NPV Analysis The recommended approach to any significant capital budgeting decision is NPV analysis NPV PV of the incremental benefits PV of the incremental costs When evaluating independent projects take a project if and only if it has a positive NPV ID: 142282
Download Presentation The PPT/PDF document "Capital Budgeting Decision Rules" is the property of its rightful owner. Permission is granted to download and print the materials on this web site for personal, non-commercial use only, and to display it on your personal computer provided you do not modify the materials and that you retain all copyright notices contained in the materials. By downloading content from our website, you accept the terms of this agreement.
Slide1
Capital Budgeting Decision RulesSlide2
NPV Analysis
The
recommended approach to any significant capital budgeting decision is NPV analysis.
NPV = PV of the incremental benefits – PV of the incremental costs.
When evaluating independent projects, take a project if and only if it has a positive NPV.
When evaluating interdependent projects, take the feasible combination with the highest total NPV.
The NPV rule appropriately accounts for the opportunity cost of capital and so ensures the project is more valuable than comparable alternatives available in the financial market.Slide3
Internal Rate of Return
Definition: The discount rate that sets the NPV of a project to zero
is
the project’s IRR.
Conceptually, IRR
asks: “What is the project’s rate of return?”
Standard Rule
: Accept a project if its IRR is greater than the appropriate market based discount rate, reject if it is less. Why does this make sense?
For independent projects with “normal cash flow patterns” IRR and NPV give the same conclusions.
IRR is completely internal to the project. To use the rule effectively we compare the IRR to a market rate.Slide4
IRR – “Normal” Cash Flow Pattern
Consider the following stream of cash flows:
Calculate the NPV at different discount rates until you find the discount rate where the NPV of this set of cash flows equals zero.
That’s all you do to find IRR.
0
1
2
3
-$1,000
$400
$400
$400Slide5
IRR – NPV Profile Diagram
Evaluate the NPV at various discount rates:
Rate
NPV
0 $200
10 -$5.3
20 -$157.4
At r = 9.7%,
NPV = 0Slide6
The Merit to the IRR Approach
The IRR
is
an approximation for the return generated over the life of a project on the initial investment.
As with NPV, the IRR is based on incremental cash flows, does not ignore any cash flows, and (by comparison to the appropriate discount rate, r) take proper account of the time value of money and risk.
In short, it can be useful.Slide7
Pitfalls of the IRR Approach
Multiple IRRs
There can be as many solutions to the IRR definition as there are changes of sign in the time ordered cash flow series.
Consider:
This can (and does) have two IRRs.
0
1
2
-$100
$230
-$132Slide8
Pitfalls of IRR cont…
Slide9
Pitfalls of IRR cont…Slide10
Pitfalls of IRR cont…
Mutually exclusive projects:
IRR can lead to incorrect conclusions about the
relative worth
of projects.
Ralph owns a warehouse he wants to fix up and use for
one
of two purposes:
Store toxic waste.
Store fresh produce.
Let’s look at the cash flows, IRRs and NPVs.Slide11
Mutually Exclusive Projects and IRRSlide12
At low discount rates, B is better. At high discount rates, A is better.
But A always has the higher IRR. A common mistake to make is choose A regardless of the discount rate.
Simply choosing the project with the larger IRR would be justified
only if
the project cash flows could be reinvested at the IRR instead of the actual market rate, r, for the life of the project.Slide13
Project Scale and the IRR
Because the IRR puts things in terms of a “rate” it may not tell you what interests you; which investment will create the most “wealth”.
Example:
Project
Investment
Time 1
IRR
NPV at 10%
A
-$1,000
+$1,500
50%
$363.64
B-$10,000
+$13,00030%$1,1818.18Slide14
Summary of IRR vs. NPV
IRR analysis can be misleading if you don’t fully understand its limitations.
For individual projects with normal cash flows NPV and IRR provide the same conclusion.
For projects with inflows followed by outlays, the decision rule for IRR must be reversed.
For Multi-period projects with
changes
in sign of the cash
flows,
multiple IRRs exist. Must compute the NPVs to see what
decision rule is appropriate.
IRR can give conflicting signals relative to NPV when ranking projects.
I recommend NPV analysis, using others as backup.Slide15
Payback Period Rule
Frequently used as a check on NPV analysis or by small firms or for small decisions.
Payback period is defined as the number of years before the cumulative cash inflows equal the initial outlay.
Provides a rough idea of how long invested capital is at risk.
Example
: A project has the following cash flows
Year 0 Year 1 Year 2 Year 3 Year 4
-$10,000 $5,000 $3,000 $2,000 $1,000
The payback period is 3 years. Is that good or bad?Slide16
Payback Period Rule
An adjustment to the payback period rule that is sometimes made is to discount the cash flows and calculate the discounted payback period.
This “new” rule continues to suffer from the problem of ignoring cash flows received after an arbitrary cutoff date.
If this is true, why mess up the simplicity of the rule? Simplicity is its one virtue.
At times the
discounted
payback period may be valuable information but it is not often that this information alone makes for good decision-making.Slide17
Economic Profit or EVA
EVA and Economic Profit
Economic Profit
The difference between revenue and the opportunity cost of all resources consumed in producing that revenue, including the opportunity cost of
capital
Economic Value Added (EVA)
The cash flows of a project minus a charge for the opportunity cost of capitalSlide18
Economic Profit or
EVA
EVA When Invested Capital is Constant
EVA in Period n
(when capital lasts forever
)
where
I
is the project’s capital,
Cn is the project’s cash flow
at time n, and r is the cost of capital. (r
× I ) is known as the capital chargeSlide19
Economic Profit or
EVA
EVA When Invested Capital is Constant
EVA Investment Rule
Accept any investment
for
which the present value (at the project’s cost of capital) of all future EVAs is positive.
When invested capital is constant, the EVA rule and the NPV rule will coincide.Slide20
Example
Problem
Ralph
has an investment opportunity which requires an upfront investment of $150 million.
The annual end-of-year cash flows of $14 million dollars are expected to last forever.
The firm’s cost of capital is 8%.
Compute the annual EVA and the present value of the project.Slide21
Example
Solution
EVA
each year is:
The present value of the EVA perpetuity is:Slide22
Economic Profit or
EVA
EVA When Invested Capital Changes
EVA in Period n
(when capital depreciates
)
Where
C
n is a project’s cash flow in time period
n, I
n – 1 is the project’s capital at time n –
1, and r is the cost of capitalWhen invested capital changes, the EVA rule and the NPV rule
continue to coincide.Slide23
Example
Ralph is considering an investment in a machine to manufacture rubber chickens.
It will generate revenues of $20,000 each year for 4 years and cost $60,000. The machine is expected to depreciate evenly over the 4 years.
The current interest rate is 5%
Should he invest in the machine?Slide24
Example
Using the NPV rule we have a cost of $60,000 and benefits that look like a 4 year annuity. The NPV is
Indicating that this is a valuable endeavor.Slide25
Example
For EVA we calculate
The present value of EVA is then:
Year
0
1
2
3
4
Capital
$60,000
$45,000
$30,000
$15,000
$0
Cash
Flow
$20,000
$20,000
$20,000$20,000
Capital Charge($3,000)($2,250)($1,500)
($750)Depreciation
($15,000)
($15,000)
($15,000)
($15,000)
EVA
n
$2,000
$2,750
$3,500
$4,250