Lecture notes, lecture 1 - Investment decision rules - mgcr 341 PDF

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Investment Decision Rules - Mgcr 341...

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Introduction to Finance – Investment Decision Rules Ismail A. Talaat

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NPV Rule – when making an investment decision, take the alternative with the highest NPV. Choosing this alternative is equivalent to receiving its NPV in cash today. NPV Profile – a graph of a project’s NPV over a range of discount rates. An investment internal rate of return (IRR) is the discount rate (interest) that sets the net present value of the cash flows equal to zero. The IRR can provide the sensitivity of your analysis is to errors in the estimates. The difference between the cost of capital and the IRR is the amount of estimation error in the cost of capital estimate that can exist without altering the original decision. When the decision rules conflict, always base your decision on the NPV rule, which is the most accurate and reliable decision rule. Payback investment rule – only projects that pay back their initial investment within the payback period are undertaken. The rule is based on the notion that an opportunity that pays back its initial investment quickly is a good idea. To apply the payback rule, o Calculate the amount of time its takes to pay back the initial investment, called the payback period. o Accept the project if the payback period is less than a pre-specified length of time—usually a few years. o Reject the project if the payback period is greater that that pre-specified length of time. The payback rule is not as reliable as the NPV because: o Ignores the time value of money. o Ignores cash flows after the payback period. o Lacks decision criterion grounded in economics (pre-specified time length?). Internal rate of return investment rule – a decision rule that accepts any investment opportunity where the IRR exceeds the opportunity cost of capital and otherwise rejects the opportunity. In general, the IRR rule works for a stand-alone project if all of the project’s negative cash flows precede its positive cash flows. When there is more than one IRR, the rule cannot be applied. Knowing the IRR can be very useful, but relying on it to make investment decisions can be hazardous. Mutually exclusive projects – projects that compete with one another by accepting one, you exclude the others. When a manager has mutually exclusive projects to choose from, the NPV rule advice to pick the project with the highest NPV. If a project has a positive NPV, then if we can double its size, its NPV will double. However, if the IRR rule does not get affected by the scale of the investment opportunity because the IRR measures the average return of the investment. Hence, the IRR rule cannot be used to compare projects of different scales. The IRR does not take into account the differences in the timing of the cash flow. The IRR is expressed as a return, but the dollar value of earning a given return—and therefore the NPV— depends on how long the return is earned. In general, it is dangerous to use the IRR in cases where you are are choosing between projects, or any time when your decision to accept or reject one project would affect you decision on another project. In such situation, always rely on the NPV. Equivalent annual annuity (EAA) – the level of annual cash flow that has the same present value as the cash flows of a project. Used to evaluate alternative projects with different lives. When cash flows are negative then the smaller the EAA the better, when cash flows are positive, then the higher the better.

Introduction to Finance – Investment Decision Rules Ismail A. Talaat

𝑁𝑃𝑉 × 𝑟 1 1− 1+𝑟 ! If there is a fixed supply of resources so that you cannot undertake all possible opportunities, simply picking the highest NPV opportunity might not lead to the best decision. In that case, finding the optimal combination can be found using the profitability index. Profitability index – measures the NPV per unit of resource consumed. 𝑉𝑎𝑙𝑢𝑒 𝐶𝑟𝑒𝑎𝑡𝑒𝑑 𝑁𝑃𝑉 = 𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝐼𝑛𝑑𝑒𝑥 = 𝑅𝑒𝑠𝑜𝑢𝑟𝑐𝑒𝑠 𝐶𝑜𝑛𝑠𝑢𝑚𝑒𝑑 𝑅𝑒𝑠𝑜𝑢𝑟𝑐𝑒𝑠 𝐶𝑜𝑛𝑠𝑢𝑚𝑒𝑑 In general, because the profitability index already includes the cost of capital (in computing the NPV), it would be better if the firm could raise additional funding to relieve the constraint. If the constraint is something else there may be no way to relieve the constraint quickly enough to avoid having to choose among projects. When multiple resource constraints apply, the profitability index can break down completely. The only surefire way to find the best combination of projects is to search through all of them. 𝐸𝐴𝐴 =

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Method NPV

Definition The difference between the present value of an investment’s benefits and the present value of its costs

Rule Take any investment opportunity where the NPV is positive and vice versa.

IRR

The interest rate that sets the net present value of the cash flows equal to zero; the average ROI.

Take any investment opportunity where IRR exceeds the opportunity cost of capital and vice versa

Payback Period

The amount if time it Accept the Simple to compute. takes to payback the project if the Favours liquidity initial investment. payback period is less than a prespecified length of time (few years).

Profitability Index

NPV/resources consumed

Rank projects according to their profitability index based on the constrained resources.

Advantages Corresponds directly to the impact of the project in the firm’s value. Direct application of the valuation principle Related to the NPV rule and usually yields the same (correct decision for conventional projects.

Uses NPV to measure the benefit. Allows projects to be ranked on value created per unit of resource used.

Disadvantages Relies on an accurate estimate of the discount rate. Can be timeconsuming to compute. Hard to compute Multiple or no IRRs leads to ambiguity Special care must be taken to choose among projects. Rule must be reversed for unconventional (borrowing-type) projects. No guidance as to correct payback cut-off period. Ignores cash flows after the cut-off period completely. Often an incorrect decision will result. Breaks down when there is more than one constraint. Requires careful attention for the full use of resources.

Introduction to Finance – Investment Decision Rules Ismail A. Talaat...