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1、Why Net Present Value Leads to Better Investment Decisions than Other CriteriaCorporate FinanceChapter 9McGraw Hill/Irwin5- 2McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved Topics CoveredwNPV and its CompetitorswThe Payback PeriodwThe Average Accounting Returnw
2、Internal Rate of ReturnwCapital Rationing5- 3McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved CFO Decision ToolsSurvey Data on CFO Use of Investment Evaluation TechniquesSOURCE: Graham and Harvey, “The Theory and Practice of Finance: Evidence from the Field,” Jo
3、urnal of Financial Economics 61 (2001), pp. 187-243.5- 4McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved Good Decision CriteriawWe need to ask ourselves the following questions when evaluating capital budgeting decision rules:Does the decision rule adjust for th
4、e 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?9-45- 5McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved Net Present ValuewThe difference between the market valu
5、e of a project and its cost.wNet Present Value (NPV) = Initial Investment + Total PV of future CFs9-55- 6McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved NPV Decision RulewEstimating NPV:1. Estimate future cash flows: how much? and when?2. Estimate discount rate
6、3. Estimate initial costs5- 7McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved NPV Decision RulewIf the NPV is positive, accept the projectwA positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the ow
7、ners.wSince our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal.9-75- 8McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved NPV Decision RulewMinimum Acceptance Criteria: Accept if NPV 0wRanking Criteria: Choose
8、the highest NPVwExample9.1 see page2635- 9McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved PaybackwThe payback period of a project is the number of years it takes before the cumulative forecasted cash flow equals the initial outlay.wThe payback rule says only ac
9、cept projects that “payback” in the desired time frame. wThis method is very flawed, primarily because it ignores later year cash flows and the the present value of future cash flows.5- 10McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved PaybackExampleExamine the
10、 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.5- 11McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved PaybackExampleExamine the three projects and note the mistake we would make i
11、f we insisted on only taking projects with a payback period of 2 years or less.5- 12McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved Decision Criteria Test - PaybackwDoes the payback rule account for the time value of money?wDoes the payback rule account for the
12、 risk of the cash flows?wDoes the payback rule provide an indication about the increase in value?wShould we consider the payback rule for our primary decision rule?9-125- 13McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved Advantages and Disadvantages of Paybackw
13、AdvantagesEasy to understandAdjusts for uncertainty of later cash flowsBiased toward liquiditywDisadvantagesIgnores the time value of moneyRequires an arbitrary cutoff pointIgnores cash flows beyond the cutoff dateBiased against long-term projects, such as research and development, and new projects9
14、-135- 14McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved Discounted Payback PeriodwCompute the present value of each cash flow and then determine how long it takes to pay back on a discounted basiswCompare to a specified required periodwDecision Rule - Accept th
15、e project if it pays back on a discounted basis within the specified time9-145- 15McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved Computing Discounted Payback for the ProjectwAssume we will accept the project if it pays back on a discounted basis in 2 years.wCo
16、mpute the PV for each cash flow and determine the payback period using discounted cash flowsYear 1: 165,000 63,120/1.121 = 108,643Year 2: 108,643 70,800/1.122 = 52,202Year 3: 52,202 91,080/1.123 = -12,627 project pays back in year 3wDo we accept or reject the project?9-155- 16McGraw Hill/IrwinCopyri
17、ght 2003 by The McGraw-Hill Companies, Inc. All rights reserved Advantages and Disadvantages of Discounted PaybackwAdvantagesIncludes time value of moneyEasy to understandDoes not accept negative estimated NPV investments when all future cash flows are positiveBiased towards liquiditywDisadvantagesM
18、ay reject positive NPV investmentsRequires an arbitrary cutoff pointIgnores cash flows beyond the cutoff pointBiased against long-term projects, such as R&D and new products9-165- 17McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved Average Accounting ReturnwThere
19、 are many different definitions for average accounting returnwThe one used in the book is:Average net income / average book valueNote that the average book value depends on how the asset is depreciated.wNeed to have a target cutoff ratewDecision Rule: Accept the project if the AAR is greater than a
20、preset rate9-175- 18McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved Computing AAR for the ProjectwAssume we require an average accounting return of 25%wAverage Net Income:(13,620 + 3,300 + 29,100) / 3 = 15,340wAAR = 15,340 / 72,000 = .213 = 21.3%wDo we accept o
21、r reject the project?9-185- 19McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved Decision Criteria Test - AARwDoes the AAR rule account for the time value of money?wDoes the AAR rule account for the risk of the cash flows?wDoes the AAR rule provide an indication a
22、bout the increase in value?wShould we consider the AAR rule for our primary decision rule?9-195- 20McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved Advantages and Disadvantages of AARwAdvantagesEasy to calculateNeeded information will usually be availablewDisadv
23、antagesNot a true rate of return; time value of money is ignoredUses an arbitrary benchmark cutoff rateBased on accounting net income and book values, not cash flows and market values9-205- 21McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved IRR Definition and De
24、cision RulewDefinition: IRR is the return that makes the NPV = 0wDecision Rule: Accept the project if the IRR is greater than the required return9-215- 22McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved Internal Rate of ReturnExampleYou can purchase a turbo powe
25、red 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?5- 23McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved Internal Rate of ReturnExample You can purchase
26、 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?5- 24McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved Internal Rate of ReturnExample You
27、 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?5- 25McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved Internal Rate of Retu
28、rnIRR=28%5- 26McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved Decision Criteria Test - IRRwDoes the IRR rule account for the time value of money?wDoes the IRR rule account for the risk of the cash flows?wDoes the IRR rule provide an indication about the increas
29、e in value?wShould we consider the IRR rule for our primary decision criteria?9-265- 27McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved Summary of Decisions for the ProjectSummaryNet Present ValueAcceptPayback PeriodRejectDiscounted Payback PeriodRejectAverage A
30、ccounting ReturnRejectInternal Rate of ReturnAccept9-275- 28McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved NPV vs. IRRwNPV and IRR will generally give us the same decisionwExceptionsNonconventional cash flows cash flow signs change more than onceMutually exclu
31、sive projectsInitial investments are substantially different (issue of scale)Timing of cash flows is substantially different9-285- 29McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved Internal Rate of ReturnPitfall 1 - Lending or Borrowing?wWith some cash flows (a
32、s noted below) the NPV of the project increases s the discount rate increases. wThis is contrary to the normal relationship between NPV and discount rates. 5- 30McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved Internal Rate of ReturnPitfall 1 - Lending or Borrow
33、ing?wWith some cash flows (as noted below) the NPV of the project increases s the discount rate increases. wThis is contrary to the normal relationship between NPV and discount rates. Discount RateNPV5- 31McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved Internal
34、 Rate of ReturnPitfall 2 - Multiple Rates of ReturnwCertain cash flows can generate NPV=0 at two different discount rates.wThe following cash flow generates NPV=$A 3.3 million at both IRR% of (-44%) and +11.6%. Cash Flows (millions of Australian dollars)5- 32McGraw Hill/IrwinCopyright 2003 by The Mc
35、Graw-Hill Companies, Inc. All rights reserved Internal Rate of ReturnPitfall 2 - Multiple Rates of ReturnwCertain cash flows can generate NPV=0 at two different discount rates.wThe following cash flow generates NPV=0 at both (-50%) and 15.2%. 1000NPV5000-500-1000Discount RateIRR=15.2%IRR=-50%5- 33Mc
36、Graw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved IRR and Mutually Exclusive ProjectswMutually exclusive projectsIf you choose one, you cant choose the otherExample: You can choose to attend graduate school at either Harvard or Stanford, but not bothwIntuitively, y
37、ou would use the following decision rules:NPV choose the project with the higher NPVIRR choose the project with the higher IRR9-335- 34McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved Example With Mutually Exclusive ProjectsPeriodProject AProject B0-500-40013253
38、252325200IRR19.43% 22.17%NPV64.0560.74The required return for both projects is 10%.Which project should you accept and why?9-345- 35McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved NPV ProfilesIRR for A = 19.43%IRR for B = 22.17%Crossover Point = 11.8%9-355- 36M
39、cGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved Conflicts Between NPV and IRRwNPV directly measures the increase in value to the firmwWhenever there is a conflict between NPV and another decision rule, you should always use NPVwIRR is unreliable in the following
40、 situationsNonconventional cash flowsMutually exclusive projects9-365- 37McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved Advantages and Disadvantages of internal rate of returnwAdvantagesClosely related to NPV, generally leading to identical decisionsEasy to un
41、derstand and communicatewDisadvantagesMay lead to incorrect decisions in comparisons of mutually exclusive investmentsMay result in multiple answers or not deal with nonconventional cash flows.9-375- 38McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved Profitabili
42、ty IndexwWhen resources are limited, the profitability index (PI) provides a tool for selecting among various project combinations and alternativeswA set of limited resources and projects can yield various combinations.wThe highest weighted average PI can indicate which projects to select.5- 39McGra
43、w Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved Profitability IndexExampleWe only have $300,000 to invest. Which do we select?ProjNPV InvestmentPIA230,000200,0001.15B141,250125,0001.13C194,250175,0001.11D162,000150,0001.085- 40McGraw Hill/IrwinCopyright 2003 by The
44、McGraw-Hill Companies, Inc. All rights reserved Profitability IndexExample - continuedProjNPV InvestmentPIA230,000200,0001.15B141,250125,0001.13C194,250175,0001.11D162,000150,0001.08Select projects with highest Weighted Avg PIWAPI (BD) = 1.13(125) + 1.08(150) + 0.0 (25) (300) (300) (300) = 1.015- 41
45、McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved Profitability IndexExample - continuedProjNPV InvestmentPIA230,000200,0001.15B141,250125,0001.13C194,250175,0001.11D162,000150,0001.08Select projects with highest Weighted Avg PIWAPI (BD) = 1.01WAPI (A) = 0.77WAPI
46、 (BC) = 1.125- 42McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved Advantages and Disadvantages of Profitability IndexwAdvantagesClosely related to NPV, generally leading to identical decisionsEasy to understand and communicateMay be useful when available investm
47、ent funds are limitedwDisadvantagesMay lead to incorrect decisions in comparisons of mutually exclusive investments9-425- 43McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved Summary DCF CriteriawNet present valueDifference between market value and costTake the pr
48、oject if the NPV is positiveHas no serious problemsPreferred decision criterionwInternal rate of returnDiscount rate that makes NPV = 0Take the project if the IRR is greater than the required returnSame decision as NPV with conventional cash flowsIRR is unreliable with nonconventional cash flows or
49、mutually exclusive projectswProfitability IndexBenefit-cost ratioTake investment if PI 1Cannot be used to rank mutually exclusive projectsMay be used to rank projects in the presence of capital rationing9-435- 44McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved S
50、ummary Payback CriteriawPayback periodLength of time until initial investment is recoveredTake the project if it pays back within some specified periodDoesnt account for time value of money, and there is an arbitrary cutoff periodwDiscounted payback periodLength of time until initial investment is r
51、ecovered on a discounted basisTake the project if it pays back in some specified periodThere is an arbitrary cutoff period9-445- 45McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved Summary Accounting CriterionwAverage Accounting ReturnMeasure of accounting profit relative to book valueSimilar to return on assets measureTake the investment if the AAR exceeds some specified return levelSerious problems and should not be used9-45
