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Chapter 6Principlesof

CorporateFinance

Ninth Edition

Why Net Present Value Leadsto Better Investment Decisions

Than Other Criteria

Slides by

Matthew Will

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw Hill/Irwin

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

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Topics Covered

A Review of The BasicsNPV and its Competitors

The Payback Period

The Book Rate of ReturnInternal Rate of Return

Capital Rationing

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NPV and Cash Transfers

Every possible method for evaluating projects

impacts the flow of cash about the company

as follows.

Cash

Investment

opportunity (real

asset)

Firm ShareholderInvestment

opportunities

(financial assets)

Invest Alternative:

pay dividend

to shareholders

Shareholders invest

for themselves

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CFO Decision Tools

Profitability

Index, 12%

Payback, 57%

IRR, 76%

NPV, 75%

Book rate of

return, 20%

0% 20% 40% 60% 80% 100%

Survey Data on CFO Use of Investment Evaluation Techniques

SOURCE: Graham and Harvey, The Theory and Practice of Finance: Evidence from the Field,

Journal of Financial Economics 61 (2001), pp. 187-243.

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Book Rate of Return

Book Rate of Return - Average income divided by averagebook value over project life. Also called accounting rateof return.

Managers rarely use this measurement to make decisions.The components reflect tax and accounting figures, notmarket values or cash flows.

assetsbook

incomebookreturnofrateBook

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Payback

The payback period of a project is the number ofyears it takes before the cumulative forecasted

cash flow equals the initial outlay.

The payback rule says only accept projects that

payback in the desired time frame.

This method is flawed, primarily because itignores later year cash flows and the the present

value of future cash flows.

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Payback

ExampleExamine the three projects and note the mistake

we would make if we insisted on only taking

projects with a payback period of 2 years or less.

050018002000-C

018005002000-B50005005002000-A

10%@NPVPeriod

PaybackCCCCProject 3210

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Payback

ExampleExamine the three projects and note the mistake

we would make if we insisted on only taking

projects with a payback period of 2 years or less.

502050018002000-C

58-2018005002000-B2,624350005005002000-A

10%@NPVPeriod

PaybackCCCCProject 3210

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Internal Rate of Return

ExampleYou can purchase a turbo powered machine tool

gadget for $4,000. The investment will generate

$2,000 and $4,000 in cash flows for two years,

respectively. What is the IRR on this investment?

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Example

You can purchase a turbo powered machine tool gadget for $4,000.

The investment will generate $2,000 and $4,000 in cash flows for two

years, respectively. What is the IRR on this investment?

0)1(

000,4

)1(

000,2000,4

21

IRRIRRNPV

%08.28IRR

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-2000

-1500

-1000

-500

0

500

1000

1500

2000

2500

10 20 30 40 50 60 70 80 90 100

Discount rate (%)

NPV(,0

00s)

IRR=28%

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Pitfall 1 - Lending or Borrowing? With some cash flows (as noted below) the NPV of theproject increases s the discount rate increases.

This is contrary to the normal relationship between NPV and

discount rates.

364%50500,1000,1364%50500,1000,1

%10@Project 10

BA

NPVIRRCC

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Pitfall 2 - Multiple Rates of Return Certain cash flows can generate NPV=0 at two different discount rates.

The following cash flow generates NPV=$A 3.3 million at both IRR%

of (-44%) and +11.6%.

150120120600

............10910

CCCC

Cash Flows (millions of Australian dollars)

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Pitfall 2 - Multiple Rates of Return

Certain cash flows can generate NPV=0 at two different discount rates.

The following cash flow generates NPV=$A 3.3 million at both IRR% of

(-44%) and +11.6%.

600NPV

300

0

-30

-600

DiscountRate

IRR=11.6%

IRR=-44%

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Pitfall 2 - Multiple Rates of Return It is possible to have a zero IRR and a positive NPV

339500,2000,3000,1

%10@Project 210

NoneC

NPVIRRCCC

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Pitfall 3 - Mutually Exclusive Projects

IRR sometimes ignores the magnitude of the project.

The following two projects illustrate that problem.

818,11%75000,30000,20182,8%100000,20000,10

%10@Project 10

E

D

NPVIRRCC

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Pitfall 3 - Mutually Exclusive Projects

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Pitfall 4 - Term Structure AssumptionWe assume that discount rates are stable during

the term of the project.

This assumption implies that all funds are

reinvested at the IRR.This is a false assumption.

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Profitability Index

When resources are limited, the profitability index(PI) provides a tool for selecting among various

project combinations and alternatives

A set of limited resources and projects can yieldvarious combinations.

The highest weighted average PI can indicatewhich projects to select.

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Profitability Index

1360400

121555

1620552153010

%10@Project 210

D

C

B

A

NPVCCC

Cash Flows ($ millions)

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Profitability Index

0.4130D

2.4125C

3.2165B

2.12110A

IndexityProfitabil($)NPV($)InvestmentProject

Cash Flows ($ millions)

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Profitability Index

Example

We only have $300,000 to invest. Which do we select?

Proj NPV Investment PI

A 230,000 200,000 1.15

B 141,250 125,000 1.13

C 194,250 175,000 1.11

D 162,000 150,000 1.08

Investment

NPVIndexityProfitabil

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Profitability Index

Example - continuedProj NPV Investment PI

A 230,000 200,000 1.15

B 141,250 125,000 1.13

C 194,250 175,000 1.11D 162,000 150,000 1.08

Select projects with highest Weighted Avg PI

WAPI (BD) = 1.13(125) + 1.08(150) + 0.0 (25)(300) (300) (300)

= 1.01

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Profitability Index

Example - continuedProj NPV Investment PI

A 230,000 200,000 1.15

B 141,250 125,000 1.13

C 194,250 175,000 1.11D 162,000 150,000 1.08

Select projects with highest Weighted Avg PI

WAPI (BD) = 1.01WAPI (A) = 0.77

WAPI (BC) = 1.12

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Linear Programming

Maximize Cash flows or NPV

Minimize costs

ExampleMax NPV = 21Xn + 16 Xb + 12 Xc + 13 Xd

subject to

10Xa + 5Xb + 5Xc + 0Xd

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Vegetron Case

YEAR

1 2 3 4 5

1.Revenue 180 180 180 180 180

2. Operating costs 70 70 70 70 70

3. Depreciation a 80 80 80 80 80

4. Net income 30 30 30 30 30

5. Start-of-year book value 400 320 240 160 80

Book rate of return 7.50% 9.40% 12.50% 18.75% 37.50%(45)

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Web Resources

www.fintools.com

www.loanpricing.com

www.djindexes.com

www.spglobal.com

www.wilshire.com

www.msci.com

www.barra.com

Click to access web sitesInternet connection required
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