Net Present Value and Other Investment Criteria PDF

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Net Present Value and Other Investment Criteria
Lecturer: Julie Byrne...

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Week 6 - Net Present Value and Other Investment Criteria NPV -

The difference between an investment’s market value and its cost.

Discounted Cash Flow Valuation -

The process of valuing an investment by discounting its future cash flows.

NPV Example -

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Cash revenues from our fertilizer business will be £20,000 per year, assuming everything goes as expected. Cash costs (including taxes) will be £14,000 per year. We shall wind down the business in eight years. Plant, property and equipment will be worth £2,000 as salvage at that time. The project costs £30,000 to launch. We use a 15 per cent discount rate on new projects such as this one. Is this a good investment? If there are 1,000 shares of equity outstanding, what will be the effect on the share price of taking this investment? The total present value is: £6,000 x [1 - (1/1.158)]/.15 + (2,000/1.158) = (£6,000 x 4.4873) + (2,000/3.0590) = £26,924 + 654 = £27,578 When we compare this to the £30,000 estimated cost, we see that the NPV is: NPV = -£30,000 + 27,578 = -£2,422

Total value of equity would decrease by £2,422 If 1,000 shares outstanding, taking on project would lead to loss in value of 2,422/1,000 = £2.42 per share An investment should be accepted if the net present value is positive and rejected if it is negative.

Strengths of NPV -

Uses Cash Flows o Cash Flows are better than Earnings

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Uses all Cash Flows o Other approaches ignore cash flows beyond a certain date

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Fully incorporates the Time Value of Money o Discounts Cash Flows

The payback rule -

The amount of time required for an investment to generate cash flows sufficient to recover its initial cost. The payback period of a project is the number of years 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 it ignores later year cash flows and the present value of future cash flows. Accept if Payback Period is less than benchmark Reject if Payback Period is more than benchmark

The Discounted Payback -

The length of time required for an investment’s discounted cash flows to equal its initial cost.

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Regular payback rule pays back in 3 years exactly. Discounted payback pays back in 4 years.

The Average Accounting Return -

An investment’s average net income divided by its average book value. Suppose we are deciding whether to open a store in a new shopping centre. The required investment in improvements is £500,000. The store would have a five-year life because everything reverts to the mall owners after that time. We will assume that the required investment would be 100 per cent depreciated (straight-line) over five years , so the depreciation would be £500,000/5 = £100,000 per year. The tax rate is 25 per cent.

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If the firm has a target AAR of less than 20%, accept the project; otherwise Reject.

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The Internal Rate of Return (most important alternative to NPV) -

The discount rate that makes the NPV of an investment zero

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With the I.R.R. we try to find a single rate of return that summarizes the merits of a project.

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Want the rate to be “internal” in the sense that it depends only on the cash flows of a particular project, not on rates offered elsewhere.

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Consider a project that costs €100 today and pays €110 in one year. If you were asked what the return on the investment is, you would say 10%. This is the IRR.

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Is the project with its 10% IRR a good investment?

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Only if our required rate of return is less than 10%.

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Accept: Internal Rate of Return is greater than discount rate

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Reject: Internal Rate of Return is less than discount rate

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An investment costs €100 and has a cash flow of €60 per year for two years. What is its Internal Rate of Return?

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Trial & Error

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13.1 %

Multiple Rates of Return -

The possibility that more than one discount rate will make the NPV of an investment zero You are looking at an investment that requires you to invest €51 today. You’ll get €100 in one year, but you must pay out €50 in two years. What is the IRR on this investment? There is no IRR. The NPV is negative at every discount rate, so we shouldn’t take this investment under any circumstances The maximum number of IRRs that there can be is equal to the number of times that the cash flows change sign from positive to negative and/or negative to positive. A situation in which taking one investment prevents the taking of another.

Modified Internal Rate of Return -

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Discounting Approach o Discount all negative cash flows back to the present at the required return and add them to the initial cost. Then, calculate the IRR. Reinvestment Approach o Compound all cash flows (positive and negative) except the first out to the end of the project’s life and then calculate the IRR. Combination Approach o Negative cash flows are discounted back to the present, and positive cash flows are compounded to the end of the project Discounting Approach o Required rate of return = 20%, Discount all negative cash flows back to the present and add to initial cost. o If required rate of return is 20%, the modified cash flows are:

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1.20 ¿ ¿ o Time 0: -60 + = -129.44 −100 ¿ o o o

Time 1: +155 Time 2: 0 Now you can calculate MIRR (19.74%)

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The Reinvestment Approach -

Compound all cash flows except the first to the end of the project’s life. Cash flows are now: Time 0: -60 Time 1: 0 Time 2: -100 + (155*1.2) = 86 Now can calculate MIRR = 19.72%

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Combination Approach -

Discount negative cash flows back to present. Compound positive cash flows to end of project. Cash flows are now:

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Time 0:

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Time 1: 0 Time 2: 155*1.2 = 186 Can now calculate MIRR is 19.87

−60+

−100 1.202

= -129.44

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The Profitability Index -

The present value of an investment’s future cash flows divided by its initial cost. Also called the benefit–cost ratio When resources are limited, the profitability index (PI) provides a tool for selecting among various project combinations and alternatives

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A set of limited resources and projects can yield various combinations. The highest weighted average PI can indicate which projects to select.

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Example -

Sandy Grey Ltd. is in the process of deciding whether or not to revise its line of mobile phones which they manufacture and sell. Their sole market is large corporations and they have not as yet focused on the retail sector. They have estimated that the revision will cost £220,000. Cash flows from increased sales will be £80,000 in the first year. These cash flows will increase by 5% per year. The firm estimates that the new line will be obsolete five years from now. Assume the initial cost is paid now and all revenues are received at the end of each year. If the company requires a 10 per cent return for such an investment, should it undertake the revision? Use three investment evaluation techniques to arrive at your answer.

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Profitability Index:

PV of future inflows initialinvestment

Capital Rationing - Limit set on the amount of funds available for investment. -

Soft Rationing - Limits on available funds imposed by management. Does not reflect imperfections is the capital market.

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Hard Rationing - Limits on available funds imposed by the unavailability of funds in the capital market. Implies capital market imperfections.

P.I. = Present value of future inflows/initial investment P.I. = 332,047/220,000 = 1.509...