Universidad Carlos III 9/2/2010

Topic 3 Investment Appraisal: Introduction to NPV

Outline:

Topic 3 SESSION 5
Investment Appraisal: 3.1 Introduction
3.2 Mathematical representation of an investment project
Introduction to NPV 3.3 NPV of an investment project
3.4 How to interpret NPVs
Copyright of Spanish version from María Gutiérrez
Translation into English by Francisco Romero

Universidad Carlos III SESSION 7

Financial Economics 3.5 Special cases: capital rationing
3.6 IRR and other techniques to evaluate projects

Topic 3 Investment Appraisal: Introduction to NPV 3.1 Introduction

Learning objectives:
 Companies create wealth when investing in real assets.
 Real or Productive Assets: assets that generate cash in the future and, as
1. To describe an investment project according to its opposed to financial investments, like stocks and bonds, are not traded in
cash flows. the financial markets.

2. To calculate and interpret the NPV of an investment

 Corporate decision making focus on investment decisions in
real assets (location, machinery, hiring, advertising, etc).
project.
 Financial managers spend most of their time analyzing and
3. Investment decisions with capital rationing. selecting the main corporate investment projects, whose
future payments are uncertain and whose strategical impact is
4. To calculate and interpret the IRR of a project and its crucial (e.g. whether to open or not a new production plant).
payback period.  How does the finance director know if an investment project
will create value?
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3.1 Introduction 3.2 Mathematical representation of an investment project

 The valuation method known as NPV (Net Present Value)

measures the monetary flows the a project will generate in the
future, calculates its PV and compares it with the costs needed to
implement the project.
 Those with a positive NPV should be undertaken since they
Example: A company has paid €2,500 euros to a consulting company for them to estimate the cost savings that could
create wealth (future flows are higher than the costs).
An investment project is characterized by the net (or incremental)
operating cash flows that it generates.
 Difference between operating cash flows (non financial) of a company
if the project is undertaken and those if it is not undertaken.
We assume that cash-flows occur at the end of period.
be obtained with the change in the equipment used to manufacture a product in the next three years.
1. The estimated annual demand for the next 3 years is 100,000 units at €70/unit.

 NPV theory appears to be simple, but some difficulties arise to: 2. The manucturing cost is €40/unit and the curremt equipment will have zero market value within three years
(its current market price is €7,000).
 Estimate future cash-flows (we assume we know them) 3. The price of the new manufacturig equipment is €750,000.
The estimated manufacturing cost with the new equipmanrt is €27/unit.
 Estimate the discount factor for each cash-flow.
4.

5. Maintenance of the new equipment needs to be performed by a skilled worker who would earn €16,000/year
 The appropriate discount factor for each expected flow is the return 6. Residual or liquidation value of the new equipment will be €9,500 within three years.
offered by the best alternative investment with similar risk. Why?
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3.2 Mathematical representation of an investment

3.3 NPV of an investment project
project
 The Present Value (PV) of an investment project is the
Cash-flows current equip. t=0 t=1 t=2 t=3 present value of the net incremental cash-flows of the project.
+Sales 7,000 7,000 7,000
CF1 CF2 CF3 CF N
-Production costs -4,000 -4,000 -4,000 PV = + + + ... +
(1 + i1 ) (1 + i2 ) 2 (1 + i3 ) 3 (1 + i N ) N
Net 0 3,000 3,000 3,000
Cash-flows new equip.  The Net Present Value (NPV) of an investment project is the
-Purchase -750 difference between the Present Value and the initial costs to implement
+Sale old equip. 7 the project.
+Sales 7,000 7,000 7,000 CF1 CF2 CF3 CF N
NPV = CF0 + + + + ... +
-Production costs -2,700 -2,700 -2,700 (1 + i1 ) (1 + i2 ) 2 (1 + i3 ) 3 (1 + i N ) N
-Salaries -16 -16 -16 t=0 t=1 t=2 t=3
+Residual value 10 Incremental CFs -0.743 1.284 1.284 1.294
Net -743 4,284 4,284 4,294 Applicable rate 10% 10% 10%
Incremental Flows -743 1,284 1,284 1,294
Discounted values -0.743 1.167 1.061 0.972
Present Value 3.200
NPV 2.457
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3.4. How to interpret NPV

3.3 NPV of an Investment
Example: An investment bank, is currently suffering from slowdown in sales and temporary
 How do we interpret NPV=0?
overstaffing.
•The PV of the future cash flows is equal to the initial costs.
•The bank could reduce personnel expenses by €600,000/year for the next three years if
•The expected return on the project compensates for its level of risk..
25 employees are made redundant.
•However, the market is expected to recover in 4 years and these 25 employees need to be re-
 How do we interpret NPV>0?
hired. Hiring and training costs for these employees are estimated to be
•The PV of the future cash flows is higher than the initial costs.
€100,000/employee.
•The expected return on the project is above the minimun required for the level
of risk it generates.
•If the discount rate is 10%, should the company maintain or reduce its workforce?
•In colloquial terms, we can say that this investment makes us “richer” or
increases the value of the company.
t 0 1 2 3 4

Net incremental CFs 0 0.6 0.6 0.6 -2.5

 How do we interpret NPV<0?
•The PV of the future cash flows is lower than the initial costs.
d/r 10% 10% 10% 10% 10% •The expected return on the project is below the minimum required for
Discounted values 0 0.545 0.496 0.451 -1.71 assuming such a risk.
VAN -0.22 (220000€)
• We can say that this investment reduces our wealth.
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3.4. How to interpret NPV 3.4. How to interpret NPV

The main task of a finance director is to identify projects with positive NPV.
 The idea is to accept (reject) projects with NPV >=0 (<0).
 When the NPV is positive, we increase our wealth as long as we invest.
 The money needed to start a project is less than the PV of the
future cash flows that the project generates.
How frequently are we going to find projects with positive
NPVs?
 Investors want to maximize their wealth. Therefore they compete
for the best investment opportunities.
 As soon as an project with positive NPV is identified many

 What can we do if several projects have positive NPVs? investors will compete for it and its initial cost or price increases.
 NPVs can be added, therefore increasing the number of positive  When there are no barriers to entry, the process continues until the
NPV projects increases our wealth even further. NPV becomes zero.
 There are important differences between investing in real and
 What can we do if all available projects have a negative NPV? in financial assets:
 We should not invest in projects with negative NPVs.
 Markets for real assets: Many barriers to entry. Potentially many
 In many cases, firms need to choose between mutually exclusive projects investments with positive NPV.
(Examples?)  Markets for financial assets: Few barriers to entry. NPV tends to
• Which criteria should we follow? zero quickly. (Does 0-NPV mean zero return?)
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3.5 Special cases: capital rationing 3.5 Special cases: capital rationing

Projects are mutually exclusive because of limited resources Example: Suppose you can invest up to 10 monetary units each period in the
(time, capital…). following potential projects:
Capital rationing: limited resources are available to face
initial costs. A
t=0
-10
t=1
30
t=2
5
NPV 10%
21,4
B -5 5 20 16,1

There are two types of capital rationing: C -5 5 15 11,9

 Soft rationing: Taking into account the capital restriction, the NPV is maximized
• An artificial limit to available funds for investment is imposed to each when investing in B+C. But, what happens if there is a fourth project?
division. (What is the rationale for this?)
• This rationing can be extended to other resources.
 Hard rationing: A
t=0
-10
t=1
30
t=2
5
NPV 10%
21,4
• Capital markets imperfections force the firm to depend on retained B -5 5 20 16,1
C -5 5 15 11,9
profits when deciding how much to invest.
D 0 -40 60 13,2

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3.6 IRR and other techniques 3.6 IRR and other techniques
Payback method
The NPV is used by many companies, however techniques to
evaluate invesment projects are also used in order to have a The Payback period is the number of years needed to recover the initial
investment.
more complete picture.
The objective is to accept projects with a payback period < K years.
These techniques do not generate better results; they are
Weaknesses of this method:
simply different and need to be interpreted  Time value of money is not taken into account
 Cashflows that take place after K are ignored (penalizing long term projects).
Examples:
 Payback method t=0 t=1 t=2 t=3 t=4 Payback NPV (10%)

 IRR (Internal Rate of Return) Project A

Project B
-2,0
-2,0
2,30
1,25
0,00
1,25
0,00
1,25
0,00
1,25
1
2
0,09
1,96
Project C -2,0 0,75 1,25 1,50 1,75 2 2,04

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3.6 IRR and other techniques 3.6 IRR and other techniques
An “improved” payback method considers discounted cash flows.  Why is the Payback method used?
In this case, time value of money before K is taken into account (however
whatever happens after K is still ignored; it is penalized even more strongly  Uncertainty makes it difficult to estimate distant cash flows,
now) particularly in changing and highly inflationary
t=0 t=1 t=2 t=3 t=4 Payback NPV (10%) environments.
Project A -2,0 2,30 0,00 0,00 0,00 1 0,09
Project B
Project C
-2,0
-2,0
1,25
0,75
1,25
1,25
1,25
1,50
1,25
1,75
2
2
1,96
2,04  As long as there are capital restrictions, additional cash
Discounted
Cash Flows
flows need to be generated very quickly, for the firm to be
able to start new projects.
t=0 t=1 t=2 t=3 t=4 Payback (d) NPV (10%)
Project A -2,0 2,1 0,0 0,0 0,0 1 0,09
Project B
Project C
-2,0
-2,0
1,1
0,7
1,0
1,0
0,9
1,1
0,9
1,2
2
3
1,96
2,04
 It is attractive to managers that are assessed based on short
term results.

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3.6 IRR and other techniques 3.6 IRR and other techniques
The Internal Rate of Return (IRR). Example: Calculate the IRR using the following incremental cash flows:

The NPV of a project is the function of a discount rate (d). t=0 t=1 t=2 t=3 NPV (10%) NPV (TIR) IRR
Cash Flows -9 4 5 3 1.02 0.00 16.60%
CF 1 CF 2 CF 3 CF N
NPV ( d ) = CF 0 + + + + ... +
(1 + d ) (1 + d ) 2 (1 + d ) 3 (1 + d ) N
NPV(D)
The Internal Rate of
d NPV(D)

Return of a project (IRR) is the discount 0

0.01
3.000
2.774 4,0
rate that makes the NPV 0, i.e.: 0.02
0.03
2.554
2.342 3,0
0.04 2.136
0.05 1.936 2,0
NPV

0.06 1.742
CF 1 CF 2 CF 3 CF N
0 = CF + + + + ... + 0.07 1.554 1,0
( 1 + IRR ) ( 1 + IRR ) 2 ( 1 + IRR ) 3 ( 1 + IRR ) N
0 0.08 1.372
0.09 1.195 0,0
0.1 1.023
0.11 0.855
-1,0 0 0,05 0,1 0,15 0,2
 There can be more than one IRR. 0.12 0.693
d
 Besides, as soon as the project lasts for more than two periods, we need to
0.13 0.535
0.14 0.381

use a trial and error method or a financial calculator to find the IRR.
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3.6 IRR and other techniques 3.6 IRR and other techniques
The IRR method implies a comparison between the IRR of a Projects with CF0 ≤ 0 and CFt ≥ 0 , t > 0.
specific project and a reference/hurdle rate: the return obtained  This is a pattern that applies to most investments in real assets.
in alternative investment with a similar risk level.  In this case IRR and NPV lead to similar conclusions.
N
CF t
NPV ( r ) = CF + 
We accept the project when the reference rate is below the (1 + r )
0 t
t = 1
N
CF t
IRR. 0 = CF 0 + t = 1 ( 1 + IRR ) t
NPV ( r ) > 0 ⇔ IRR > r

Observations about the IRR:

Example:
t=0 t=1 t=2 t=3 NPV (3%) NPV (IRR) IRR

 In many cases, NPV and IRR lead to the same conclusions.

CFs -100 0 0 112 2,50 0,000 0,0385

But this is not always the case.

d NPV (d)
0 12,000 NPV (d)

 Computing the NPV is easy and its always leads to the correct
0,01 8,706 20,0
0,02 5,540
10,0
0,03 2,496
0,0
result. However, the IRR summarizes the results in one single
0,04 -0,432

NPV
0,05 -3,250 -10,0 0 0,05 0,1 0,15 0,2
0,06 -5,963 -20,0
figure and this results attractive to managers. 0,07
0,08
-8,575
-11,091
-30,0
-40,0
0,09 -13,515
d
0,1 -15,853
0,11 -18,107
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3.6 IRR and other techniques 3.6 IRR and other techniques
Projects with CF0 ≥ 0 and CFt ≤ 0, t > 0. Other projects
Pattern usually applicable to loans. When there are alternating negative and positive CFs there could be multiple
IRR and NPV are equivalent, however the potential debtor should accept loans IRR and cases with no IRR.
when IRR<interest rate Example:
t=0 t=1 t=2 t=3 NPV (30%) NPV (IRR) IRR
N
CF t
NPV ( r ) = CF 0 + 
t = 1 (1 + r ) t
CFs -4 25 -25 0 0,44 0,000
0,000
0,25
4
N
CF t
0 = CF 0 +  t = 1 ( 1 + IRR ) t
d
0
NPV (d)
-4,000 NPV (d)
0,25 0,000 3,0
NPV ( r ) > 0 ⇔ IRR < r 0,5 1,556
2,0
0,75 2,122
1 2,250 1,0
Example: 1,25 2,173 0,0
t=0 t=1 t=2 t=3 NPV (13%)NPV (IRR) IRR 1,5 2,000
VAN

1,75 1,785 -1,0 0 1,25 2,5 3,75 5

CFs 50 -5 -5 -55 3,54 0,000 0,1 2 1,556 -2,0
2,25 1,325
2,5 1,102 -3,0
d VAN (d)
VAN (d) 2,75 0,889 -4,0
0 -15,000
15,0 3 0,688
0,01 -13,234 -5,0 d
10,0 3,25 0,498
0,02 -11,536
3,5 0,321
0,03 -9,900 5,0
3,75 0,155
0,04 -8,325 0,0
VAN

4 0,000
0,05 -6,808 -5,0 0 0,05 0,1 0,15 0,2 4,25 -0,145
0,06 -5,346 -10,0 4,5 -0,281
0,07 -3,936
-15,0 4,75 -0,408
0,08 -2,577
-20,0
0,09 -1,266 d 23 24

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3.6 IRR and other techniques Readings

Example:
1. Grinblatt , M. and S.Titman, “Financial Markets
and Corporate Strategy”, McGraw-Hill 2003.
t=0 t=1 t=2 t=3 NPV (30%) NPV (IRR) IRR
CFs 1 -3 2,5 0 0,17

d
0
NPV (d)
0,500
CHAPTERS 10
0,1 0,339 NPV (d)
0,2 0,236 1,0
0,3 0,172
0,4 0,133
0,5
0,6
0,111
0,102 2. Brealey, R., S. Myers and Allen, “Principles of
VAN

Corporate Finance” 8th edition, Mcgraw-Hill 2006

0,7 0,100
0,5
0,8 0,105
0,9 0,114
1 0,125
1,1
1,2
0,138
0,153
0,0
CHAPTERS 5 and 6
1,3 0,168
1,4 0,184 0 0,5 1d 1,5 2
1,5 0,200
1,6 0,216
1,7 0,232
1,8 0,247

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