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MBAC 6060 Chapter 5
MBAC 6060 Chapter 5
Chapter 5
Net Present Value &
Other Investment Rules
1
Capital Budgeting is…
• Budgeting the firm’s capital
• Spending the big money
– Not small, short-term money
The light bill, salaries, office supplies…
• But BIG, long-term money
– These are called Capital Expenditures
• So if a firms sells stocks, sells bonds, retains
earnings…
• What does it do with the money?
2
Here’s the idea:
• The CAPITAL BUDGETING DECISION is about
ADDING VALUE to the firm
• To pay for capital investments, a firm can
sell stocks, sell bonds or retain earnings…
• But SHOULD a firm sell stocks, sell bonds or
retain earnings?
– Does it have something WORTHWILE to do with the
money?
– Does it have GOOD CAPITAL PROJECTS?
– Does the proposed project ADD VALUE?
• If the proposed project does not add value…
– Then DON’T sell stocks, DON’T sell bonds, DON’T
retain earnings
– Instead the firm should PAY DIVIDENS
3
Net Present Value
• So how do we know if a proposed project Adds Value?
• We calculate the proposed project’s Net Present Value
• Called NPV
4
Net Present Value is
1. The PV of all the project’s future cash flows…
– CF1, CF2, CF3,…
2. Discounted at the Proper discount rate (R)…
– A higher discount rate for riskier projects
– A lower discount rate for less risky projects
3. Plus the initial (time 0) cash flow...
– CF0 is the Initial Cost of the project
– CF0 is usually an outflow, so it is usually negative
5
How to think about NPV
• Think about paying $1,000 today for “something”
– A bond, an annuity, a truck, a machine…
• Assume that “something” will pay a net of $400 per year
for the next 3 years
• Also assume the proper discount rate is 10%
• So pay $1,000 now for $400 at time 1, 2 and 3.
– Is it a good deal?
– First we have to get all the CFs to the same time period
– we will use time zero
– So take the PV of all the CFs
– Since all CFs are the same, use the TVM function:
N = 3 R = 10% PMT = $400 PV = $995
• So pay $1,000 today to get CFs that are worth only $995
• We would be losing $5 in present value terms
• NPV = -$5 So don’t do it!
6
Review Question:
• A project costs $100,000 today (buy a truck)
• The project will have Net CFs of $18,000 per
year
for 10 years
– $18,000 is CASH IN (revenues) less CASH OUT
(expenses)
for each of the next 10 years
• The proper discount rate is 10%
• Calculate the project’s Net Present Value:
• Hint: First calculate the PV of $18k per year
for 10 years discounted at 10%
7
Review Answer:
• A project costs $100,000 today (buy a truck) and has CFs of
$18,000 per year for 10 years
• The proper discount rate is 10%.
• NPV = Initial CF + PV of Future CFs
• PV of Future CFs:
N = 10 R = 10% PMT = 18,000 PV = $110,602
• Initial CF = -100,000
• NPV = – $100,000 + $110,602 = $10,602
• So the firm can pay $100,000 for truck that will earn
(in PV terms) $110,602
• So the firm can trade $100,000 for $110,602
• This adds $10,602 of value to the firm!
• Why don’t firm’s do this all the time? They do.
8
Chapter Outline:
5.1 Net Present Value (Calculate and Interpret)
5.2 Payback Rule
5.3 Discounted Payback Rule (skip this)
5.4 Internal Rate of Return (IRR)
5.5 Problems with IRR
5.6 Profitability Index
5.7 The Practice of Capital Budgeting
13
How to Calculate NPV in Excel:
14
Example
• Recall the R = 15% and CF0 = -30, CF1 to CF7 = 6, CF8 = 8
A B C D E F G H I
1 0 1 2 3 4 5 6 7 8
2 -$30 $6 $6 $6 $6 $6 $6 $6 $8
3
4 Rate 15%
5 NPV =A2+NPV(B4,B2:I2)
A B C D E F G H I
1 0 1 2 3 4 5 6 7 8
2 -$30 $6 $6 $6 $6 $6 $6 $6 $8
3
4 Rate 15%
5 NPV -2.42
15
Example Continued:
What if the discount rate is 10% instead of 15%.
• Just change R to 10% and NPV = 2.94 > 0
• Now NPV > 0, so the project does add value
17
Review Question:
• A project costs $3,000 today
• It will have positive CFs of $600 per year for 10 years.
• In addition, it will cost $200 to clean up the mess caused
by the project at time 10
• The proper discount rate is 10%.
• Calculate the project’s NPV:
18
Review Answer:
• Costs $3,000 so CF0 = -$3,000
• Pays $600 10 times but costs $200 at time 10
• So CF1 through CF9 = $600 and CF10 = $600 - $200 = $400
In Excel:
=–3000+NPV(.10,600,600,…,600,400) = 609.63
Be sure to type (or reference) $600 nine times
Extra Question:
What if the discount rate increases to 15%
NPV at 15% = -$38.18
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Consider NPV as a Decision Rule:
1. The NPV rule accounts for the time value of money
• Further out CFs are discounted by a greater amount
• (1 + R)2 vs. (1 + R)10
2. The NPV rule accounts for the risk of the cash flows
• The greater the risk, the greater the cost of the company’s
capital
• You want to make yachts? Give me 145% on my loan.
• You want to make toilet paper? I’ll take 10% on my loan.
• The cost of the firm’s capital is the discount rate (R)
• The greater the R, the smaller the NPV
3. NPV measures the increase in value from undertaking
the project
• If we have two mutually exclusive projects
• Select the one with the higher NPV
• Since it adds more value to the firm
20
Other Rules:
• Are there other ways to determine if we
should go ahead with a project?
• NO!
• But we’ll look at some other common rules
anyway and try to see why they are
flawed.
• The Payback Period Rule
• Internal Rate of Return
• Profitability Index
21
5.2 The Payback Period Rule
• Count the number of years it takes to recoup the initial
investment
• If the number of years is fewer than the required
years, accept.
• 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:
– It is Easy
– Biased toward liquidity
22
Payback Period Example:
• CF0 = -$165,000; CF1 = $63,120; CF2 = $70,800; CF3 = $91,080
• Year 1: $165,000 – $63,120 = $101,880 (cost not yet recovered)
• Year 2: $101,880 – $70,800 = $31,080 (cost not yet recovered)
• Year 3: $31,080 – $91,080 = -$60,000 (recovered during year 3)
• Payback Period = 2 yrs + Portion of next year needed to get the rest
2 + $31,080 / $91,080 = 2 + 0.34 = 2.34 years
• If required payback period is 2 years, reject the project.
• If required payback period is 3 years, accept the project.
23
One More Payback Period Example
• Assume a 2 year payback requirement
Year Long Short 1 Short 2
0 -250 -250 -250
1 100 100 200
2 100 200 100
3 100
4 100
Payback Period 2.5 1.75 1.50
NPV @ 13% $47.45 ($4.88) $5.31
25
Review Answer:
Project 1: $500 = $200 + $200 + .5($200) 2.50 Years
Project 2: $500 > 4($100) NEVER
Project 3: $500 = $0 + $0 + $0 + .25($2,000) 3.25 Years
26
Consider Payback Period as a Decision Rule:
• The Payback rule does not account for the time value of
money
• With a 2 year rule, CF1 and CF2 are the same
• The Payback rule does not account for the risk of the
cash flows
• High risk projects and low risk projects are the same
• Payback rule gives no indication of the project’s value.
• If we have two mutually exclusive projects
• Select the one with the shorter payback period
• Since it adds more value to the firm
• Consider “Long” and Short 2 from the previous page:
Long Short 2
Payback Period 2.50 1.50
NPV at 13% 47.45 5.31
• Long adds more value but has the longer Payback period
27
Consider Payback Period as a Decision Rule:
• R = Infinity
– For all CFs after the Payback Period
– Since they are not considered
28
5.3 The Discounted Payback Period
• 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.
• By the time you have discounted the cash flows,
you might as well calculate the NPV.
• So we’ll skip this rule
29
5.4 Internal Rate of Return (IRR)
• IRR is the discount rate that sets NPV to zero
NPV = CF0 + CF1/(1 + R) + … + CFN/(1 + R)N
A B C D E
1 CF0 -100
2 CF1 60
3 CF2 60
4 IRR 13.07%
33
Graph of NPV and R:
• When NPV = 0, R = IRR. This happens at R = 13.07%
• If the Required Rate (the Hurdle Rate) < IRR, then accept since NPV > 0
• If the Required rate is 12%, accept. If it is 14%, reject.
$20.00
$15.00
$5.00
$0.00
NPV
-$15.00
-$20.00
-$25.00 34
Review Question:
• A project costs $5,000 today
• It will have positive CFs of $800 per year
for 10 years.
• Calculate the project’s IRR
35
Review Answer:
• Note that since all the CFS are the same you
can use the Excel Rate Function
NPER = 10, PMT = 800, PV = -5000
=RATE(nper, pmt, pv, [fv], type])
=RATE(10,800,-5000) = 9.61%
• Or you can enter the values in cells and use the IRR
function
Extra Question:
• What is the NPV of these CF at 9.61%?
• The NPV is $0.00.
• The IRR is the discount rate that sets NPV = 0
36
5.5 Problems with IRR:
Irregular Cash Flows that change signs (more than once):
A mining project costs $90
It pays $132 in year 1 and $100 in year 2
Clean up costs in year 3 are $150
CF0 = -$90, CF1 = $132, CF2 = $100, CF3 = -$150
5% NPV = -$90 + $132/1.05 + $100/1.052 - $150/1.053 = -$3.16
25% NPV = -$90 + $132/1.25 + $100/1.252 - $150/1.253 = $2.80
50% NPV = -$90 + $132/1.5 + $100/1.52 - $150/1.53 = -$2.00
If the CFs are not regular, the IRR rule may not work
37
Example with Irregular CFs
CF0 = -$90, CF1 = $132, CF2 = $100, CF3 = -$150
A B C D E F G H I
1 CF0 -90 Guess 10%
2 CF1 132
3 CF2 100
4 CF3 -150
5 NPV =IRR(B1:B4,E1) = 10.11%
A B C D E F G H I
1 CF0 -90 Guess 50%
2 CF1 132
3 CF2 100
4 CF3 -150
5 NPV =IRR(B1:B4,E1) = 42.66%
38
Graph of NPV and R for this Project:
• When NPV = 0, R = IRR. This happens at R = 10.11% and 42.66%
• If Required Rate < 42.66%, accept, but less than 10.11%, reject
• The IRR rule (if the required rate is less than IRR, accept) does not
work!
4.00
0.00
0% 10% 20% 30% 40% 50% 60%
-2.00 R (Discount Rate)
NPV
-4.00
-6.00
-8.00
39
-10.00
Another Problem with IRR:
• Mutually Exclusive Projects:
• Both require the same factory or land or HR or…
Project A Project B
CF0 -500 -400
CF1 325 325
CF2 325 200
50.00
IRR = 22.18%
NPV
0.00
0% 5% 10% 15% 20% 25% 30%
R (Discount Rate)
IRR =19.43%
-50.00
-100.00
42
How to find Cross Over Point:
Calculate the IRR of the differences in the CFs:
IRR of (A – B) = 11.80%
– This also works for B – A as well. Try it.
43
5.6 The Profitability Index (PI)
Profitability Index = PV/Cost
Project A Project B
CF0 -500 -400
CF1 325 325
CF2 325 200
• Now look at the NPV & PI for each project at different discount rates:
Project A Project B
R Cost PV NPV PI Cost PV NPV PI
5% 500 604 104 1.21 400 491 91 1.23
10% 500 564 64 1.13 400 461 61 1.15
15% 500 528 28 1.06 400 434 34 1.08
20% 500 497 -3 0.99 400 410 10 1.02
25% 500 468 -32 0.94 400 388 -12 0.97
30% 500 442 -58 0.88 400 368 -32 0.92
46
5.7 The Practice of Capital Budgeting
What do firms use? (Table 5.3, page 157)
47
5.7 The Practice of Capital Budgeting
What do firms use? (Table 5.4, page 158)
• Firms Asked frequency of use: 0 = Never, 4 = Always
48
Another Criteria:
– Not in the text but sort of related to Payback Period:
• How long until a Positive CF?
• Consider this Project:
– Pay $200 now and again every year for 4 more years
– Then get $400 for the 5 years after that.
– 10% discount rate
• Time Subscript Notation:
– CF0 through CF4 = -$200 and CF5 through CF9 = $400
49
The “How long until a Positive CF” Criteria
• Project NPV > 0, but doesn’t make money for 5 years
– If this a small project proposed by a big company
– Then maybe this not a problem
– Maybe a big company can finance a “negative CF” project for a
few years
• But if this is a STARTUP
• Investors may not be willing to wait that long
• The amount of cash a company loses each year
– And therefore needs to have replenished to do business the next
year
Is called it’s Burn Rate
50
Burn Rate
Think of it this way: Start a new company:
• Time 0: Buy computers, manufacturing equipment, hire
people
• 1st year: Don’t sell anything, but pay salaries
– So a negative CF
– That money must be supplied by owners or lenders
• 2st year: Sell a little, still pay salaries
– So still a negative CF
– So need more money to get through year 2
• Keeps happening until a year’s CF is greater then zero
• Now the firm (or project?) has generated enough cash to
cover that year’s expenses
51
Burn Rate
1 2 3 4 5 6
Inflows 0 $100 $200 $300 $800 $900
Outflows -$500 -$500 -$600 -$650 -$700 -$750
CF -$500 -$400 -$400 -$350 $100 $150
52
So where Do We Go From Here?
• We will spend a lot of time looking a capital budgeting decisions:
CF1 CF2 CFN
NPV CF0
1 R 1 R 2 1 R N
To do this we need to know two things:
1. How to calculate the correct cash flows to use each period:
The Numerators (CF0, CF1, …, CFN)
– We’ll need to calculate the net cash generated by a project
– lots of accounting
2. How to calculate the correct discount rate:
The denominators (R)
– Calculate risks and returns needed to determine R in general
– And then how to R for a specific company or project
• Along the way will learn a lot of finance terminology, history,
methodology…
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