Net Present Value and Other

Investment Criteria
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Investment Criteria
Business 2039
1 K. Hartviksen
This Chapter - Topics
Net Present Value
Payback Period
Multiple IRRs
Mutually Exclusive y
Discounted Payback
Average Accounting
y
Investments (NPV
vs. IRR)
g g
Return
Internal Rate of
Profitability Index
capital rationing
Return
2 K. Hartviksen
Long-Term Investments
When a firm considers a new project, corporate
acquisition, plant expansion or asset acquisition that
will produce income over the course of many will produce income over the course of many
yearsthis is called capital budgeting.
It is imperative that in the analysis of such projects p y p j
that we consider the timing, riskiness and magnitude
of the incremental, after-tax cashflows that the project
is expected to generate for the firm is expected to generate for the firm.
Payback Method
This is a simple approach to capital budgeting that is
d i d t t ll h it ill t k t designed to tell you how many years it will take to
recover the initial investment.
It is often used by financial managers as one of a set It is often used by financial managers as one of a set
of investment screens, because it gives the manager
an intuitive sense of the projects risk.
Payback Example
Initial cost = 100000
AT cash flow benefits = 60000
Useful life(years) = 5
Cost of Capital = N/A
Cumulative
Cashflow After-tax incremental CF PV Factor Cash Flows
Initial cost -100000 -$100,000
ATCF ti b fit 60000 $40 000 ATCF operating benefit 60000 -$40,000
ATCF operating benefit 60000 $20,000
ATCF operating benefit 60000
ATCF operating benefit 60000
ATCF operating benefit 60000 ATCF operating benefit 60000
ATCF operating benefit 60000
Payback period = 1.7 years
Discounted Payback Example
AT cash flow benefits = 60000
Useful life(years) = 5
Cost of Capital = 0.1 Cumulative
P V Discounted
Y ear Cashflow After-tax incremental CF P V Factor Cash Flows Cash flows
0 Initial cost -100000 1 -$100,000 -$100,000
1 ATCF operating benefit 60000 0.9090909 $54,545 -$45,455
2 ATCF operating benefit 60000 0 8264463 $49 587 $4 132 2 ATCF operating benefit 60000 0.8264463 $49,587 $4,132
3 ATCF operating benefit 60000 0.7513148 $45,079 $49,211
4 ATCF operating benefit 60000 0.6830135 $40,981 $90,192
5 ATCF operating benefit 60000 0.6209213 $37,255 $127,447
6 ATCF operating benefit 60000 0.5644739 $33,868 $161,316
P ayback period (years)= 1.916671708
Discounted Payback Graphed
NPV
$$
Discounted Payback
Point
Years
Discounted Payback
Overcomes the lack of consideration of
the time value of money y
can help us see the pattern of cashflows
beyond the payback point beyond the payback point.
If carried to the end of the projects
useful life will tell us the projects NPV useful lifewill tell us the projects NPV
(if you are using the firms WACC)
Net Present Value
NPV = -PV of initial cost + PV of
incremental after-tax benefits
= if greater than 0 - accept
=if equal to 0 indifferent = if equal to 0 - indifferent
= if less than 0 - reject
Firms Cost of Capital
At this point in the course, you will be given the firms
cost of capital cost of capital
the firms cost of capital determines the minimum rate
of return that would be acceptable for a capital p p
project.
The weighted average cost of capital (WACC) is the
relevant discount rate for NPV analysis relevant discount rate for NPV analysis.
NPV Example
I iti l t 100000 Initial cost = 100000
AT cash flow benefits = 60000
Useful life(years) = 6
Cost of Capital = 0.12
Year Cashflow After-tax incremental CF PV Factor Present Value
0 Initial cost -100000 1 -$100,000
1 ATCF operating benefit 60000 0.892857 $53,571
2 ATCF operating benefit 60000 0 797194 $47 832 2 ATCF operating benefit 60000 0.797194 $47,832
3 ATCF operating benefit 60000 0.71178 $42,707
4 ATCF operating benefit 60000 0.635518 $38,131
5 ATCF operating benefit 60000 0.567427 $34,046
6 ATCF operating benefit 60000 0.506631 $30,398 p g ,
NPV = $146,684
NPV Example
Initial cost = 100000
AT cash flow benefits = 60000
Useful life(years) = 6
Cost of Capital = 0
Year Cashflow After-tax incremental CF PV Factor Present Value
0 Initial cost -100000 1 -$100,000
1 ATCF operating benefit 60000 1 $60,000
2 ATCF ti b fit 60000 1 $60 000 2 ATCF operating benefit 60000 1 $60,000
3 ATCF operating benefit 60000 1 $60,000
4 ATCF operating benefit 60000 1 $60,000
5 ATCF operating benefit 60000 1 $60,000
6 ATCF operating benefit 60000 1 $60 000 6 ATCF operating benefit 60000 1 $60,000
NPV = $260,000
NPV Example
Initial cost = 100000
AT cash flow benefits = 60000
Useful life(years) = 6
Cost of Capital = 0.05
Year Cashflow After-tax incremental CF PV Factor Present Value
0 Initial cost -100000 1 -$100,000
1 ATCF ti b fit 60000 0 952381 $57 143 1 ATCF operating benefit 60000 0.952381 $57,143
2 ATCF operating benefit 60000 0.907029 $54,422
3 ATCF operating benefit 60000 0.863838 $51,830
4 ATCF operating benefit 60000 0.822702 $49,362
5 ATCF operating benefit 60000 0 783526 $47 012 5 ATCF operating benefit 60000 0.783526 $47,012
6 ATCF operating benefit 60000 0.746215 $44,773
NPV = $204,542
NPV Example
Initial cost = 100000
AT cash flow benefits = 60000
Useful life(years) = 6
Cost of Capital = 0.15
Year Cashflow After-tax incremental CF PV Factor Present Value
0 Initial cost -100000 1 -$100,000
1 ATCF ti b fit 60000 0 869565 $52 174 1 ATCF operating benefit 60000 0.869565 $52,174
2 ATCF operating benefit 60000 0.756144 $45,369
3 ATCF operating benefit 60000 0.657516 $39,451
4 ATCF operating benefit 60000 0.571753 $34,305
5 ATCF operating benefit 60000 0 497177 $29 831 5 ATCF operating benefit 60000 0.497177 $29,831
6 ATCF operating benefit 60000 0.432328 $25,940
NPV = $127,069
NPV Example
Initial cost = 100000
AT cash flow benefits = 60000
Useful life(years) = 6
Cost of Capital = 0.3
Year Cashflow After-tax incremental CF PV Factor Present Value
0 Initial cost -100000 1 -$100,000
1 ATCF ti b fit 60000 0 769231 $46 154 1 ATCF operating benefit 60000 0.769231 $46,154
2 ATCF operating benefit 60000 0.591716 $35,503
3 ATCF operating benefit 60000 0.455166 $27,310
4 ATCF operating benefit 60000 0.350128 $21,008
5 ATCF operating benefit 60000 0 269329 $16 160 5 ATCF operating benefit 60000 0.269329 $16,160
6 ATCF operating benefit 60000 0.207176 $12,431
NPV = $58,565
NPV Example
Initial cost = 100000
AT cash flow benefits = 60000
Useful life(years) = 6
Cost of Capital = 0.5581

Year Cashflow After-tax incremental CF PV Factor Present Value
0 Initial cost -100000 1 -$100,000
1 ATCF ti b fit 60000 0 641807 $38 508 1 ATCF operating benefit 60000 0.641807 $38,508
2 ATCF operating benefit 60000 0.411917 $24,715
3 ATCF operating benefit 60000 0.264371 $15,862
4 ATCF operating benefit 60000 0.169675 $10,181
5 ATCF operating benefit 60000 0 108899 $6 534 5 ATCF operating benefit 60000 0.108899 $6,534
6 ATCF operating benefit 60000 0.069892 $4,194
NPV = -$6
NPV Example
Initial cost = 100000
AT cash flow benefits = 60000
Useful life(years) = 6
Cost of Capital = 0.7

Year Cashflow After-tax incremental CF PV Factor Present Value
0 Initial cost -100000 1 -$100,000
1 ATCF ti b fit 60000 0 588235 $35 294 1 ATCF operating benefit 60000 0.588235 $35,294
2 ATCF operating benefit 60000 0.346021 $20,761
3 ATCF operating benefit 60000 0.203542 $12,212
4 ATCF operating benefit 60000 0.11973 $7,184
5 ATCF operating benefit 60000 0 07043 $4 226 5 ATCF operating benefit 60000 0.07043 $4,226
6 ATCF operating benefit 60000 0.041429 $2,486
NPV = -$17,837
NPV Profile
NPV
$
IRR
Discount Rate
0
Discount Rate
NPV Profiles
The slope of the NPV profile depends
on the timing and magnitude of g g
cashflows.
Projects with cashflows that occur late Projects with cashflows that occur late
in the projects life will have an NPV that
is more sensitive to discount rate is more sensitive to discount rate
changes.
IRR
The internal rate of return (IRR) is that
discount rate that causes the NPV of the
project to equal zero.
If IRR > WACC, then the project is acceptable
b it ill t t f t because it will return a rate of return on
invested capital that is likely to be greater
than the cost of funds used to invest in the than the cost of funds used to invest in the
project.
IRR Example
Time Type of Cash Flow ATCF
0 Initial Project cost = -56000
1 Incremental ATCF Benefit= 5000 1 Incremental ATCF Benefit 5000
2 Incremental ATCF Benefit= 10000
3 Incremental ATCF Benefit= 15000
4 Incremental ATCF Benefit= 20000 4 Incremental ATCF Benefit 20000
5 Incremental ATCF Benefit= 25000
IRR = 8%
IRR Example
Time Type of Cash Flow ATCF ATCF ATCF
0 Initial Project cost = -56000 -56000 -56000
1 Incremental ATCF Benefit= 5000 25000 10000
2 Incremental ATCF Benefit= 10000 20000 10000
3 Incremental ATCF Benefit= 15000 15000 10000
4 Incremental ATCF Benefit= 20000 10000 10000
5 Incremental ATCF Benefit= 25000 5000 10000
IRR = 8% 14% -4%
IRR vs. NPV
Both methods use the same basic
decision inputs. p
The only difference is the assumed
discount rate discount rate.
The IRR assumes intermediate
cashflows are reinvested at IRR NPV cashflows are reinvested at IRRNPV
assumes they are reinvested at WACC
NPV Profile
NPV
$
IRR(B)
IRR(A)
Discount Rate
( )
0
( )
Discount Rate
Profitability Index
Uses exactly the same decision inputs as NPV
simply expresses the relative profitability of the
j t i t l ft t hfl b fit projects incremental after-tax cashflow benefits as a
ratio to the projects initial cost.
PI = PV of incremental ATCF benefits
PV of initial cost of project
If PI>1, then we accept; because the PV of benefits exceeds the
PV of costs.
Capital Rationing
The corporate practice of limiting the
amount of funds dedicated to capital p
investments in any one year.
Is academically illogical Is academically illogical.
In the long-run could threaten a firms
continuing existence through erosion of continuing existence through erosion of
its competitive position.