Net Present Value and Other Investment Rules When a company is desing whether o invest a new prj ec, ange suns of money can be at stake. For example, con- struction ofthe $4 billon Resorts Weld Las Vegas, the fst ‘roundup resort bul in that ly n more than a decade, wes setto begin nthe third quaner of 207 The new resor would hhave 3000 hotel rooms and more than 100,000 square feet (of gaming space, plus estaurans, shops and theaters. And in May 207, Lamprell PLC announced a joint versure with Saud ‘Arabian il Co. to bull a $52 bison marine yard in Ras Ab Khair on the east coost of Saud Arabia, The yard would be the largest in the region and would seve offshore ol and ges Fg, Ofbhore support vessels, and commercial vessels. But nether ofthese announcements wes a lage a the announce ‘ment by GoerMobl, which stated thatthe company would spend $20 billon a stos on the US. Gut Coast o expand Is chemical and of ering capecty in the region by 2022. 5.1 “The projet would resultin 35,000 temporary constuction jobs ‘nd 12,000 permanent obs. Projects such as these, with price tags in the bions, are obviously major undertkengs, en the ‘sks and rewards must be carefly weighed. nts chapter, we cscuss the bese tools used in mang such decisions. Ir Chapter t, we showed that inreasing the value of {2 company's stock Is the goal of financial management ‘What we need to know is how to tell whether a particular Investment will achieve that purpose oF not This chapter Considers a variety of techniques financial analysts rou- tihely use. More importantly i shows how many of these techniques can be misleading, and it expains why the net present value approach is the right one to use. Please vist us at rwjeorporatefnance.blogspotcom for the latest developments in the word of corporate finance, Why Use Net Present Value? a Excl its. ereeae one ‘This chapter, as well as the next two, focuses on capital budgeting, the decision making process for accepting or rejecting projets. This chapter develops the basic capital budget- ‘ng methods, leaving much of the practical application to subsequent chapters. But we don't have to develop these methods from scratch. In Chapter 4, we pointed out that a dollar received in the future is worth less than a dollar received today. The reason is thet today’s dollar can be reinvested, yielding a greater amount in the future. And we showed in Chapter 4 that the exact worth of a dollar to be received in the future is its present value. Furthermore, Section 4.1 suggested calculating the net present value (NPV) of any project, which is the difference between the sum of the present values of the projects future cash flows and the initial cost of the project. ‘The NPV method isthe fist one to be considered in ths chapter. We begin by reviewing ‘the approach with an example. Then, we ask wiy the method leads to good decisions. . 133 & sone rasan134 MM —_PARTII_ Valuation and Capital Budgeting Net Present Value The Alpha Corporation is considering Investing in @rakless project costing $100. The project receives $107 In one year and has no ather cash flows. The discount rate on Fsiess investments is 2 percent ‘The NPV of the projet can easly be calculated as: S490 en From Chapter 4, we know that the project should be accepted because its NPV is postive, This Is true because the project generates $107 of future cash flows fom a $100 investment, whereas comparabie Irvestments only generate $102, 2 we wil show below. ‘The basic investment rule can be generalized to: Accept a project if the NPV is greater than zero. Reject @ project if the NPV is less than zero, We refer to this a the NPV rule ‘Why does the NPV rule lead to good decisions? Consider the following two strategies available to the managers of Alpha Corporation: 1, Use $100 of corporate cash to invest in the project. The $107 will be paid as a dividend in one year. 2, Forgo the project and pay the $100 of corporate cash to stockholders as a divi end today, If Strategy 2 is employed, the stockholder might deposit the cash dividend in a bank for one year. With an interest rate of 2 percent, Strategy 2 would produce cash of $102 (= $100 x 1.02) atthe end of the year. The stockholder would prefer Strategy 1 because Strategy 2 produces less than $107 at the end of the year Our basie point is: Accepting positive NPV projects benefits the stockholders. How do we interpret the exact NPV of $4.90? This is the increase in the value of the firm from the project. Imagine that the firm today has productive sssets worth SV and has $100 of cash. IF the firm forgoes the projet, the value of the firm today would be sy + $100 If the firm accepts the project, the firm will receive $107 in one year but will have no cash today. The firm's value today would be: y 4 S107 SV + Ton ‘The difference between these equations is $4.90, the net present value of Equation 5.1 Thus: ‘The value of the firm rises by the NPV ofthe project. [Note that the value of the firm is merely the sum of the values ofthe different proj ects, divisions, or other entities within the firm, This property, called value additivity, is quite important. 1 implies that the contsibution of any project to a firm's value is the seleer 08.13 once 1 & sone rasanCHAPTER 5 Net Present Value and Other Investment Rules mm 135; NPV of the project. As we will see later, alternative methods discussed ia this chapter do not generally have this property. ‘The NPV rule uses the correct discount rate One detail remains. We assumed thet the project was riskless, a rather implausible assumption. Future cash flows of real-world projects are invariably risky. In other words, cash flows can only be estimated, rather than Known. Imagine that the managers of Alpha ‘expect the cash flow of the project to be $107 next year. Tha is, the cash flow could be higher, say $117, or lower, say $97, With this slight change, the project is risky. Suppose ‘the project is about as risky as the stock market as @ whole, where the expected return this year is perhaps 10 percent. Then 10 percent becomes the discount rate, implying that the NPV of the project would be: _ s107 =s2.73 = -s100 + ST Because the NPV is negative, the project should be rejected. This makes sense: A stockholder of Alpha receiving a $100 dividend today could inves it in the stock market, expeeting # 10 percent return. Why accept a project with the same risk as the market but With an expected return of only 7 percent? SPREADSHEET APPLICATIONS Calculating NPVs with a Spreadsheet ‘Spreadsheets are commonly used to ealedate NPVs. Examining the use of spreadsheets nhs context oo ‘slows us to isue an important waming, Corser te flowing: In our spreadshost example, notice that we have provided two answers. The fst answer Is wrong even ‘though we used the spreadsheets NPV formula. What happened Is that the "NPV" functon in our spread heat is setunly # PY Kren; unfortunatly, one of he origina spreadsheet programmers many years 980 501 the cefntion vrang, and sudzequent oragrammers have capied i! Our second answer smows how to use the formula propery ‘The example hore ilusrates the danger of bingy using calustors or comptes wthovt understansing| ‘etfs going on; we shudder fo tink of how many captl budgeting dec'sions inthe real word ae based ‘on incorrect us ofthis paren funetion. fete 08 13 once 18 & sone rasan126 5.2 Nisa. overage online Figure 54 Cash Flows of an Investment Project PART II Valuetion and Capital Budgeting Conceptually, the discount rate on a risky project is the return that one can expect to earn on a financial asset of comparable risk. This discount rate is often referred to a8 an opportunity cost because corporate investment in the project takes away the stockholders’ option to invest the dividend in other opportunities. Con- ceptually, we should look for the expected return of investments with similer risks available in the capital markets. The calculation of the discount rate is by no means impossible. We forgo the calculation in this chapter but will discuss it in detail in later chapters. Having shown that NPV is a sensible approach, how can we tell whether alternative ‘methods are as good as NPV? The key to NPV is its three attributes: NPV uses cash flows. Cash flows from a project can be used for other corporate purposes (such at dividend payments, other capital budgeting projects, or payments of corporate interest). By contrast, earnings are an artificial construct. Although ‘earnings are useful to accountants, they should not be used in capital budgeting because they do not represent cash. 2. NPV uses all the cash flows of the project, Other approaches ignore cash flows beyond a particular date; beware of these approaches. 3. NPV discounts the cash flows propery: Other approaches may ignore the time value fof money when handling cash flows. Beware of these approaches, at well Calculating NPVs by hand can be tedious. A nearby Spreadsheet Applications box shows how to do it the easy way and also illustrates an important caveat caleulator. The Payback Period Method DEFINING THE RULE (One alternative to NPV is the payback period. Here is how payback works: Consider a project with an initial investment of ~$50,000, Cash flows are $30,000, $20,000, and $10,000 in the frst three years, respectively. These flows are illustrated in Figure 5.1. A useful way of writing investments like the preceding is with the notation: ($50,000, $30,000, $20,000, $10,000) The minus sign in front of the $50,000 reminds us that this is @ cash outflow for the investor, and the commas between the different numbers indicate that they are received-or if they are cash outflows, that they are paid out—at different times, In this example we $30,000 $20,000 $1,000 cash infiow TimeCHAPTER 5 Net Present Value and Other Investment Rules mlm 137, are assuming that the cash flows occur one year apart, with the frst one occurring the moment we decide to take on the investment. ‘The firm receives cash flows of $30,000 and $20,000 in the first two years, which ad ‘up to the $50,000 original investment, This means thatthe firm has recovered its investment ‘within two years. In this ease, two years is the payback period of the investment, Based on the payback period rule, a project is acceptable if its calculated payback is less than a prespecified number of years, say two years. All projects that have payback periods of two years or less are accepted, and those that pay back in more than two ‘years-if at all-are rejected. PROBLEMS WITH THE PAYBACK METHOD ‘There are at least three problems with payback. To illustrate the frst two problems, we ‘consider the three projects in Table S.I. All three projects have the tame three-year pay- ‘back period, so they should all be equally attractive—right? ‘Actually, they are not equally attractive, as can be scen by a comparison of different pairs of projects Problem 1: Timing of Cash Flows within the Payback Period Let ur ‘compare Project A with Project B. In Years | through 3, the cash flows of Project A rise from $20 to $50, while the cash flows of Project B fll from $50 to $20, Because the large cash flow of $50 comes earlier with Project B, its net present value must be higher. Never ‘theless, we saw that the payback periods of the two projects are identical. A problem with the payback method is that it doet not consider the timing of the cash flows within the payback period. This example shows that the payback method is inferior to NPV because, 188 we pointed out earlier, the NPV method discounts the essh flows property. Problem 2: Payments after the Payback Period Now consider Projects B and C, which have identical cash flows within the payback period. However, Project C is clearly preferred because it has a cash flow of $100 in the fourth year. Another problem with the payback method is that it ignores all cash flows occurring after the payback period. Because of the short-term orientation ofthe payback method, some valuable long ‘etm projects ate likely to be rejected. The NPV method does not have this flaw because, a8 we pointed out eazlier, this method uses all the eash flows of the project. Problem 3: Arbitrary Standard for Payback Period We do not need to refer to Table 5.1 when considering 2 third problem with the payback method. Capital markets help us estimate the discount rate used in the NPV method. The riskess r perhaps proxied by the yield on a U.S. Treasury instrument, would be the appropriate rate for a riskless investment; a higher rate should be used for risky projects. Later chapters Table 54. Expected Cash Flows for Projects A through C ° -$100 “$100 -$100 1 20 50 50 2 30 30 30 3 50 20 20 4 60 60 100 Payback period (years) 3 3 2 Nev $215 $253 $535 seleer 08.13 once 17 & sone rasan128 PART II Valuation and Capital Budgeting of this textbook show how to use historical returns in the capital markets to estimate the Accept If NPV > 0. ‘al remaining cash flows are Reject IRR 0. ‘al remaining cash flows are Reject IRR > © Reject if NPV < 0 negative. Some cash flows afer fist are Maybe No valid IRR.—_Accept If NPV > 0. posve and some cash more than 1 Reject NPV < 0. ‘ows ater frst sre negatve, [Note that the NPV criterion is the same for each of the three cases. In other words, [NPV analysis is alvays appropriate. Conversely, the IRR can be used only in certain cases. ‘When it comes to NPY, the preacher's words, *You just can’t lose with the stuff I use." clearly apply. PROBLEMS SPECIFIC TO MUTUALLY EXCLUSIVE PROJECTS ‘As mentioned earlier, two or more projects are mutually exclusive ifthe firm can accept only one of them. We now present two problems dealing with the application of the IRR approach to mutually exclusive projects. These two problems are quite similar, though logically distinct. The Scale Problem A professor we know motivates discussions of this topic with this statement: “Students, I am prepared to let one of you choose between two mutually exclusive ‘business’ propositions. Opportunity 1: You give me $1 now and Ill give you $1.50 back at the end of the class period. Opportunity 2: You give me $10 and T' give you $11 back at the end of the class period. You can choose only one of the two oppor tunities, and you cannot choose either opportunity more than once. Ill pick the first volunteer” ‘Which would you choose? The correct answer is Opportunity 2. To see this, ook at the following chart a Opportunity 1 $50 50% Opportunity 2 110010 "Eis rue wl mney bre. Tote my ets ae die poo the o's AE he ee 8 set at hen Opprtnty The pec tht rat ane Pr "Wessel bce led et 90 mine just oed he t nCHAPTER 5 Net Present Value and Other Investment Rules M149) ‘As we have stressed earlier in the text, one should choose the opportunity with the highest NPV. This is Opportunity 2 in the example, Or, a8 one of the profestor’s stu- ‘dents explained it, “I'm bigger than the professor, so I know I'll get my money back. ‘And I have $10 in my pocket right now so I can choose either opportunity. At the end ‘of the clas, I'l be able to buy one song on iTunes with Opportunity 2 and still have ‘iy original investment, safe and sound. The profit on Opportunity 1 pays for only one- half of a tong.” ‘This business proposition illustrates a defect with the internal rate of return criterion. ‘The basic IRR rule indicates the selection of Opportunity 1 because the IRR is $0 percent. ‘The IRR is only 10 percent for Opportunity 2, Where does IRR go wrong? The problem with IRR is that it ignores isues of scale. Although Opportunity I has a greater IRR, the investment is much smaller In other ‘words, the high percentage return on Opportunity 1 is more than offset by the ability 10 ‘earn at least 2 decent return’ on a much bigger investment under Opportunity 2. Because IRR seems to be misguided here, can we adjust or correct it? We illustrate hhow in the next example. NPV versus IRR Stanley Jaffe and Shey Lansing have purchased the rights to Corporate Finance: The Motion Picture. They wil produce this major motion picture on ether @ smal uc: ‘get or 8 large budget Here are the estimated cash tows ca cog RR ‘Small budget -$10 millon $40 millon $22 milton 300% Large budget =25 millon 65 millon 27 millon 160 ecause of high tsk, a 25 percent dscount rate considered appropriate, Sheny wants to ‘adopt the large budget because the NPV Is higher. Stanley wants to adopt the small budget ‘because the IRR i higher Who Is right? For the reasons explained in the classcoam example, NPV is correct. Hence, Sheryis right However, Staniey is very stubdom were IRR is concerned, How can Sherry justify the large ‘budget to Stanley using the IRR approach? ‘This is where incrementol IRR come’ in. Sherry calculates the incremental cash flows from choosing the large budget Instead ofthe small budget as follows: err err Cini) Incremental eash flows from $25 — (10) ‘choosing large budget Instead of small budget $5 $65 ~ 40 $25 ‘This chart shows thatthe Incremental cashflows are ~$15 millon st Year © and $25 millon at Year 1 Sheny eniculates incremental IRR as follows (continued) & sone rasan150m PART Il Valuation and Capital Budgeting Formula for Calculating the Incremental IRR: 0 = -815 mition + $28. Hlon JR equals 6.67 percent inthis equation, impng tat the incremental TRR is 65.57 percent incremental isthe RR on the incremental investment ftom choosing the lage Project nstea ofthe smal pret in odo, we can eau the NPV of the incremental cas flows NPV of nremental Cash lows = $15 ton + $25,282 — 55 miton wo know te smal ug petiro woul bo aecplabl san ndopondont projet because 1s NPV i postive, We want kne whee ts beefalo vest a atonal St millon tomate te ige nudge pice seed ofthe sal ouepel pcre. moter words Eber tent to vest on ana $18 malin to foo an ate! 828 mon host yea? Fs Curcalesnvon sem ne heromora NEV w be postve Secon te emer! Rf 6387 percent sg thant count rato of 25 pect. Fr bah aso te terra ves Inet canbe hse so te lrge bug! mee Shou be made, The Secnd Tenn lr what Stony need to Rew to be cominee In review, we can handle this example (or any mutually exclusive example) in one of three ways: |. Compare the NPVs of the rwo dices. The NPV of the large-budget picture is greater than the NPV of the smaltbudget picture. That is, $27 milion is greater than $22 milion, 2. Calewlate the incremental NPV from making the large-budget picture instead of the ‘smalt budget picture. Because the incremental NPV equals $5 million, we choose the large-budget picture. 3. Compare the incremental IRR to the discount rate. Because te incremental IRR is 66.67 percent and the discount rate is 25 percent, we choose the large‘udget picture. All three approaches always give the same decision. However, we must not compare the IRRS of the two pictures. If we did. we would make the wrong choice. That is, we would accept the small-budget picture ‘Although students frequently think that problems of scele are relatively unimportant, the truth is just the opposite. No reaworid project comes in one clear-cut size. Rather, the firm has to determine the best size forthe project. The movie budget of $25 millon is not fixed in stone. Peshaps an extra $1 million to hire a bigger star or to film at a better loca tion will increase the movie's gross. Similarly, an industrial firm must decide whether it Wants a warehouse of, say, $00,000 square feet or 600,000 square feet. And, earlier in the chapter, we imagined McDonalds opening an outlet on a remote island. If it does ths, it must decide how big the outlt should be. For almost any project, someone in the firm has to decide on its size, implying that problems of scale abound in the real would One final note here. Students often ask which project should be subtracted from the other in lulating incremental flows, Notice that we are subtracting the smaller project's cash flows from the bigger project's cash flows. This leaves an outflow at Year 0. We then use the basic IRR rule on the incremental flows? “Raa we cud este pj sho hsp ct le, T no a et tnt te ning enya Oe RR al eats Th mt wi rf receCHAPTER 5 Net Present Value and Other Investment Rules ol 151 The Timing Problem Next we illustrate another, somewhat similar problem, with the IRR approach to evaluating mutually exclusive projets EXAMPLE 53 Mutually Exclusive Investments Suppose that the Kaufold Corporation has ‘wo aiternative uses for a warehouse, It ean store toxic waste containers (Project A or electronic equipment (Project 8} The eash flows ae as follows: NPV 80% G10% e1SK Project A ~$10,000 $10,000 $1,000 $ 1,000 $2,000 $669 $109 16.04% Project 8 10.000 1,000 1,000 12000 4.000 751-484 1294 We find thatthe NPV of Project is higher with lw dscount rates, andthe NPV of Project A Is higher with high discount rates. Tis isnot surprising f you look closely atthe cash flow pat- toms, The cash lows of A occur ear, whereas the cash flows of 8 occu later. With the time value of money, ear cash flows are less affected by higher discount rates, so As Year t cash flow is mare valuable. Because Project 8's cash flows are greater, B's value is relatively high with low discount rates because the cost of waitng on the larger cash flows Is lower. ‘The NPV profiles for both projets appear in Figure 5. Project A has an NPV of $2,000 ax zero discount rate, hie caleulated by adding up the cash flows without discounting them. Project B has an NPV of $14,000 at the zero discount rat. However, the NPV of Project B declines more rapidly as the discount rate increases than does the NPV of Project A. AS we mentioned, this oocurs because the cash flows of B occur later. Both projects have the same [NPV at a discount rate of 10.55 percent. The IRR for a projec i the rate at which the NPV equals zero. Because the NPY of B declines more rapidly, B actually has a lower IRR. ‘As with the movie example, we can select the better project with one of three differ ont methods: 1 Compare NPVs ofthe ovo projects. Figure 5.6 aids our decision. Ifthe discount rate is below 10.55 percent, we should choose Project B because B has a higher NPV. Ifthe rate is above 10.55 percent, we should choose Project A because A has a higher NPV. Figure 5.6 Net Present Value ‘and the Internal Rate of Return for Mutually Exclusive Projects Project A Project 8 ele 08 129088 1 & sone rasan12 PART Il Valuation and Capltal Budgeting 2. Compare incremental IRR to discount rate, Another way of determining whether A. for Bia better project isto subtract the cash flows of A from the cash flows of B sand then calculate the IRR, This ie the incremental IRR approach, TThe incremental cash flows are: [NPV of incremental Cash Flows my B-A 0 $9000 9 $11,000 1085 $2,000 $3. $593. ‘This chart shows that the incremental IRR is 10.55 percent. Ia other words, the [NPV on the incremental investment it zero when the discount rate it 10.55 per cent. Thus, if the relevant discount rate is below 10.5 percent, Project B ie pre ferred to Project A. Ifthe relevant discount rate is above 10,55 pereent, Project A. is preferred to Project B. Figure 5.6 shows that the NPVs of the two projects are equal when the dis, count rate is 10.55 percent. In other words, the crossover rate in the figure is 10.55 percent. The incremental cash flows chart shows that the incremental IRR is also 10.55 percent. It is not a coincidence thet the crossover rate and the incre ‘mental IRR are the same; this equality must always hold, The incremental IRR is the rate that causes the incremental cash flows to have zero NPV. The incremental cash flows have zero NPV when the two projects have the same NPY. 3. Calculate NPV on incremental cash flows, Finally, we could calculate the NPV on the incremental eash flows. The chart that appears with the previous method dis plays these NPVs. We find that the incremental NPV is positive when the discount rate is either O percent or 10 percent. The incremental NPV is negative if the dis count rate is 15 percent. Ifthe NPV is positive on the incremental flows, we should choose B. If the NPV is negative, we should choose A. ‘In summary, the same decision is reached whether we (1) compare the NPVs of the two projects, (2) compare the incremental IRR to the relevant discount rate, or (3) exam: ine the NPV of the ineremental cash flows. However, as mentioned easier, we should nor compare the IRR of Project A with the IRR of Project B. We suggested earlier that we should subtract the cash flows of the smaller project 1m the cash flows of the larger project. What do we do here when the two projects have the same initial investment? Our suggestion in this ease is to perform the subtraction so that the first nonzero cash flow is negative. In the Kaufold Corp. example we achieved this by subtracting A from B. In this way, we can still use the basic IRR rule for evaluat Ing eash flows. The preceding examples ilustrate problems with the IRR approach in evaluating mutually exclusive projects. Both the professorstudent example and the motion picture example illustzate the problem that arises when mutually exclusive projects have different initial investments. The Kaufold Corp. example illustrates the problem that arises when ‘mutually exclusive projects have different cash flow timing. When working with mutually exclusive projets, itis unnecessary to determine whether it is the scale problem or the timing problem that exists. Very likely both occur in any real-world situation. Instead, the practitioner should use either an incremental IRR or an NPV approach. seleer os 13 once 18 & sone rasanCHAPTER 5 Net Present Value and Other Investment Rules mm 153, REDEEMING QUALITIES OF IRR IRR probably survives because it fills a need that NPV does not. People seem to ‘want a rule that summarizes the information about a project in a single rate of return. This single rate gives people a simple way of discussing projects. For exam- ple, one manager in a firm might say to another, “Remodeling the north wing has 2 20 percent IRR.” To their credit, however, companies that employ the IRR approach seem to under. stand its deficiencies. Companies frequently restrict managerial projections of cash flows to be negative at the beginning and strictly positive later. Peshaps both the ability of the IRR approach to capture « complex investment project in a single number and the ease of communicating that number explain the survival of the IRR. ATEST ‘To test your knowledge, consider the following two statements: |. You must know the discount rate to compute the NPV of a project, but you com: pute the IRR without referring to the discount rate, 2. The IRR rule is easier to apply than the NPV rule because you don't use the dis count rate when applying IRR. The first statement is true. The discount rate is needed to compute NPV. The IRR. is computed by solving for the rate where the NPV is zero, No mention is made of the discount rate in the mere computation. However, the second statement is false To apply IRR, you must compare the internal rate of return with the discount rate. Thus, the discount rate is needed for meking a decision under either the NPV or IRR approach, The Profitability Index Another method used fo evaluate projects is called the profitability index. It isthe ratio of the present value of the future expected cash flows after initial investment divided by the amount of the initial investment. The profitability index can be caleulated as: PY of cath flows subs overage onine Profitability index (PD) = initial investment Proftabily Index Hiram Finnegan, Ine. HH, apples a 12 percent discount rate to two invest iment opportunites. er Slo (i$ millions) Flows Subsequent ee ee on CY ae) eee) 1 $20 $70 $10 $7047 352 $50.47 2 =10 15 40 45.28 453 3528 seleer os 15 once 18 & sone rasan154 mM PARTI Valuation and Capital Sudgeting CALCULATION OF PROFITABILITY INDEX The profitability index is caleulsted for Project 1 as follows. The present value ofthe cash flows after the initial investment is: _ $10, $10 soar = Fp + SS The profitability index is caleulated by dividing this result by the inital investment of $20. This yields: 5p = S147 382 = "$20 Application of the Profitability Index How do we use the profitability index? We consider three situations 1. Independent projects: Assume that HET's two projects are independent. According to the NPV rule, both projects should be accepted because NPV is positive in each case. The profitability index (PI) is greater than one whenever the NPV is positive. Thus, the PL decision rule is: + Accept an independent project if PI > 1 + Reject it if PL < 1 2. Mutually exclusive projects: Let us now assume that HFI can only accept one of ils two projects. NPV analysis says accept Project 1 because this project has the larger NPV. Because Project 2 has the higher PI, the profitability index Teads to the ‘wrong selection, For mutually exclusive projects, the profitability index suffers from the seale problem that IRR also suffers ftom. Project 2 is smaller than Project 1. Because the PL is ratio, it ignores Project 1s larger investment, ke IRR, the flaw with the Pl approach can be corrected using ineremental analysis. We write the incremental cash flows after subtracting Project 2 from Prof ect | as follows: to tn CH ts ener me cd Go Yt) ree) 1-2 $10 $55 $30 $25.19 252 s1519 Because the profitability index of the incremental cash flows is greater than 0, we should choose the larger project-that is, Project 1. This is the same deci sion we get with the NPV approach. 3. Capital rationing: The first two cases implicitly assumed that HFI could always attract enough capital to make any profitable investments. Now consider the case when the firm does not have enough capital to fund all postive NPV projects. ‘This is the case of eapital rationing. Imagine that the firm has a thitd project, as well as the first two. Project 3 has the following cash flows: feleer 08 15 once 1 & sone rasanCHAPTER 5 Net Present Value ang Other Investment Rules 15 Cash Flows PV 212% of Cash 9 $ mitions) pene Ce an aa) oe) {in $ millions) eer a) 3 $10 $5 $60 $4337 434 $3337 Further, imagine that (I) the projects of Hiram Finnegan, Inc., are independent, bt (2) the firm has only $20 million to invest. Because Project 1 has an initial investment of $20 million, the firm cannot select both this project and another one. Conversely, because Projects 2 and 3 have intial investments of $10 million each, both these projects can be chosen. In other words, the cash constraint forces the firm to choose either Project 1 or Projects 2 and 3. ‘What should the firm do? Individually, Projects 2 and 3 have lower NPVs than. Project I has. However, when the NPVs of Projects 2 and 3 are added together, the sum is higher than the NPV of Project 1. Common sense dictates that Projects 2 and 3 should be accepted. ‘What does our conclusion have to say about the NPV rule or the PI rue? In the case of limited funds, we cannot rank projects according to their NPVs, Under certain assump- tions, we can rank them according to the ratio of present value to intial investment. This is the PI rule. Both Project 2 and Project 3 have higher PI ratios than does Project | TThus, they should be ranked shead of Project 1 when capital is rationed ‘The usefulness of the profitability index under capital rationing can be explained in nilitary terms. The Pentagon speaks highly of a weapon witha lot of “bang for the buck.” In capital budgeting, the profitability index measures the bang (the dollar return) for the buck invested. Henee, it is useful for capital rationing It should be noted thatthe profitability index doesnot work if funds are also limited beyond ‘the initial time period, For example, if heavy eath outflows elsewhere inthe firm were to occur at Year |, Project 3, which also hs a cash outflow at Year 1, might need tobe rejected. In other words, the profitability index cannot handle capital rationing over multiple time periods Tn addition, what economists term indivisibliies may reduce the effectiveness of the PI rule, Imagine that HEI has $30 milion available for capital investment, not $20 milion, The frm now has enough cash for Projects 1 and 2. Because the sum of the NPVs of these two projets is greater than the sum of the NPVs of Projects 2 and 3, the firm would be better served by accepting Projects | and 2. But because Projects 2 and 3 tll have the highest profi ability indexes, the PI rule now leads to the wrong decision. Why does the PI rule lead us astray here? The key is that Projects | and 2 use up all of the $30 million, whereas Projets 2 and 3 have a combined intial investment of oniy $20 million (= $10 + 10). If Projects 2 and 3 are accepted, the remaining $10 million must be left in the bank ‘This situation points out that care should be exercised when using the profitability index in the real world. Nevertheless, while not perfect, the profitability index goes a long way toward handling capital rationing 5.7 The Practice of Capital Budgeting So fr this chapter has asked, “Which capital budgeting methods should companies be using?” An equally important question is this: Which methods are companies using? Table 5.3 helps answer this question. As ean be seen from the table, approximately feleer 08.15 once 18 & sone rasan186 Table 53 Percentage of CFOs Who Always oF Almost Always Use Given Technique Table 5.4 Frequency of Use of Various Capital Budgeting Methods. PART 11 Valuation and Capltal Budgeting or eyes Internal rate of return (RR) 736% Net present value (NPV) us Payback metho 567 Discounted payback 235 Profitability index 19 three-quarters of U.S. and Canadian companies use the IRR and NPV methods. This is not surprising given the theoretical advantages of these approaches. Over half of these companies use the payback method, a rather surprising result given the conceptual prob- Jems with this approach. And while discounted payback represents a theoretical improve ‘ment over regular payback, the usage here is far les. Perhaps companies are attracted to the user‘riendly nature of payback. In addition, the flaws of this approach, as mentioned inthe current chapter, may be relatively easy to correct. While the payback method ignores all cash flows after the payback period, an alert manager can make ad hoe adjustments for a project with backioaded cash flows. Capital expenditures by individual corporations can add up to enormous sums for the economy as a whole. For example, for 2018, ExxonMobil announced that it expected to have about $25 billion in capital outlays during the year, down from its record $42.5, billion in 2013, About the same time, competitor Chevron announced that it would ectease its capital budgeting for 2018 to $18. billion, down from about $19.1 billion in 2017. Other companies with large capital spending budgets included Walmart, which pzo- jected capital spending of about $6.9 billion for 2018, and Apple, which projected capital spending of about $16 billion for 2018, Large-scale capital spending is often an industrywide occurrence. For example, in 2018, capital spending in the semiconductor industry was expected to reach $77.4 billion. This tidy sum was also spent by the industry in 2017. ‘According to information released by the Census Bureau in 2017, capital investment for the economy at a whole was $1.40] trillion in 2013, $1,507 trilion in 2014, and $1.45 trillion in 2015. The total for the three years exceeded $44 trillion! Given the sums at stake, itis not too surprising that careful analysis of capital expenditures is some- thing at which successful businesses seek to become adept. ‘One might expect the capital budgeting methods of large firms to be mote sophist- cated than the methods of small firms. After all, large firms have the financial resources to hire more sophisticated employees. Table 54 provides some support for ths idea. Here 9 Firms Internal rate of return ORR) 341 287 Net present value (NPV) 3.42 283 Payback method 225 272 Discounted payback 155 158 Proftabity index B a8CHAPTER 5 Net Present Value and Other Investment Rules M157 firms indicate frequency of use of the various capital budgeting methods on a scale of 0 (never) to 4 (always). Both the IRR and NPV methods are used more frequently, and payback less frequently, in large firms than in small firms. Conversely, large and small firms employ the last two approaches about equally. ‘The use of quantitative techniques in capital budgeting varies withthe industry. As one ‘would imagine, firms that are beter able to estimate cash flows are more likely to use NPV. For example, estimation of ash flow in certain aspects of the oil business is quite feasible Because of this, energyrlated firms were among the frst to use NPV analysis. Conversely the cash flows in the motion picture business are very hard to projec. The grosses of great hits like Spiderman, Harry Potter, and Star Wars were far, far greater than snyone imagined. ‘The big failures tke King Arthur: Legend of the Sword and Deepwater Horizon were unex: pected, as well. Because of this, NPV analysis is frowned upon in the movie business. How does Hollywood perform capital budgeting? The information that a studio uses to accept or reject a movie idea comes from the pitch. An independent movie producer Schedules an extremely brief mecting with studio to piteh his or her idea for a movie. Consider the following four paragraphs of quotes concerning the pitch from the thor oughly delightful book Ree! Power: “They [studio executives] don't want to know tao much” says Ron Simpson, “They want to know concept... They want to know what the thretiner i, because they want it to sugeet the ad campuin. They want a title... They don't want to hear any eateries, And ithe meeting lasts more than five minutes, they're probably not going todo the projec.” A guy comes in and says this is my idea: Jaws on 2 spaceship.” says writer Cay Frohman (Under Fire). "And they say "Brillant, fantastic” Becomes Allen That is Jans on 1 spaceship, ukimatey... And that’s &. Thats all they want to hear, Tair attude is "Don't confuse us with the details of the story" “Some high-oncept stories are more appealing to the studios than others. The leas liked best are sufficiently orginal thatthe audience will not fel it has already seen the move, yet similar enough to past isto reassure executives wary of anything too far cout, Thus, the fequently used shorthand: I's Flashdance inthe country (Fotoo) or High [Noon in oster space (Outland), “One gambit not to use during a piel" says executive Barbara Boyle, “is to talk bout big boxoffice groses your sory issue 10 make, Executives know at wll as anyone that i's impossible to predict how much money a move wil make, and declarations tothe contrary are considered pure malakey” TSRETR nk Me ed oD rf an Sesh od New Wi Mare Summary and Conclusions A. In this chapter, we covered diferent investment decision rules. We evaluated the most popular alternatives to NPV: the payback period, the discounted payback period, the internal rate of return, and the profitability index. In doing so, we learned more about the NPV. 2 While we found thatthe alternatives have some redeeming qualities, when sll is said and done, they are not NPV; for those of us in finance, that makes them decidedly secondrate, 3. Ofthe competitor to NPY, IRR mus be ranked above payback. Infact, IRR always reaches the same decision as NPV for an independent project with conventional cash flows. setae 08.15 once 17 &158 PART 1 Valuation and Captal Budgeting J. We classified the flaws of IRR into two types, Firs, we considered the general ease apply: ing o both independent and mutually exclusive projets. There appeared to be two prob- Jems here 4 Some projects have cash inflows followed by one or more outflows. The IRR rule is inverted here: One should accept when the IRR is befow the discount rate. , Some projects have a number of changes of sign in their cashflows, Here, there are Iikely to be multiple internal rates of return, The practitioner must use NPV. . Next, we considered the specific problems with the IRR for mutually exclusive projects. ‘We showed that, due to differences in either size or timing, the project with the highest IRR anced not have the highest NPV. Hence, the IRR rule should not be applied. (Of course, NPV can still be applied.) However we then calculated incremental cash flows, For ease of calculation, we suggested subtracting the cash flows ofthe smaller project from the eash flows ofthe larger project. In that way, the incremental inital cash flow is negative. One can always reach a correct decision by accepting the larger project f the incremental IRR is greater than the discount rte, 5. We described capital rationing as the ease where funds are limited to a fixed dollar amount With capital rationing, the profitability index is useful method of adjusting the NPV. Concept Questions 1 Payback Period and Net Present Value IF «project with conventional cash flows has a payback period less than the project's life, ean you definitively state the algebraic sign of the NPV? Why or wiy not? Ifyou know thatthe discounted payback period is less than the projet’ life, what ean you say about the NPV? Explain, [Net Present Value Suppose a project has conventional cash flows and a positive NPV. ‘What do you know about its payback? lis discounted payback? Its profitability index? Its IRR? Explain, Comparing Investaent Criteria Define each of the following investment rules and dis uss any potential shortcomings ofeach. In your definition, state the eitrion for accept ing or rejecting independent projects under each rule a, Payback petiod. Ds. Internal rate of return, . Profitability index. 4. Net present value Payback and Internal Rate of Return A project has perpetual césh flows of C per period, a cost of /, and a required return of r. What is the relationship between the Droject’s payback and its IRR? What implications Goes your answer have for long-lived projects with relatively constant cash flows? International Investment Projects In June 2017, BMW announced plans to spend $600 million to expand production at its South Carolina plant. The new investment would allow BMW to prepare for new X model SUVs. BMW apparently fet it would be better fable to compete and create value with a US-based facility. In fact, BMW expected to export 70 percent of the vehicles produced in South Carolina. Also in 2017, noted ‘Taiwanese iPhone supplier Foxconn announced plans to build a $10 billion plant in Wisconsin, and Chinefe tire manufacturer Wank Tire Corp. announced plans to build $1 bilion plant in South Carolina, What are some of the reasons that foreign manu: facturers of products as diverse as automobiles, cell phones, and tires might arrive at the same conclusion to build plants in the United States?