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Chapter 8 Net Present Value and Other Investment Criteria

Good Decision Criteria

We need to ask ourselves the following questions when evaluating decision criteria

Does the decision rule adjust for the time value of money?

Does the decision rule adjust for risk?

Does the decision rule provide information on whether we are creating value for the firm?

Payback Period

ow soon is the initial investment recovered?

t Project !Cumulative Cash "lows Project

#Cumulative Cash "lows

$ %&'$($$$)'$($$$ %

&'$($$$)'$($$$

' *($$$ )+($$$ '($$$ ),($$$

- .($$$ )*($$$ -($$$ )+($$$

* /($$$ -($$$ *($$$ ).($$$

. 0($$$ /($$$ '($$$

Decision 1ule2 !ccept if the payback period is less than some preset limit

A: Payback period = ! "#$%%%&"'$%%% = () years

*: Payback period = # ! "+$%%%&"'$%%% = #(8 years

3f the required payback is * years( accept Project ! and reject Project #4

5valuate Payback against criteria

Does the decision rule adjust for the time value of money? NO

Does the decision rule adjust for risk? NO

Does the decision rule provide information on whether we are creating value for the firm? NO

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8et Present ;alue

8P; < P; of outflows = P; of inflows

:he difference between the market value of a project and its cost

ow much value is created from undertaking an investment?

:he first step is to estimate the e>pected future cash flows4

:he second step is to estimate the required return for projects of this risk level4

:he third step is to find the present value of the cash flows and subtract the initial investment4

3f the required return '$ percent( should you accept either project?

t Project ! Project #

$ %&'$($$$ %&'$($$$

' *($$$ '($$$

- .($$$ -($$$

* /($$$ *($$$

. 0($$$ /($$$

3 < '$ '$

Cpt4 8P; < *(66+4+' )'(+0,4$$

Decision 1ule2 3f the 8P; is positive( accept the project

! positive 8P; means that the project is e>pected to add value to the firm and will thereforeincrease the wealth of the owners4

@ince our goal is to increase owner wealth( 8P; is a direct measure of how well this project willmeet our goal4

5valuate 8P; against criteria

Does the decision rule adjust for the time value of money? ,-.

Does the decision rule adjust for risk? ,-.

Does the decision rule provide information on whether we are creating value for the firm? ,-.

8P; is a primary model4

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Disadvantages

'4 1equired return?

!dvantages

'4 !ccounts for time value of money4

-4 !djusts for risk4

*4 Ases all cash flows4

.4 Can be used to rank projects4

!nother 5>ample

t Project B Project

$ %&'+/($$$ %&-6$($$$

' 0/($$$ '$$($$$

- 6/($$$ '.$($$$

* +/($$$ '-$($$$

. 0/($$$ 6$($$$

3 < '$ '$

Cpt4 8P; < &//($6*4** &+'(.'$4.-

What if Project B and are utual 5>clusive Projects?

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Profitability 3nde>

P3 < P; of inflows E P; of outflows

t Project ! Project #

$ %&'$($$$ %&'$($$$

' *($$$ '($$$

- .($$$ -($$$

* /($$$ *($$$

. 0($$$ /($$$

3 < '$ '$

P; 3nflows < '*(66+4+' 6(-*'4$$

P; Futflows < '$($$$'$($$$4$$

P3 < '4*666 $46-*'

3f the required return is '$ percent( what is the P3 of each project?

t Project B Project

$ %&'+/($$$ %&-6$($$$

' 0/($$$ '$$($$$

- 6/($$$ '.$($$$

* +/($$$ '-$($$$

. 0/($$$ 6$($$$

'4*'.6 '4-//$

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!dvantages2

'4 Closely related to 8P;( and will give identical decision with normal cash flows4!ssuming normal cash flows( if the 8P; is positive( what is the profitability inde>?

-4 5asy to understand and communicate4

Disadvantages

'4 8ot appropriate with non)normal cash flows4

-4 Cannot be used to rank mutually e>clusive investments4

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3nternal 1ate of 1eturn

311 is the interest rate that makes the 8P; of the project equal to ero4

3f the required return is '$ percent( what is the 311 of each project?

t Project B Project

$ %&'+/($$$ %&-6$($$$

' 0/($$$ '$$($$$

- 6/($$$ '.$($$$

* +/($$$ '-$($$$

. 0/($$$ 6$($$$

Cpt4 3112 -*46/ -'40/

5valuate 311 against criteria

Does the decision rule adjust for the time value of money? ,-.

Does the decision rule adjust for risk? ,-.

Does the decision rule provide information on whether we are creating value for the firm? ,-.

311 is a primary model4

!dvantages2

'4 @ame decision as 8P; for normal cash flows4

-4 5asy to understand and communicate4

Disadvantages

'4 ay result in multiple answers with non)normal cash flows4

-4 ay lead to incorrect decision with non)normal cash flows4

*4 ay not be used to rank mutually e>clusive projects4

.4 Fthers to come4

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8P; Profile

Graph of 8P; for different interest rates4

t Project B Project

$ %&'+/($$$ %&-6$($$$

' 0/($$$ '$$($$$

- 6/($$$ '.$($$$

* +/($$$ '-$($$$

. 0/($$$ 6$($$$

$ &''/($$$4$$ "/)%$%%%(%%

/ &6-(-0/4+/ "///$)08(0#

'$ &//($6*4** "1/$+/%(+

'/ &*-(-+'40* "#1$+'8(8+

-$ &'-(,.*40+ "8$'8%('

-/ %&*(/+04$$ "/)$/0(%%

311 -*46/ -'40/

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utually 5>clusive Projects

t Project B Project Delta H % BI

$ %&'+/($$$ %&-6$($$$ %&'$/($$$

' 0/($$$ '$$($$$ */($$$

- 6/($$$ '.$($$$ //($$$

* +/($$$ '-$($$$ ./($$$

. 0/($$$ 6$($$$ '/($$$

Cpt4 3112 '+40-

Crossover rate < '+40-

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Problems with 311

'4 3nvesting or "inancing?

t Project 1 Project @

$ %&'$$ &'$$

' '*$ %'*$

$ &*$ %&*$

'/ &'*4$. %&'*4$.

*$ &$ &$

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-4 ultiple 311s

Project !!

C"$ )&,$($$$

C"' &'*-($$$C"- &'$$($$$

C"* )&'/$($$$

W!CC '/4$$

311' '$4'' 1eject

8P; &'(+0,4/. !ccept

#! 33 Plus 311 < '$4''

What is the second 311?

.-400

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*4 @cale

t Project Project 8

$ %&' %&'$

' '4/$ ''

$ &$4/$ &'

311 /$ '$

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.4 :iming

t Project " Project G

$ %&'$($$$ %&'$($$$

' '$($$$ '($$$- '($$$ '($$$

* '($$$ '-($$$

$ &-($$$4$$ &.($$$4$$

'$ &00, &+/'

'/ &'$, %&.6.

311 '04$. '-4,.

Crossover rate '$4//

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/4 8o 311

t Project Cash flows

$ &'$

' %*$- */

a

acbb

-

.-

Page '."in *'' Chapter 6 7ecture 8otes