CHAPTER 8: Net Present Value and Other Investment Criteria 8.

1 Net Present Value The capital budgeting decision of the firm is concerned with finding out investments that maximize the value of the firm

Opportunity cost of capital: expected rate of return given up by investing in a project Net present value (NPV): present value of cash flows minus initial investment The net present value rule states that manager increase shareholders wealth by accepting all projects that are worth more than they cost. Therefore they should accept all projects with a positive net present value A risky dollar is worth less than a safe one NPV = PV of cash flows initial investment Expected rate of return given up by investing in a project is the opportunity cost of capital

RISK AND NET PRESENT VALUE o The discount rate used to discount a set of cash flows must match the risk of the cash flows o LOOK AT EXAMPLE ON PGS 264 &265 VALUING LONG LIVED PROJECT: o The NPV rule works for projects of any length o o o

PV = (PV = cash flow x annuity factor) Mutually exclusive projects: two or more projects that cannot be pursued simultaneously (ONE OR THE OTHER) The critical problems in any NPV problem are to determine: The amount and timing of the cash flows The appropriate discount rate Net present value rule:

Managers increase shareholders wealth by accepting all projects that are worth more than they cost Therefore they should accept all projects with a positive net present value

8.2 Other Investment Criteria Project with a net present value is worth more than it costs Other criteria are sometimes used by firms when evaluating investment opportunities. o Some of these criteria can give wrong answers! o Some of these criteria simply need to be used with care if you are to get the right answer! Three of the alternative investment criteria o PAYBACK: payback is the time period it take for the cash flows generated by the project to cover the initial investment in the project. If the payback period is less than a specified cut off point, the project is a go Payback period: time until cash flows recover the initial investment of the project o DISCOUNTED PAYBACK PERIOD: the time period it takes for the discounted cash flows generated by the project to cover the initial investment in the project. The acceptance rule is still the same the discounted payback should be less than a pre-set cut off point. Although better than payback, it still ignores all cash flows after an arbitrary cut off date Therefore it will reject some positive NPV projects INTERNAL RATE OF RETURN (IRR) IRR is the discount rate at which the NPV of the project equals zero. A project is acceptable if the IRR is more than the cost of capital of the project Two rules for deciding whether to proceed with an investment project: 1. The NPV rule: invest in any project that has a positive NPV when its cash flows are discounted at the opportunity cost capital 2. The rate of return rule: invest in any project offering a rate of return that is higher than the opportunity cost of capital ROR = profit/investment = C1 investment / investment = C1+C0/-C0 The ROR rule will give the same answer as the NPV rule as long as the NPV of a project declines smoothly as the discount rate increases IRR POTENTIAL PITFALLS o Borrowing vs. Lending: Lets say project J involves LENDING $100 at 50% interest. Project K involves BORROWING $100 at 50% interest. Which one will you chose? According to the IRR rule, both projects have a 50% rate of return and are thus equally desirable.

However, you lend in project J, and earn 50%; you borrow in Project K, and pay 50% Pick the project where you earn more than the opportunity cost of capital Multiple rates of return Projects with cash flows that change direction more than once will have more than one discount rate at which the NPV will be zero. That means, there are multiple IRRs for non-conventional projects The IRR rule would not work in this case; NPV works!

8.3 More Examples of Mutually Exclusive Projects The Investment Timing Decision: sometimes you have the ability to defer an investment and select a time that is more ideal at which to make the investment decision o the decision rule is to choose the investment date that results in the highest NPV today o ex: you can buy a computer system now or wait and think again next year

o Long-Lived VS. Short-Lived Equipment o Suppose you must choose between buying two machines with different lives Machine D and E are designed diff. But have identical capacity and do the same job Machine D costs $5000 and lasts 3 years. It costs $1500 to operate per yr Machine E costs $8000 and lasts 5 years. It costs $1000 to operate per yr What machine should the firm enquire?

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We cant compare the PV of costs of assets with different lives For comparing assets with different lives, we need to compare their equivalent annual costs The equivalent annual cost is the cost per period with the same PV as the cost of the machine. SELECT MACHINE WITH LOWEST EQUIV ANNUAL COST

o o Use annuity formula: c[1/r 1/r(1+r)^t] to find the annuity for 3 years replacing an old machine o we usually decide when to replace a machine, the machine will rarely decide for us o use chart and annuity factor again look at pg 285/286 example capital rationing: sometimes a corporation might find it beneficial to set a limit on the funds available for investment o soft rationing: imposed by the senior management , not by investors o Hard rationing: imposed by the unavailability of capital in the market. Ex: the limit set during the 2008 credit crunch crisis (firm cannot raise the money it needs) o Profitability index: ratio of net present value to initial investment. Pick the projects that give the highest net present value per dollar of investment PROFITABILITY INDEX = NPV / INITIAL INVESTMENT Look at table 8.3 on page 288 for comparisons of investment rules

Summary of chapter 8 NPV is the only measure which ALWAYS gives the correct decision when evaluating projects The other measures can mislead you into making poor decisions if used alone The other measures are: o IRR o Payback o Discounted payback o PI profitability index Firms often have mutually exclusive projects o Investment timing o Choice between long lived VS short lived equipment o Replacing Firms often have limited fund and have to deal with capital rationing