McGraw-Hill/Irwin

Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Valuation Techniques

This chapter presents multiple valuation techniques used during the capital budgeting process.

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Net Present Value

Opportunity Cost of Capital - Expected rate of
return given up by investing in a project

Net Present Value - Present value of cash flows

minus initial investments

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Net Present Value

Terminology C0 Initial Cash Flow (often negative) Cl Cash Flow at time 1 C2 Cash Flow at time 2 Ct Cash Flow at time t t Time period of the investment r Opportunity cost of capital

Ct C1 C2 NPV C0 ... 1 2 t (1 r ) (1 r ) (1 r )
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Net Present Value: Example 1

Assume you plan to invest $1,000 today and will receive $600 each year for two years (assume the cash is received at the end of the year). What is the net present value if there is a 10% opportunity cost of capital?

C0 = $1,000 C1 = $600 C2 = $600 r = 0.10

$600 $600 NPV $1,000 $41.32 1 2 (1 .10) (1 .10)

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Net Present Value: Example 2

Assume you invest $1,000 today and will receive $1,200 in two years (assume the cash is received at the end of the 2nd year). What is the net present value if there is a 10% opportunity cost of capital?

C0 = ? C1 = ? C2 = ? r =?

$0 $1, 200 NPV $1, 000 $8.26 1 2 (1 .10) (1 .10)

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Net Present Value Rule

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

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Using the NPV Rule to Choose among Projects

When choosing among mutually exclusive projects, calculate the NPV of each alternative and choose the highest positive-NPV project. Example: Consider two projects, assuming a 10% opportunity cost of capital. Which project should be selected? Cash Flows Project Project 1 Project 2 C0 - $1,000 - $1,000 C1 $700 $500 C2 $500 $700 NPV $49.59 $49.59 $33.06

Challenges to the NPV Rule

1. 2. 3. The Investment Timing Decision The Choice between Long and Short-Lived Equipment When to Replace an Old Machine
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Investment Timing
Sometimes you have the ability to defer an investment and select a time that is more ideal at which to make the investment decision.
Example: A common example involves a tree farm. You may defer the harvesting of trees. By doing so, you defer the receipt of the cash flow, yet increase the cash flow. Assume an opportunity cost of capital of 10%. Year 0 1 2 3 4 5 Cost 50 55 60 64 68 70 Sales 70 80 88 95 102 105 Value 20 25 28 31 34 35 NPV 20.0 22.7 23.1 23.3 23.2 21.7
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Long- vs. Short-Lived Equipment: Equivalent Annual Annuity

The Choice between Long- and Short-lived Equipment:

Equivalent Annual Cost -

present value of cash flows PVCash Flows EAA = 1 annuity factor 1 t r r(1 r )
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Equivalent Annual Annuity: Example

Given the following costs of operating two machines and an 8% cost of capital, select the lower-cost machine using the equivalent annual annuity method.
Cash Flows Project Machine 1 Machine 2 C0 - $3,000 - $2,000 C1 -$800 -$1,300 C2 -$800 -$1,300 C3 -$800 NPV -$5,062 -$4,318

Annuity Factor
2.577 1.783

EAA -$1,964 -$2,422

Select Machine 1 because its EAA is less negative.

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Payback Method

Payback Period - Time until cash flows recover the initial investment of the project.

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Payback Rule
Says a project should be accepted if its payback period is less than a specified cutoff period.

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Payback Method: Example

Example: The three projects below are available. The company accepts all projects with a 2 year or less payback period. Show how this will impact your decision.

Cash Flows Project

Project 1 Project 2

C0
- $1,000 - $1,000

C1
$700 $500

C2
$500 $700

C3

Payback Period 1.6 years 1.7 years

NPV (@ 10%) $49.59 $33.06

Project 3

- $1,000

$500

$700

$700

1.7 years

$558.98

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Drawback of Payback Rule

1. Though Projects 1, 2 and 3 have payback periods less than 2 years, notice the differences in NPV.

2. The Payback Rule ignores the time value of money.

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Other Investment Criteria: IRR

Internal Rate of Return (IRR) Terminology C0 Initial Cash Flow (typically negative) Cl Cash Flow at time 1 C2 Cash Flow at time 2 Ct Cash Flow at time t t Time period of the investment IRR Internal Rate of Return

Ct C1 C2 0 C0 ... 1 2 (1 IRR) (1 IRR) (1 IRR)t

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Internal Rate of Return: Example*

Cash Flows
Project Project 1 Project 2 C0 - $1,000 - $1,000 C1 $700 $500 C2 $500 $700 NPV (@ 10%) $49.59 $33.06 IRR 13.90% 12.32%

Project 1 0 1, 000 700 500 (1 IRR)1 (1 IRR) 2 IRR 13.90%

Project 2 0 1, 000 500 700 (1 IRR)1 (1 IRR) 2 IRR 12.32%

* Calculating the IRR can be a laborious task. Fortunately, financial calculators and spreadsheets can perform this function easily. See Appendix A.
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Internal Rate of Return Rule

Managers increase shareholders wealth by accepting all projects which offer a rate of return that is higher than the opportunity cost of capital.

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NPV and Internal Rate of Return

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IRR vs. NPV Lending or Borrowing?

Pitfall 1 - Lending or Borrowing?

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IRR vs. NPV: Mutually Exclusive Projects

Pitfall 2 - Mutually Exclusive Projects
Project C0 C1 Initial Proposal -350,000 400,000 Revised Proposal -350,000 16,000 C2 16,000 C3 466,000 IRR 14.29% 12.96% NPV@7% $ 23,832 $ 59,323

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IRR vs. NPV Multiple Rates of Return

Pitfall 3 Multiple Rates of Return This problem can be corrected using MIRR (modified internal rate of return). See Chapter 8 appendix for details.

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Other Investment Criteria: Profitability Index

NPV Profitability Index Initial Investment

Cash Flows Project Project 1 Project 2 C0 - $1,000 - $1,000 C1 $700 $500 C2 $500 $700

NPV (@ 10%)
$49.59 $33.06

Profitability Index
.0496 .0331

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Capital Rationing
Limit set on the amount of funds available for investment. Soft Rationing Limits on funds imposed by management. Hard Rationing Limits on funds imposed by the lack of
available funds in the capital market.
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Appendix A: IRR -- Financial Calculators and Excel

Calculating the IRR can be a laborious task. Fortunately, financial calculators and spreadsheets can perform this function easily. Consider the example Project 1:

HP-10B -1,000 700 500 CFj CFj CFj

BAII Plus CF 2nd{CLR Work} -1,000 ENTER 700 ENTER 500 ENTER IRR CPT

Calculating IRR by using a spreadsheet Year Cash Flow 0 (1,000) 1 700 2 500 Formula IRR = 13.90% =IRR(B4:B6)

{IRR/YR}

All three methods generate an IRR of 13.90%.

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Appendix B: Capital Budgeting Techniques

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Appendix C: Valuation Technique Usage

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