2201AFE Corporate Finance

Week 4: Net Present Value and Other Investment Criteria Readings: Chapter 7

Agenda
Last Week Net Present Value and Other Inv. Criteria
Key Concepts and Skills

Real World Application

Is Your Degree worth $1 million?

Next Week

Last Lecture
Bonds
Bond value = PV coupons (annuity) + PV of par Inverse relationship between yield & prices Premium and Discount bonds

Shares
Zero growth dividends are equal perpetuity Constant growth dividends increase DGM Supernormal growth combination of different growth rates & DGM discount each cash flow

Net Present Value and Other Investment Criteria

Chapter 7

1. Introduction & Financial Statements

7. Mid-semester Exam 8. Some Lessons from Capital Market History

2. Time Value of Money 9. Return, Risk & the Security Market Line

3. Valuing Shares & Bonds

4. Net Present Value & Other Investment Criteria

10. Cost of Capital

5. Making Capital Investment Decisions & Project Analysis

11. Financial Leverage & Capital Structure Policy 12. Dividends & Dividend Policy

6. Revision for Mid-sem Exam

13. Options & Revision

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Key Concepts and Skills

Net Present Value (NPV) Payback Period (PP) Discounted Payback Period (DPP) Average Accounting Return (AAR) Internal Rate of Return (IRR) Present Value Index (PVI)

RED COLOUR = MOST IMPORTANT

Good Decision Criteria

We need to ask ourselves the following questions when evaluating capital budgeting decision rules
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?

Project Example Information

We will be using these information for the following calculations.

You are looking at a new project and you have estimated the following cash flows:
Year 0: CF = -$165,000 (investment outlay/costs) Year 1: CF = $63,120; NI = $13,620 Year 2: CF = $70,800; NI = $3,300 Year 3: CF = $91,080; NI = $29,100 Average Book Value = $72,000

Your required return for assets of this risk is 12%.

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Net Present Value (NPV)

NPV is the difference between the PV of the future cash flows, and the initial outlay (costs) required to fund the project. That is, NPV = PV initial cost If there are t periods and the required rate is R then: NPV = C0 + C1/(1+R) + C2/(1+R)2 + C3/(1+R)3 + + Ct/(1+R)t
where: C0 is negative, the initial cash outflow at the start Ct represents the cash flow in period t.

How to calculate NPV: Estimate future cash flows

Estimate required return R

Find the PV of the cash flows Subtract initial cost from PV
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NPV Decision Rule

Computing NPV for the Project
NPV = C0 + C1/(1+R) + C2/(1+R)2 + C3/(1+R)3 + + Ct/(1+R)t 63,120 70,800 91,080 NPV 165,000 12,627.41 2 3 (1.12) (1.12) (1.12) If the NPV is positive, accept the project. If the NPV is negative, reject the project. A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners. Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal.

Question: Do we accept or reject the project?

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Payback Period (PP)

How long does it take to get the initial cost back in a nominal sense? Computation:
Estimate the cash flows. Subtract the future cash flows from the initial cost until the initial investment has been recovered.

Decision Rule:
Accept if the payback period is less than some preset limit.

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Computing Payback
Assume we will accept the project if it pays back within 2 years.
Year 0: -$165,000 initial outlay Year 1: $165,000 Year 2: $101,880 Year 3: $31,080
Year 0 1 2 3 Cash flow -$165,000 $63,120 $70,800 $91,080 Cumulative -$165,000 -$101,880 -$31,080 +$60,000

The project pays back in year 3 (2 + 31,080/91,080 = 2.34 years) Do we accept or reject the project?
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Advantages and Disadvantages of Payback

Advantages
Easy to understand. Adjusts for uncertainty of later cash flows. Biased towards liquidity.

Disadvantages
Ignores the time value of money. Requires an arbitrary cutoff point. Ignores cash flows beyond the cutoff date. Biased against long-term projects, such as research and development.

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Discounted Payback Period (DPP)

Method of calculation:
Compute the present value of each cash flow. Subtract the discounted cash flows from initial cost. Compare to a specified required period.

Decision Rule:
Accept the project if it pays back on a discounted basis within the specified time.

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Computing Discounted Payback

Assume the discounted payback period is 2 years. Discount rate is 12% Year CF PV of CF Cumulative PV Compute the PV for each CF Subtract from initial cost Compare with required period:
0 1 2 3 -165,000 -165,000 63,120 70,800 91,080 56,357 56,441 64,829 -$165,000 -$108,643 -$52,202 +$12,627

Year 1: -165,000 63,120/1.121 = -$108,643

Year 2: -108,643 70,800/1.122 = -$52,202 Year 3: -52,202 91,080/1.123 = +$12,627

The project pays back in year 3 (2 + 52,202/64,829 = 2.8 years).

Do we accept or reject the project?
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Advantages and Disadvantages of Discounted Payback

Advantages
Includes time value of money. Easy to understand. Does not accept negative estimated NPV investments when all future cash flows are positive. Biased towards liquidity.

Disadvantages
May reject positive NPV investments. Requires an arbitrary cutoff point. Ignores cash flows beyond the cutoff point. Biased against long-term projects, such as R&D and new products.

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Average Accounting Return (AAR)

A ratio between two accounting numbers. AAR = Average net income / Average book value.
Note that the average book value depends on how the asset is depreciated.

Need to have a target cutoff rate.

Decision Rule:
Accept the project if the AAR is greater than a specified rate.

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Computing AAR
Computing AAR for the Project:
Assume we require an average accounting return of 25% Average Net Income: (13,620 + 3,300 + 29,100) / 3 = 15,340 Average Book value: 72,000

AAR = Average net income / Average book value. AAR = 15,340 / 72,000 = 0.213 = 21.3%

Do we accept or reject the project?

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Advantages and Disadvantages of AAR

Advantages
Easy to calculate. Needed information will usually be available.

Disadvantages
Not a true rate of return; time value of money is ignored. Uses an arbitrary benchmark cutoff rate. Based on accounting net income and book values, not cash flows and market values.

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Internal Rate of Return (IRR)

Definition: IRR is the return that makes the NPV of an investment = 0

Decision Rule:
Accept the project if the IRR is greater than the required return (hurdle rate).

IRR is the most important alternative to NPV.

It is often used in practice and is intuitively appealing. It is based entirely on the estimated cash flows and is independent of interest rates found elsewhere.

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Computing IRR
Computing IRR for the project: Trial & Error
63,120 70,800 91,080 NPV 0 165,000 2 (1 IRR) (1 IRR) (1 IRR)3

IRR = 16.13% R=12%

Do we accept or reject the project?

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NPV Profile For The Project

70,000 60,000 50,000 40,000 NPV 30,000 20,000 10,000 0 -10,000 -20,000 Discount Rate 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22 Hurdle rate or Required rate

IRR = 16.13%

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Net Present Value vs. Internal Rate of Return

NPV and IRR will generally give us the same decision. Exceptions:
Non-conventional cash flows cash flow signs change more than once (more than one IRR). Mutually exclusive projects (accepting a project at the expense of rejecting the other).

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Example Non-conventional Cash Flows

Suppose an investment will cost $90,000 initially and will generate the following cash flows:
Year 1: 132,000 Year 2: 100,000 Year 3: -150,000

The required return is 15%.

Should we accept or reject the project?

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NPV Profile
IRR = 10.11%
$4,000.00 $2,000.00 $0.00

and

42.66%

NPV

($2,000.00) ($4,000.00) ($6,000.00) ($8,000.00) ($10,000.00)

0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55

Discount Rate

NPV 90,000

132,000 100,000 150,000 1,769.54 (1.15) (1.15)2 (1.15)3

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We should accept the project if the required return is between 10.11% and 42.66%

IRR and Mutually Exclusive Projects

Mutually exclusive projects:
If you choose one, you cannot choose the other. Example: You can choose to attend graduate school at either Harvard or Stanford, but not both.

Intuitively you would use the following decision rules:

NPV choose the project with the higher NPV. IRR choose the project with the higher IRR.

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Example With Mutually Exclusive Projects

Period 0 1 2 IRR NPV Project A -$500 $325 $325 19.43% $64.05 Project B -$400 $325 $200 22.17% $60.74

The required return for both projects is 10%. Which project should you accept and why?

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NPV Profiles
$160.00 $140.00 $120.00 $100.00 NPV $80.00 $60.00 $40.00

IRR for A = 19.43% IRR for B = 22.17% Crossover Point = 11.8% Hurdle rate = 10%
A B

$20.00
$0.00 ($20.00) 0% ($40.00) Discount Rate 5% 10% 15% 20% 25% 30%

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Conflicts Between NPV and IRR

NPV directly measures the increase in value to the firm.

Whenever there is a conflict between NPV and another decision rule, you should always use NPV. IRR is unreliable in the following situations:
Non-conventional cash flows. Mutually exclusive projects.

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Present Value Index

Measures the benefit per unit of cost, based on the time value of money. PVI = PV of CF / Cost
Example: Project cost = $200, PV of CF = $220 PVI = 220 / 200 = 1.1

A present value index of 1.1 implies that for every $1 of investment, we create an additional $0.10 in value. This measure can be very useful in situations in which we have limited capital.
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Advantages and Disadvantages of Present Value Index

Advantages
Closely related to NPV, generally leading to identical decisions. Easy to understand and communicate. May be useful when available investment funds are limited.

Disadvantages
May lead to incorrect decisions in comparisons of mutually exclusive investments.

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Summary Investment criteria

Net Present Value (NPV)
Difference between market value and cost. Take the project if the NPV is positive. Has no serious problems. Preferred decision criterion.

Payback Period (PP)

Length of time until initial investment is recovered. Take the project if it pays back in some specified period. Doesnt account for time value of money and there is an arbitrary cutoff period.

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Summary Investment criteria

Discounted Payback Period (DPP)
Length of time until initial investment is recovered on a discounted basis. Take the project if it pays back in some specified period. There is an arbitrary cutoff period.

Average Accounting Return (AAR)

Measure of accounting profit relative to book value. Similar to return on assets measure. Take the investment if the AAR exceeds some specified return level. Serious problems and should not be used.
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Summary Investment criteria

Internal Rate of Return (IRR)
Discount rate that makes NPV = 0. Take the project if the IRR is greater than the required return. Same decision as NPV with conventional cash flows. IRR is unreliable with non-conventional cash flows or mutually exclusive projects.

Present Value Index (PVI)

Benefit-cost ratio. Take investment if PVI > 1. Cannot be used to rank mutually exclusive projects.

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What is done in practice (optional)

References:
Truong et al., Cost of Capital Estimation and Capital Budgeting in Australia Australian Journal of Management, June 1988. Graham and Harvey, The Theory and Practice of Corporate Finance Journal of Financial Economics, 2001.

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Real World Application Is Your Degree worth $1 million?

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Is Your Degree worth $1 million?

Financial journalist, Liz Pulliam Weston in investigated the NPVs of various degrees in the United States With college tuitions heading toward the stratosphere, you might well be wondering whether a degree is still a good investment, especially if you're facing the prospect of going into debt to pay the tab. And if, as we all know, some bachelor's and master's degrees are much more lucrative than others, which are the best investments? To find out, I sat down with my handy-dandy financial calculator to play with some numbers.
Associate's degrees are a slam dunk. These two-year degrees seem to result in a massive payback, compared to their relatively low cost, for a high school graduate. Ditto, usually, a bachelor's degree. Any bachelor's degree you get at a public university is likely to pay off handsomely, as well. Some degrees are a step back. Thinking of a master's degree in a liberal arts or social sciences field? Let's hope you're in it for the love of learning, because on average there doesn't seem to be any financial payoff. Professional degrees rule. There's a reason why people borrow tons of money to attend business, law and medical schools. The return for a professional degree is huge.

Source: http://articles.moneycentral.msn.com/CollegeAndFamily/SavingForCollege/IsYourDegreeWorth1million.aspx

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Assumptions and Results

I started with a set of Census Bureau figures average pay rates for specific degrees. As a proxy for real lifetime earnings, its not perfect, but it does reflect the wide range of pay scales for each degree, from those just starting out to those ready for retirement. What I was looking for was the present value of the increase in future income that could be expected with various educations. Using a discount rate of 5% for the increase in lifetime income from various degrees are:
Associate degree
Average $116,550 Business $92,908

Bachelor's degree
Average $308,588 Business $349,028

Master's degree
Average $180,010 Business $375,780

Professional degree
Average (incl. Business) $716,927 Law $748,865 Medicine $977,601 The magic PV $1m mark!

Source: http://articles.moneycentral.msn.com/CollegeAndFamily/SavingForCollege/IsYourDegreeWorth1million.aspx

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Next Week
Next week we investigate further capital budgeting techniques by looking closer at how cash flows are derived and special cases of cash flow analysis.

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