Topic 2 -Valuation and Capital Budgeting

Lecture 4: Net Present Value and Other

Investment Rules
Chapter 6
Overview of Lecture
Why Use NPV? The Internal Rate of Return

The Payback Period Method Problems with the IRR Approach

The Discounted Payback Period The Profitability Index

The Average Accounting Method The Practice of Capital Budgeting

Example 6.1: Net Present Value
• Alpha Corporation is considering investing in a
riskless project costing £100. The project
receives £107 in one year and has no other
cash flows. The discount rate is 6 percent.
• What is the NPV of the project?

£107
£.94  £100  (6.1)
1.06
 NPV Investment Rule

• NPV is Greater
Accept than Zero

• NPV is Less
Reject than Zero
 Strengths of NPV
Uses Cash Uses all Cash Discounts Cash
Flows Flows Flows
• Cash Flows • Other • Fully
are better approaches incorporates
than ignore cash the Time
Earnings flows beyond Value of
a certain Money
date
The Payback Period Method
• Payback Period is less
Accept than benchmark

• Payback Period is
Reject greater than
benchmark
Payback Period Example
• What is the payback period of the following cash flow
stream?
 Problems with the Payback Period

Weaknesses
Payments Arbitrary
Timing of after the Standard for
Cash Flows Payback the Payback
Period Period
 Problems with the Payback Period
Year A B C
0 £100 £100  £100
1    20    50     50
2    30    30     30
3    50    20     20
4    60    60 60,000
Payback period (years)     3     3     3
Advantages of Payback Period

Strengths
Firms with
Very small Exceptionally
severe
scale Simple to
capital
investments Understand
rationing
Discounted Payback Period
• Discounted Payback
Accept Period is Less than
Benchmark

• Discounted Payback
Reject Period is Greater
than Benchmark
 Strengths and Weakness of
Discounted Payback Period

Strengths Weaknesses
• Simple • Ignores Cash
• Uses Time Flows beyond
Value of Money benchmark
• Arbitrary
Benchmark
The Average Accounting Return Method

• Average Accounting
Accept Return is Greater than
Target Return

• Average Accounting
Reject Return is Less than
Target Return
Example 6.2: Average Accounting Return
• Consider a company that is evaluating whether to buy a
store in a new shopping centre. The purchase price is
£500,000. We will assume that the store has an
estimated life of five years and will need to be
completely scrapped or rebuilt at the end of that time.
• For simplicity sake, the asset will depreciated using
straight line depreciation (this does not occur in
countries that use IFRS but suits to illustrate the
method).
• The Target Return on new Investments is 15 percent.
 Example 6.2: Average Accounting Return
Year 1 Year 2 Year 3 Year 4 Year 5
Revenue £433,333 £450,000 £266,667 £200,000 £133,333
Expenses  200,000  150,000  100,000  100,000  100,000
Before-tax cash flow  233,333  300,000  166,667  100,000   33,333

Depreciation  100,000  100,000  100,000  100,000  100,000

Profit before taxes  133,333  200,000   66,667        0   66,667
Taxes (tc=. 25)*   33,333   50,000   16,667        0   16,667
Net income £100,000 £150,000 £ 50,000 £      0 £ 50,000
*Corporate tax rate  tc. The tax rebate in year 5 of  £16,667 occurs if the rest of the firm is profitable.
Here the loss in the project reduces the taxes of the entire firm.
Example 6.2: Average Accounting Return

• Determine Average Net Income

Step 1

• Determine Average Investment

Step 2

• Determine Average Accounting Return

Step 3
 Example 6.2: Average Accounting Return

Step 1: Determine Average Net Income

[£100,000  150,000  50,000  0  (50,000)]/5  £50,000

Step 2: Determine Average Investment

£(500,000 + 400,000 + 300,000+200,000+100,000+0)/6 = £ 250,000

Step 3: Determine Average Accounting Return

£50, 000
AAR   20%
£250, 000
Example 6.2: Average Accounting Return

Average Target
Accounting Accounting
Return is 20% Return is 15%

Accept
Strengths and Weaknesses of the Average
Accounting Return

Strengths Weaknesses
• Simple return • Does not use cash
based measure flows
• Does not use time
value of money
• Arbitrary target
rate
The Internal Rate of Return
• Internal Rate of
Accept Return is greater than
discount rate

• Internal Rate of
Reject Return is less than
discount rate
The Internal Rate of Return Rule

•Consider the simple

project (£100, £110)
****Find IRR £110
NPV  £100 
that sets NPV 1 R
equal to Zero
£110
0  £100 
1.10
 IRR: A More Complex Example

• Use Trial and Error

€100 €100 €100
0  €200   
1  IRR (1  IRR) 2 (1  IRR)3
IRR: A More Complex Example
 Some Important Definitions
Mutually Exclusive
Independent Project
Projects
• An independent project • With mutually exclusive
is one whose projects, you can accept
acceptance or rejection A or you can accept B or
is independent of the you can reject both of
acceptance or rejection them, but you cannot
of other projects. accept both of them.
 Some Problems with IRR: Investment

Project A

Dates: 0 1 2

Cash flows £100 £130

IRR 30%

NPV @10% £18.2

Accept if market rate 30%

Financing or investing Investing

 Some Problems with IRR: Financing

Project B

Dates: 0 1 2
Cash flows £100 £130

IRR 30%

NPV @10% £18.2

Accept if 30%
market rate

Financing or Financing
investing
 Some Problems with IRR:
Mixed Cash Flows

Project C

Dates: 0 1 2

Cash flows £100 £230 £132

IRR 10% and 20%

NPV @10% 0

Accept if market 10% but 20%

rate
Financing or Mixture
investing
 General Investment Rules: IRR and NPV
1st Cash Flow • Number of IRRs: 1
Negative; • Accept if IRR > R; Reject if IRR < R
Remaining Cash • Accept if NPV > 0; Reject if NPV < 0
Flows Positive
1st Cash Flow • Number of IRRs: 1
Positive; Remaining • Accept if IRR < R; Reject if IRR > R
Cash Flows Negative • Accept if NPV > 0; Reject if NPV < 0

Mixture of Positive • Number of IRRs: Usually More than 1

and Negative Cash • No Valid IRR
Flows • Accept if NPV > 0; Reject if NPV < 0
 IRR Problems Specific to
Mutually Exclusive Projects

Scale of Timing of
Cash Flows Cash Flows
 Scale of Cash Flows

IRR Ignores Scale

 Example 6.3: NPV versus IRR

• Stanley Jaffe and Sherry Lansing have just purchased

the rights to Corporate Finance: The Motion Picture.
They will produce this major motion picture on either a
small budget or a big budget. Here are the estimated
cash flows:
Cash Flow at Cash Flow at NPV IRR
Date 0 Date 1 @25%
Small budget $10 million $40 million $22 million 300%
Large budget  25 million  65 million  27 million 160%

• Because of high risk, a 25 percent discount rate is considered appropriate.

Sherry wants to adopt the large budget because the NPV is higher. Stanley
wants to adopt the small budget because the IRR is higher. Who is right?
 Incremental IRR
When scale is an issue, calculate the incremental cash flows and IRR from them

Cash Flow at Date Cash Flow at Date

0 1
(in $ millions) (in $ millions)
Incremental cash flows from choosing $25  ( 10) $65  40
large budget instead of small budget  $15  $25

$25 million
0  $15 million 
1  IRR
IRR is 66.67 percent
Timing of Cash Flows

IRR Ignores the

Timing of Cash
Flows
 A General Rule with Mutually
Exclusive Investments

To avoid issues such

as Timing and Scale,
use Incremental NPV
or Incremental IRR
The Profitability Index

Profitability index (PI) 

PV of cash flows subsequent to initial investment
Initial investment
 Example 6.5: Profitability Index

• Hiram Finnegan Int. (HFI) applies a 12 percent discount rate to two

investment opportunities.

Cash Flows PV @ 12% of Cash

(€000,000) Flows Subsequent
to Initial Investment

PI NPV @12%
Project C0 C1 C2 (€000,000) (€000,000)

1 €20 €70 €10 €70.5 3.53 €50.5

2  10  15  40  45.3 4.53  35.3
Application of the Profitability Index

Mutually
Independent
Exclusive
Projects
Projects

Capital
Rationing
Profitability Index: Independent Projects

• Profitability Index
Accept is Greater than 1

• Profitability Index
Reject is Less than 1
 Profitability Index: Capital Rationing

Capital Rationing occurs Under Capital Rationing

when there is not you cannot rank
enough cash to invest in projects according to
all positive NPV projects NPV

Should use Profitability

Index or Incremental
NPV
 Example 6.5 Continued: Capital
Rationing Example

• You only have €20 million to invest:

Cash Flows
(€000,000) Profitability NPV @12%
Project C0 C1 C2 Index (€000,000)
1 €20 €70 €10 3.53 €50.5
2 10  15 40 4.53 €35.3
3 10 5 60 4.34 €33.4

• Can invest in project 1 or (2 + 3).