. Its stream of EBDIT during first
year through five year is expected to be 10000, 12000, 14000,
16000, and 20000. Assume a 50% tax and depreciation on straight
line basis. Compute ARR.
Period 1 2 3 4 5 Average
EBDIT 10000 12000 14000 16000 20000 14400
(-)Dep 8000 8000 8000 8000 8000 8000
EBIT 2000 4000 6000 8000 12000 6400
(-) Tax 1000 2000 3000 4000 6000 3200
EBIT(1-T) 1000 2000 3000 4000 6000 3200
BV of Investment
Beginning 40000 32000 24000 16000 8000
Ending 32000 24000 16000 8000 -
Average 36000 28000 20000 12000 4000 20000
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Disadvantages:
◦ Ignores the time value of money
◦ Uses an arbitrary benchmark cutoff rate
◦ Based on book values, not cash flows and market
values
Advantages:
◦ The accounting information is usually available
◦ Easy to calculate
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Net Present Value (NPV) =
Total PV of future CF’s - Initial Investment
Estimating NPV:
1. Estimate future cash flows: how much? and when?
2. Estimate discount rate
3. Estimate initial costs
Minimum Acceptance Criteria: Accept if NPV > 0
Reject if NPV < 0
Indifferent if NPV =0
Ranking Criteria: Choose the highest NPV
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Total PV of Future Cash Flows
PI
Initial Investent
Minimum Acceptance Criteria:
◦ Accept if PI > 1
◦ Reject if PI < 1
◦ Indifferent if PI = 1
Ranking Criteria:
◦ Select alternative with highest PI
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Disadvantages:
◦ Problems with mutually exclusive investments
Advantages:
◦ May be useful when available investment funds are limited
◦ Easy to understand and communicate
◦ Correct decision when evaluating independent projects
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Ex. The initial cash outlay of a project is 100000
and can generate cash flow of 40000, 30000,
50000, and 20000 in year1 to year 4. Assume at
10% rate of discount. Find PI of this project?
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Ranking Criteria:
◦ Select alternative with the highest IRR
Reinvestment assumption:
◦ All future cash flows are assumed to be reinvested at the
IRR
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Disadvantages:
◦ Does not distinguish between investing and
borrowing
◦ IRR may not exist, or there may be multiple IRRs
◦ Problems with mutually exclusive investments
Advantages:
◦ Easy to understand and communicate
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0 1 2 3
-$200
The internal rate of return for this project is 19.44%
$50 $100 $150
NPV 0 200
(1 IRR) (1 IRR) 2 (1 IRR) 3
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If we graph NPV versus the discount rate, we can see the IRR
as the x-axis intercept.
0% $100.00 $150.00
4% $73.88
8% $51.11 $100.00
12% $31.13
16% $13.52 $50.00 IRR = 19.44%
20% ($2.08) NPV
24% ($15.97) $0.00
28% ($28.38) -1% 9% 19% 29% 39%
32% ($39.51) ($50.00)
36% ($49.54)
40% ($58.60) ($100.00)
44% ($66.82) Discount rate
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There are two IRRs for this project:
$200 $800
Which one should
we use?
0 1 2 3
-$200 - $800
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Would you rather make 100% or 50% on your
investments?
What if the 100% return is on a $1 investment, while
the 50% return is on a $1,000 investment?
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$5,000.00 Project A
$4,000.00 Project B
$3,000.00
$2,000.00
10.55% = crossover rate
$1,000.00
NPV
$0.00
($1,000.00) 0% 10% 20% 30% 40%
($2,000.00)
($3,000.00)
($4,000.00)
12.94% = IRRB 16.04% = IRRA
($5,000.00)
Discount rate
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0 ($10,000) ($10,000) $0 $0
11 $10,000 $1,000 $9,000 ($9,000.00)
2 $1,000 $1,000 $0 $0
$3,000.00
$2,000.00
10.55% = IRR
$1,000.00
NPV
A-B
$0.00
B-A
($1,000.00) 0% 5% 10% 15% 20%
($2,000.00)
($3,000.00)
Discount rate
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NPV and IRR will generally give the same decision.
Exceptions:
◦ Non-conventional cash flows – cash flow signs change
more than once
◦ Mutually exclusive projects
Initial investments are substantially different
Timing of cash flows is substantially different
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Varies by industry:
◦ Some firms may use payback, while others choose an
alternative approach.
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Compute the IRR, NPV, PI, and payback period for the
following two projects. Assume the required return is
10%.
Year Project A Project B
0 -$200 -$150
1 $200 $50
2 $800 $100
3 -$800 $150
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Project A Project B
CF0 -$200.00 -$150.00
PV0 of CF1-3 $241.92 $240.80
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Payback Period:
Project A Project B
Time CF Cum. CF CF Cum.CF
0 -200 -200 -150
-150
1 200 0 50 -100
2 800 800 100
0
3 -800 0 150 150
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NPV
$400
$300
IRR 1(A) IRR (B) IRR 2(A)
$200
$100
$0
-15% 0% 15% 30% 45% 70% 100% 130% 160% 190%
($100)
($200)
Project A
Discount rates
Cross-over Rate Project B
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Compute the internal rate of return for the
cash flows of the following two projects.
Year Project A Project B
0 -$5700 -$3450
1 $2750 $1380
2 $2800 $1800
3 $1600 $1200
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Consider the following cash flows on two mutually exclusive projects
for the Bahamas recreation Corporation. Both projects required and
annual return of 14%.
Year Deepwater fishing New Submarine ride
0 -$850000 -$1650000
1 $320000 $810000
2 $470000 $750000
3 $410000 $690000
As a financial analyst for BRC you are asked the following question:
a. If your decision rule is to accept the project with the greater IRR,
which project should you choose?
b. Because you are fully aware of the IRR rules scale problem, you
calculate the incremental IRR for the cash flows. Based on your
computation, which project should you choose?
c. To be prudent, you compute the NPV for both projects. Which
project should you choose? Is it consistent with the increment the
IRR rule?
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Consider the case when the firm does not have enough capital
to fund all positive NPV projects. This is the case of capital
rationing.
In the case of limited funds, we cannot rank projects according
to their NPVs. Instead we should rank them according to the
ratio of present value to initial investment. This is the PI rule.
“Bang for the buck”
Indivisibilities, different project durations may reduce the
effectiveness of the PI rule.
Nevertheless, while not perfect, the profitability index goes a
long way toward handling capital rationing.
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Cash flows matter—not accounting earnings.
Sunk costs do not matter.
Incremental cash flows matter.
Opportunity costs matter.
Side effects like cannibalism and erosion matter.
Taxes matter: we want incremental after-tax cash
flows.
Inflation matters.
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Sunk costs are not relevant
◦ Just because “we have come this far” does not
mean that we should continue to throw good
money after bad.
Opportunity costs do matter. Just because a project
has a positive NPV, that does not mean that it should
also have automatic acceptance. Specifically, if
another project with a higher NPV would have to be
passed up, then we should not proceed.
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Cash Flow from Operations
◦ Recall that:
OCF = EBIT – Taxes + Depreciation
Net Capital Spending
◦ Do not forget salvage value (after tax, of course).
Changes in Net Working Capital
◦ Recall that when the project winds down, we enjoy a return of
net working capital.
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0 1 2 3 4 5 6
Initial investment xxx
Sales
Less: Expense
Less: Depreciation
PBT
Less: Tax
PAT
Add: Depreciation
Operating cash flow
Add: Net Salvage Value ##
Net Working Capital (NWC) adjustments
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