BerkCH08 in Class

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Copyright © 2012 Pearson Prentice Hall. All rights reserved.

Chapter 8

InvestmentRules

IN CLASS



Copyright © 2012 Pearson Prentice Hall. All rights reserved. 8-2

Chapter Quiz – After watchingvideos

1. Explain the NPV rule for stand-alone projects.

2. Under what conditions will the IRR rule lead tothe same decision as the NPV rule?

3. What is the most reliable way to choose betweenmutually exclusive projects?

4. Explain why choosing the option with the highestNPV is not always correct when the options have

different lives.

5. What does the profitability index tell you?




Comprehensive Problem

•

An investment project has the followingcash flows: CF0 = -1,000,000; C01 – C08 =200,000 each

• If the required rate of return is 12%, what

decision should be made using NPV?

• How would the IRR decision rule be used forthis project, and what decision would be

reached?• How are the above two decisions related?




Mutually Exclusive Projects

• A company is analyzing two mutually exclusiveproject, S and L, whose cash flows are asfollows:

0 1 2 3 4

S -1,000 900 250 10 10

L -1,000 0 250 400 800

• The company’s cost of capital is 10% and itcan get an unlimited amount of capital at thatcost.

• What is the IRR of the better project?

• What is the crossover rate and what is itssignificance?




10.73%

13.49%

11.74%

NPV

Discount Rate

$30.7

L

S




Leasing Cash Flows

• Sharon Evans, who graduated from the local university 3years ago with a degree in marketing, is manager of AnnNaylor’s store in the Southwest Mall.

• Sharon’s store has 5 years remaining on its lease. Rent is$2,000 per month, 60 payments remain, and the nextpayment is due in one month.

• The mall’s owner plans to sell the property in a year andwants rents at that time to be high so the property willappear more valuable.

• Therefore, Sharon has been offered a “great deal” (owners’words) on a new 5 year lease.

• The lease calls for 0 rent for 9 months, then payment of$2,600 per month for the next 51 months.

• The lease cannot be broken, and Ann Naylor Corp.’s cost ofcapital is 12% or 1% a month.

• Should Sharon accept the new lease?




Lease Payments and Cost of Capital

• Suppose Sharon decided to bargain withthe mall’s owner over the new leasepayment.

• What new lease payment would makeSharon indifferent between the new and oldleases?

• Sharon is not sure of the 12% cost of

capital – it could be higher or lower.• At what nominal cost of capital would

Sharon be indifferent between the two

leases?




Carlson Company

• Carlson Co. is choosing between two models ofproduction machinery.

• Model A costs $500 and has a life of 3 years.

• Maintenance expenses will amount to $120 to be

paid at the end of each of the three years.• Model B costs $600 and has a life of 4 years.

• Carlson will have to spend $100 at the end ofeach of these years to maintain model B.

• Which machine should be acquired if the discountrate is 10%.




Example 8.6a Profitability Indexwith a Human Resource Constraint

Problem:• AaronCo is considering several projects to

undertake.

• All of the projects currently under considerationhave a positive NPV, but AaronCo has a fixedcapital budget of $300 million.

• The company does not believe they will be able toraise any additional funds.

• How should AaronCo prioritize the projects (listedon the following slide)?




Example 8.6a Profitability Indexwith a Human Resource Constraint

Problem (cont’d):

Project NPV ($ Millions) Initial Cost ($ Millions)

A $15 $25

B $25 $75

C $110 $200

D $60 $150

E $25 $50

F $20 $35G $35 $40

Total $290 $575




Ethics Issues• An ABC poll in the spring of 2004 found that one-

third of students age 12– 17 admitted to cheating

and the percentage increased as the students gotolder and felt more grade pressure. If a bookentitled “How to Cheat: A User’s Guide” wouldgenerate a positive NPV, would it be proper for apublishing company to offer the new book?

• Should a firm exceed the minimum legal limits ofgovernment imposed environmental regulations andbe responsible for the environment, even if thisresponsibility leads to a wealth reduction for the

firm? Is environmental damage merely a cost ofdoing business?

• Should municipalities offer monetary incentives toinduce firms to relocate to their areas?




Example 8.5a Computing anEquivalent Annual Annuity Cost

Problem:

• You considering a maintenance contract from twovendors.

• Vendor Y charges $100,000 upfront and then$12,000 per year for the three-year life of thecontract.

• Vendor Z charges $85,000 upfront and then

$35,000 per year for the two-year life of thecontract.

• Compute the NPV and EAA for each vendorassuming an 8% cost of capital.




ADDITIONALPROBLEMS/SAME

CONCEPT AS PRIORPROBLEMS




Mutually Exclusive Projects

• Davis Industries must choose between a gaspowered and an electric powered forklift truck.

• The electric powered truck will cost more, but itwill be less expensive to operate.

• It will cost $22,000 and the gas powered truckwill cost $17,500.

• The cost of capital is 12%. Each truck will last 6years.

• The cash flows for the electric powered truck willbe $6,290/year and $5,000/year for the gaspowered truck.

• What is the NPV and IRR for each truck? Which

would you recommend?




Example: The NPV Is Equivalent toCash Today

Problem: • After saving $2,500 waiting tables, you are about

to buy a 50-inch LCD TV.

• You notice that the store is offering “one-yearsame as cash” deal.

• You can take the TV home today and pay nothinguntil one year from now, when you will owe thestore the $2,500 purchase price.

• If your savings account earns 4% per year, whatis the NPV of this offer? Show that its NPVrepresents cash in your pocket.




Example 8.2a Using the PaybackRule

Problem:

• Assume a company requires all projects to have apayback period of three years or less.

• For the project below, would the firm undertakethe project under this rule?

Year Expected Net Cash Flow

0 -$10,000

1 $1,000

2 $1,000

3 $12,000




Example 8.3a NPV and MutuallyExclusive Projects

Problem:• You own a small piece of commercial land near a university. You are

considering what to do with it. You have been approached recentlywith an offer to buy it for $300,000.

• You are also considering three alternative uses of the land foryourself: a bar, a coffee shop, and an apparel store. You assume thatyou would operate your choice indefinitely, eventually leaving thebusiness to your children.

• You have collected the following information about the uses. Whatshould you do?

Initial

Investment

Cash flow in the

First Year

Growth

rate

Cost of capital

Bar $400,000 $65,000 5.0% 12.0%

Coffee shop $250,000 $45,000 5.5% 12.5%

Apparel Store $800,000 $90,000 4.5% 13.0%




Example 8.4a Computing theCrossover Point

Problem:

• Solve for the crossover point for the following twoprojects.

YearExpected Net Cash Flow

Project A Project B

0 -$12,000 -$10,000

1 $5,000 $4,1002 $5,000 $4,100

3 $5,000 $4,100




NPV Profiles Question

• The NPV profile provides a way to see howthe NPV changes according to the discountrate or cost of capital.

• Why does uncertainty exist among theseelements?

• Is there any way to eliminate or reduce theuncertainty of this highly important rate?




Managers like rates--prefer IRR toNPV comparisons. Can we give them

a better IRR?

Yes, MIRR is the discount rate whichcauses the PV of a project’s terminal value (TV) to equal the PV of costs.TV is found by compounding inflowsat WACC.

Thus, MIRR assumes cash inflowsare reinvested at WACC.




MIRR = 16.5%

10.0 80.060.0

0 1 2 310%

66.012.1

158.1

MIRR for Franchise L (r = 10%)

-100.010%

10%

TV inflows

-100.0

PV outflows

MIRRL = 16.5%

$100 = $158.1(1+MIRRL)3




• MIRR correctly assumes reinvestmentat opportunity cost = WACC. MIRR alsoavoids the problem of multiple IRRs.

• Managers like rate of returncomparisons, and MIRR is better for thisthan IRR.

Why use MIRR versus IRR?




NPV Rule

• How is the NPV rule related to the goal ofmaximizing shareholder wealth?




IRR Rule

• What is the intuition behind the IRR rule?What are some of its drawbacks?




NPV and IRR

• Under what conditions will the IRR rule andthe NPV rule give the same accept/rejectdecision?




IRR

• When is it possible to have multiple IRRs?




MIRR

• How does MIRR solve the problem ofmultiple IRRs?




Profitability Index

• What is the intuition behind the profitabilityindex?




8.7 Putting It All Together

TABLE 8.5Summary ofDecision Rules




8.7 Putting It All Together

TABLE 8.5Summary ofDecision Rules(cont.)

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BerkCH08 in Class