Titman - PPT - CH11 Investment Decision Criteria STUDENTS

Financial Management:
Principles & Applications

Thirteenth Edition
Chapter 11
Investment Decision
Criteria
Copyright © 2018, 2014, 2011 Pearson

CopyrightEducation, Inc. All
© 2018, 2014, 2011 Pearson Rights
Education, Inc. All Reserved
Rights Reserved
Learning Objectives
1. Understand how to identify the sources and
types of profitable investment opportunities.
2. Evaluate investment opportunities using net
present value and describe why net present
value is the best measure to use.
3. Use the profitability index, internal rate of return,
and payback criteria to evaluate investment
opportunities.
4. Understand current business practice with
respect to the use of capital-budgeting criteria.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
2
11.1 AN OVERVIEW OF CAPITAL BUDGETING
3
Disney’s Capital Budgeting Decision:
Three Important Lessons (1 of 2)
Disney’s decision to invest $17.5 million to build
Disneyland park in California in 1955 is an example
of a major capital budgeting decision.
How did this decision impact Disney? What
important lessons can we learn from Disney theme
park story?
4
Disney’s Capital Budgeting Decision:
Three Important Lessons (2 of 2)
1. Capital budgeting decisions are critical in
defining a company’s business
2. Very large investments frequently consist of
smaller investment decisions that define a
business strategy
3. Successful investment decisions lead to the
development of managerial expertise and
capabilities that influence the firm’s choice of
future investments.
5
The Typical Capital—Budgeting Process
• Phase I: The firm’s management identifies
promising investment opportunities.
• Phase II: The investment opportunity’s value-
creating potential-what some refer to as its value
proposition-is thoroughly evaluated.
6
Types of Capital Investment Projects
1. Revenue enhancing Investments (such as
introducing a new product line),
2. Cost-reducing investments (such as replacing
old equipment with a more efficient equipment),
and
3. Mandatory investments that are a result of
government mandates (such as investments to
meet safety and environmental regulations)
7
11.2 NET PRESENT VALUE
8
Net Present Value
• The net present value (NPV) is the difference
between the present value of cash inflows and the
cash outflows. NPV estimates the amount of
wealth that the project creates.
9
Calculating an Investment’s NPV (1 of 2)
A positive NPV implies that the project is adding

value to the firm’s bottom line and therefore when
comparing projects, the higher the NPV the better.
10
Calculating an Investment’s NPV (2 of 2)
NPV reflects the first three principles: The project’s
cash flows are used to measure the benefits the
project provides (Principle 3, cash flows are the
source of value), cash flows are discounted back to
the present (Principle 1, money has time value),
and the discount rate used to discount the cash
flows back to the present reflects the risk in the
future cash flows (Principle 2, There is a risk-return
tradeoff)
11
Calculating the NPV For Project Long
Project Long requires an initial investment of

$100,000 and is expected to generate cash flows of
$70,000 in Year 1, $30,000 per year in Years 2 and
3, $25,000 in Year 4, and $10,000 in Year 5. The
discount rate (k) appropriate for calculating the NPV
of Project Long is 17 percent. Is Project Long a
good investment opportunity?
12
Solving the equation, we get

NPV = –$100,000 + $59,829 + $21,915 + $18,731 + $13,341 +
$4,561
= –$100,000 + $118,378 = $18,378
13
Using a Financial Calculator.
Using an Excel Spreadsheet.

= NPV (rate, CF1, CF2, .. CFn) + CF0
= NPV (0.17,70,000,30,000,30,000,25,000,10,000) – 100,000 =
$18,378
• Since the NPV is positive, the project is an accepted.
14
Calculating the NPV
YOUR TURN
Individual exercise in class
15
Exercise of Calculating the NPV
Saber Electronics provides specialty manufacturing
services to defense contractors located in the Seattle,
Washington area. The initial outlay is $3 million and,
management estimates that the firm might generate
cash flows for years one through five equal to $500,000;
$750,000; $1,500,000; $2,000,000; and $2,000,000.
Saber uses a 20% discount rate for projects of this type.
Is this a good investment opportunity?

16
Solution:
Net k=
Present
Value = ?
20% 0 1 2 3 4 5
Years −$3M +$0.5M +$0.75M +$1.5M $2M $2M
Cash flows
(in $ millions)
17
Solution (cont.):
18
Independent Versus Mutually Exclusive
Investment Projects
• An independent investment project is one that
stands alone and can be undertaken without
influencing the acceptance or rejection of any
other project (single investment).
• Accepting a mutually exclusive project prevents
another project from being accepted (multiple
investment opportunities simultaneously).
19
Evaluating an Independent Investment
Opportunity
It requires two steps to evaluate:
1. Calculate NPV;
2. Accept the project if NPV is positive and reject if
it is negative.
20
Evaluating Mutually Exclusive Investment
Opportunities
Following are two situations where firm is faced with
mutually exclusive projects:
1. Substitutes – When a firm is analyzing two or
more alternative investments, and each
performs the same function.
2. Firm Constraints – Firm faces constraints such
as limited managerial time or limited financial
capital that limit its ability to invest in every
positive NPV project (capital rationing).
21
Choosing Between Mutually Exclusive
Investments (1 of 4)
1. If mutually exclusive investments have equal
lives, we will calculate the NPVs and choose the
one with the higher NPV.
2. If mutually exclusive investments do not have
equal lives, we must calculate the Equivalent
Annual Cost (EAC). The EAC technique
provides an estimate of the annual cost of
owning and operating the investment over its
lifetime. We will then select the one that has a
lower EAC.
22
The EAC can be calculated as follows:
1. First, we calculate the sum of the present values
of the project’s costs, including the project’s
initial cost and the costs the firm will incur to
operate the equipment over its projected
lifespan.
2. Next, we convert the present value of the costs
into its annual equivalent, which is the EAC of
the investment.
23
Computation of EAC
• Using an Excel Spreadsheet

= PV (rate, nper, pmt, fv)
24
Solve for EAC using a financial calculator as follows:
Step 1. Calculate the present value of the annual
operating costs for the equipment over one life cycle of
the project and add this sum to the initial cost of the
equipment.
Step 2. Divide the present value of the costs (calculated
in step 1) by the annuity present value interest factor
25
Calculating the Equivalent Annual Cost
Example:
What is the EAC for a machine that costs $50,000,
requires payment of $6,000 per year for
maintenance and operation expense, and lasts for 6
years? You may assume that the discount rate is
9% and there will be no salvage value associated
with the machine. In addition, you intend to replace
this machine at the end of its life with an identical
machine with identical costs.
26
k = 9% EAC = ?
Years 0 1 2 3 4 5 6
−$50 −$6 −$6 −$6 −$6 −$6 −$6
Cash flows
(in $, thousands)
Using a Mathematical Formula

It requires 2 steps:
1. Computation of NPV
2. Computation of EAC
27
NPV = −$50,000 + PV of $6,000 each year

= −$50,000 + −$6,000 (PV of Annuity Factor)
= −$50,000 + −$6,000 {[1−(1/(1.09)6] ÷ (.09)}
= −$50,000 + −$6,000 {4.4859) = −$76,915
EAC = NPV ÷ Annuity Factor

= −$76,915 ÷ 4.4859 = −$17,145.95
No decision: example is only for calculation purposes.
28
Using a Spreadsheet
1- Find PV = NPV (rate, CF1, CF2, .. CFn)
=NPV(0.09,-6000,-6000,-6000,-6000,-6000,-6000) = -26,915.51
Or = PV (rate, nper, pmt, fv) =PV(0.09,6,-6000) = -26,915.51
2- Find NPV
NPV = -50,000 – 26,915.51 = −76,915.51
3 - Find EAC
EAC = pmt(rate,nper,pv,[fv],type)
PMT(0.09,6,-76,915.51) = −$17,145.95
29
Calculating the Equivalent Annual Annuity
YOUR TURN
30
Example:
Let’s say that there are two tanning beds available,
one lasts for 3 years while the other for 4 years.
The owner realizes that she will have to replace
either of these two beds with new ones when they
are at the end of their productive life, as she plans on
being in the business for a long time.
Using the cash flows listed below, and a cost of
capital is 10%, help the owner decide which of the
two tanning beds she should choose.
31
I =10%
= NPV (rate, CF1, CF2, .. CFn)
= pmt(rate,nper,pv,[fv],type)
32
33
34
35
11.3 OTHER INVESTMENT CRITERIA
36
Profitability Index
The profitability index (PI) is a cost-benefit ratio
equal to the present value of an investment’s future
cash flows divided by its initial cost.
𝑃𝑉
𝑃𝐼=
𝐶𝑜𝑠𝑡
• In essence, it tells us how many dollars we are
getting per dollar invested.
37
Profitability Index
Decision Criteria:
– If PI is greater than one, the NPV will be positive, and
the investment should be accepted
– When PI is less than one, which indicates a bad
investment, NPV will be negative, and the project
should be rejected.
38
Calculating the Profitability Index
Example:
Project Long is expected to provide five years of
cash inflows and to require an initial investment of
$100,000. The discount rate that is appropriate for
calculating the PI of Project Long is 17 percent. Is
Project Long a good investment opportunity? See
previous example of NPV slide #13
39
Solution:
We can proceed in two steps:
1. Compute PV of expected cash flows
= NPV (rate, CF1, CF2, .. CFn)
= NPV (0.17,70,000,30,000,30,000,25,000,10,000) = $118,378
2. Compute PI
Profitability index = $118,378/100,000 = 1.18378
The project’s future cash flows are worth 1.18378 times the
initial investment. It is an acceptable project since PI is
greater than one.
40
YOUR TURN
41
Exercise: PI Calculation
Using the cash flows listed below, and a discount rate of 10%,
calculate the PI of each project. Which one should be
accepted, if they are mutually exclusive? Why?
= NPV (rate, CF1, CF2, .. CFn) 𝑃𝑉

𝑃𝐼=
𝐶𝑜𝑠𝑡
42
Exercise: PI Solution
43
Internal Rate of Return (1 of 2)
The internal rate of return (IRR) of an investment
is analogous to the yield to maturity (YTM) on a
bond as defined in Chapter 9. Specifically, the IRR
is the discount rate that results in a zero NPV for
the project.
We can compute the IRR using trial & error, financial

calculator or an excel spreadsheet.
EXCEL function = IRR(Values,[guest])
44
Internal Rate of Return (2 of 2)
Decision Criteria:
The decision rule that would be applied is as follows:
• IRR > discount rate → NPV > 0 → accept project
• The IRR is measured as a percent while the NPV
is measured in dollars.
45
Internal Rate of Return
Example:
Knowledge Associates is a small consulting firm in
Portland, Oregon, and they are considering the
purchase of a new copying center for the office that
can copy, fax, and scan documents. The new
machine costs $10,010 to purchase and is expected
to provide cash flow savings over the next four
years of $1,000; $3,000; $6,000; and $7,000.
If the discount rate the firm uses to value the cash
flows from office equipment purchases is 15%, is
this a good investment for the firm?
46
Years 0 1 2 3 4
Cash flows −$10,010 +$1,000 +$3,000 +$6,000 +$7,000
IRR = ?
Calculating IRR with a Financial Calculator

CF0 = −$10,010; CF1 = $1,000; CF2 = $3,000;
CF3 = $6,000; CF4 = $7,000
Minimum discount rate = 15%
IRR = 19% => Accepted, IRR > required rate
47
Using an Excel Spread sheet
Period Amount (CF)
0 -$10,010 C6
1 $1,000 C7
2 $3,000 C8
3 $6,000 C9
4 $7,000 C10
IRR = 19.00%
=IRR(C6:C10)
48
NPV Profile
NPV Profile
Discount Computed NPV Profile
$8,000
Rate NPV
$ 2,677.41 $6,000
0.0% $ 7,000.00
NPV (Thousands)
5.0% $ 4,615.41 $4,000
10.0% $ 2,677.41 $2,000
15.0% $ 1,085.37 $-
NPV=0 20.0% $ (235.34)
0.0%
10.0%
25.0%
35.0%
5.0%
15.0%
20.0%
30.0%
$(2,000)
25.0% $ (1,340.80)
30.0% $ (2,273.73) $(4,000)
IRR (percent)
35.0% $ (3,067.04)
49
YOUR TURN
50
Exercise
Using the cash flows for the tanning Bed A, with a
discount rate = 10%. Calculate its IRR and state
your decision.
EXCEL function = IRR(Values,[guest])

51
52
Complications with IRR: Multiple Rates of
Return
When the first cash flow is negative and the
subsequent cash flows are positive, there is one
unique IRR. However, there can be multiple values
for the IRR when at least one of the later cash flow
is negative. Let’s demonstrates a project that has
two IRRs.
53
Multiple Rates of Return
The Problem
Consider a project that has three cash flows:
−$235,000 outlay in Year 0,
+$540,500 inflow in Year 1, and
–$310,200 outflow at the end of Year 2.
Calculate the IRR for the investment.
54
• To solve the problem, we determine the discount

rate that makes the NPV = 0 by constructing an
NPV profile for the project. In this instance, we
use discount rates in increments of 2% ranging
from 0% to 30%.
55
= IRR (Values,[guess])
• There are two IRRs for this project 10%, and 20% were NPV
is equal to zero. NPV will be a better decision tool to use
under this situation or use a modified version of IRR.
56
Using the IRR with Mutually Exclusive
Investments
There often are ranking conflicts between the NPV
and the IRR of the evaluated projects.
Figure 11.1 shows that if we use NPV, project AA+
is better while if we use IRR, project BBR is better.
How to select under such circumstances?
So, when in doubt go with the project with the
highest NPV, it will always be correct.
57
Using the IRR with Mutually Exclusive
Investments
• Apex Engineering is considering the purchase of
an automated accounting system and is trying to
decide between the AA+ and BBR systems. Both
systems have the same cost, but because of
functionality differences, the patterns of cash flows
are quite different. Apex uses a 15 percent
required rate of return or discount rate to evaluate
its investments
58
Figure 11.1 Ranking Mutually Exclusive Investments: NPV
vs. IRR (1 of 3)
(Panel A) Expected Cash Flows • Both alternatives have positive NPVs

and IRRs that exceed Apex’s 15%
required rate of return.
• However, the projects are ranked
differently using NPV or IRR: AA+ has
the higher NPV, while BBR has a
higher IRR.
• The ranking difference is due to the
effect of discounting and the difference
in the patterns of the cash flows for the
two projects.
• AA+’s cash flows increase over time,
while BBR’s decrease.
• Higher discount rates have a
disproportionate effect on present
values, as we see in Panel B.
59
vs. IRR (2 of 3)
(Panel B) NPV Profiles
60
vs. IRR (3 of 3)
(Panel C) Estimating the Break-Even Discount Rate
• Using a 19.5% discount rate,

the two projects have exactly
the same NPV.
• For discount rates lower than
this break-even 19.5% rate,
AA+ has the higher NPV,
whereas for higher discount
rates BBR has the higher
NPV.
• Trust NPV. Given the
IRR of the Differential Cash Flows = 19.5% discount rate appropriate for
valuing project cash flows,
NPV gives the correct
ranking of projects!
61
Modified Internal Rate of Return (1 of 2)
Modified Internal Rate of Return (MIRR)
eliminates the problem of multiple IRRs. MIRR
rearranges the project cash flows such that there is
only one change in the sign of the cash flows over
the life of the project.
Under the MIRR, all cash outflows are assumed to
be reinvested at the firm’s cost of capital or hurdle
rate, which makes it more realistic.
There are two steps to computing MIRR.
62
Modified Internal Rate of Return (2 of 2)
Step 1: Modify the project’s cash flow stream by
discounting the negative cash flows back to time 0
using the discount rate.
Step 2: We calculate the future value of all positive
cash flows at the terminal year of the project using
the discount rate.
Then, solve
63
Calculating the MIRR
Example:
Analyze the MIRR for the preceding problem used to calculate
Multiple IRR’s, assume the required rate of return used to
discount the cash flows is 12%. What is the MIRR?
−$235,000 outlay in Year 0,

+$540,500 inflow in Year 1, and
–$310,200 outflow at the end of Year 2.
64
If we use IRR, we will get multiple IRRs as there are two sign
changes in cash flow stream.
We can use MIRR by doing the following:
– First, discount the year 2 negative cash flows back to year 0
using the 8% discount rate.
– Second, calculate the MIRR of the resulting cash flows for
years 0 and 1.
65
Discount the Year 2 negative cash flow back to Year 0 and
add it to the Year 0 initial cash outlay.
Now, move positive cash flow to end of project time
T=0 T=1 T=2

-482,290 540,500
540,500x(1.12)1 = 605,360
66
Apply Formula to get the MIRR
T=0 T=1 T=2

-482,290 0 605,360
MIRR = (605,360/482,290)½ - 1
=(1.255178)½ - 1 = 12.03%
The IRR (MIRR) for these modified cash flows is: 12.03% which
is greater than 12.0% required.
67
Analyze
The MIRR is not the same as the IRR because it is
based on modified cash flows. Consequently, the
MIRR depends on the discount rate used to move the
cash flows from period to period and is no longer
intrinsic to the project. For example, if the required
rate of return had been 14 percent in this example,
the MIRR would have been 14.06 percent (not 12.03
percent). The NPV, on the other hand, does not suffer
from the multiple IRR problem and yields consistent
results even in the face of multiple sign changes.
68
YOUR TURN
69
Exercise:
Using the cash flows given in PI’s Example above,
and a discount rate of 10%; calculate the MIRRs for
Projects A and B. Which project should be accepted?
Why?
FV = PV(1+i)n
= FV(rate,nper,pmt, pv)
70
Solution
71
Payback Period
• The Payback period for an investment opportunity
is the number of years needed to recover the initial
cash outlay required to make the investment.
• The method assumes that all cash outflows occur
right at the beginning of the project’s life followed
by a stream of inflows.
• Also assumes that cash inflows occur uniformly
over the year.
72
Payback Period Limitations
73
Discounted Payback Period
• Discounted payback period approach is similar

except that it uses discounted cash flows to
calculate the payback period.
• Incorporates time value of money by adding up
the discounted cash inflows at time 0, use the
discount rate.
• It is still flawed in that cash flows after the
payback is ignored.
74
Discounted Payback Period Limitations
• The discounted payback period equals 2.97 years for Project Long. Three
years of discounted cash flows sum to a positive $476. However, since we
need to sum to 0, we do not need a full three years of discounted cash
flows (we need $18,256/$18,731 = .97 of Year 3’s cash inflow).
75
Discounted Payback Period Limitations
• Discounted payback is never achieved for Project Short. The

discounted cash flows never cumulate to equal zero.
76
Calculating the Payback Period
YOUR TURN
77
You will invest in a project with initial

investment of $40,000.
CF = $15,000 per year for 3 years
Required PBP = 2.5 years
Will you accept the project?.
78
Solution:
79
11.4 A GLANCE AT ACTUAL CAPITAL
BUDGETING PRACTICES
80
A Glance at Actual Capital Budgeting
Practices
• Figure 11.2 provides the results of a survey of the
CFOs of large US firms, showing the popularity of
various tools.
• The results show that NPV and IRR methods are
by far the most widely used methods, although
more than half the firms surveyed did use the
Payback method.
81
Figure 11.2 Survey of the Popularity of Capital—Budgeting
Methods
82
Summary of of Six Decision Models
83
Key Terms (1 of 2)
• Capital rationing
• Discounted payback period
• Equivalent annual cost (EAC)
• Independent investment project
• Internal rate of return (IRR)
• Modified internal rate of return (MIRR)
• Mutually exclusive projects
84
Key Terms (2 of 2)
• Net present value (NPV)
• NPV profile
• Payback period
• Profitability index
85
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Financial Management:

Principles & Applications

Copyright © 2018, 2014, 2011 Pearson

A positive NPV implies that the project is adding

Project Long requires an initial investment of

Solving the equation, we get

Using a Financial Calculator.

Using an Excel Spreadsheet.

= NPV (rate, CF1, CF2, .. CFn) + CF0

• Using an Excel Spreadsheet

Using a Mathematical Formula

NPV = −$50,000 + PV of $6,000 each year

EAC = NPV ÷ Annuity Factor

No decision: example is only for calculation purposes.

= NPV (rate, CF1, CF2, .. CFn)

= NPV (rate, CF1, CF2, .. CFn) 𝑃𝑉

We can compute the IRR using trial & error, financial

Calculating IRR with a Financial Calculator

10.0% $ 2,677.41 $2,000

EXCEL function = IRR(Values,[guest])

• To solve the problem, we determine the discount

(Panel A) Expected Cash Flows • Both alternatives have positive NPVs

• Using a 19.5% discount rate,

−$235,000 outlay in Year 0,

Now, move positive cash flow to end of project time

T=0 T=1 T=2

T=0 T=1 T=2

• Discounted payback period approach is similar

• Discounted payback is never achieved for Project Short. The

You will invest in a project with initial

CF = $15,000 per year for 3 years

Required PBP = 2.5 years

Will you accept the project?.

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