Finance Chapter 9: Net Present Value and Other Investment Criteria

What is the capital budgeting decision? the decision to determine what fixed assets to buy.
Why is it important to contemplate these decisions carefully? because they are generally long lived and not easily reversed once they are made.
What is the most fundamental decision a firm must make? its product linewhat to sell/servicewhat markets to compete in what new product need to be introduce
What is the more fitting name for capital budgeting? strategic asset allocation
Why is the capital budget the most important issue in coporate finance? fixed assets define the business of the firm
when is an investment worth undertaking? if it creates value for its owners. worth more in the market then the cost to acquire it
How can an asset be worth more in the market then the cost to acquire it? Buy a run down house for 25,000 and spend 25,000 to fix it up (plumers, paint, technicians, etc…), the total investment is 50,000. When the work is completed, the house goes back on the market for 60,000. The market worth is 10,000 > cost to acquire the assetI add 10,000 worth of value to the house
What is the job of financial mangers in respect to capital budgeting? they must determine beforehand if the asset will be worth more on the market than its cost to buy.
what is net present value? (NPV) the difference between an investment’s market value and its costmeasure of how much value is created or added today by undertaking an investment.
given that the main goal is to increase stockholder value, how can we look at the capital budgeting process? the goal of capital budgeting is to invest in assets that will have a positive NPV
How would we detemine the estimated NPV of the house before purchasing it? look at how how similar houses are selling in the marketlook at the cost of labor for the work that needs to be done on the houseDetermine estimate total cost and estimate market value in order to estimate NPV
When does capital budgeting become much more difficult? when there is not a preexisting market for the product that would allow for the determination of estimate market value.
How would we go about estimated the value of starting our own organic fertilizing company? estimate future cash flows expect to be produced by businessapply discounted cash flows flow procedure to estimate the present value of the cashthen estimate NPV as the difference bxt the present value of future cash floes and the cost of investment
What is discounted cash flow (DCF) valuation? the process of valuing an investment by discounting its future cash flows.
Suppose i believe cash revenues will be 20,000 per year. Cash costs will be 14,000 per year. We will wind down the business in eight years. The PPE will be worth 2,000 at salvage. The projects will cost 30,000 to lauch, We use a 15% discount rate on new projects such as this one. Is this a good investment? Future Cash Flows = 20,000 per year – 14,000 year = $6,000 per yearThis is an annuity of $6000 being paid to company at the end of every year.Present Value = $6,000 * [1-(1/1.15^8)] /.15 + (2000/1.15^8)(6,000 * 4.4873) + (2,000/3.0590)26,924+654PV = 27,578NPV = -30,000 + 27,578 = -2,422NOT A GOOD INVESTMENT
In the previous problem, if there were 1000 shares outstanding, how would this investment effect the price per share? the share would have a loss of 2,422/1000 = 2.42 per share
How does NPV effect share value? NPV positivie… the effect is favorable.NPV negative…. the effect is unfavorable
What is the NPV rule? an investment should be accepted if the NPV is positive and rejected if NPV is negative.
What if NPV = zero? indifferent
What is the preferred approach for assessing potential profitiability from an asset? Net Present Value
What is payback? the length of time it takes to recover the to recover the initial investment or “get our bait back” how long do we have to wait until the cash flows equal or exceed the initial cost of the investment
Exampleinitial cost of investment = $50,000Cash flows from one year = 30,000the cash flow in the second period is 20,000what is the pay back? 2 years exactly
The payback period the amount of time required for an investment to generate cash flows sufficient to recover its initial cost
What is the payback rule? an investment ins acceptable if its calculated payback period is less than some prespecified number of years
How does a firm determine to accept or reject an investment based on payback period? 1. pick a pre specified time (ex, 2 years)2. any investment that will be paid back in 2 years or less is accepted. any that are two years or more are rejected.
Short comings of the payback rule? 1. there can be more then one payback for a single investment2. no discounting involved, so time value of money is ignored3. fails to consider risk differences because it is calculated the same way no matter what4. difficult to come up with correct cutoff period. (no economic rationale or guide to choose the cut off)
What can happen by ignoring time value of money in the payback method? we may be led to investments that actually are worth less than they cost
What can happen by ignoring cash flows after the cutoff in the payback method? we may be led to reject profitable long term investments`
what is using a payback method bias toward? the shorter term investment
When is the payback method used by companies and why when making minor decisionsthese decisions simply do not warrant detailed analysis because the cost of the analysis would exceed the possible loss from a mistake
as practical matter, what can be said about an investment that pays back rapidly and has benefits extending beyond the cutoff point? the NPV is probably positive
What are some benefits to payback method? simple (easy to use on minor decisions)it is biased toward short-term investments and liquidity but ignoring risk all together, the method adjusts for the extra riskiness of later cash flows
Why is the payback period a “break even” measure? length of time it takes to break even in an accounting sense but not an economic sense.
what is the biggest drawback to the payback period rule? it doesnt ask the right question.we need to focus on the impact the investment has on shares of stock npt how long it takes to recover initial investment
advantages of payback period? easy to understandAdjusts for uncertainty of later cash flowsBiased toward liquidity
disadvantages of payback period? ignore the time value of money requires arbitrary profitignores the cash flows beyond cut off datebiased against long term investments
What is the discounted payback period? the length of time required for an investment’s discounted cash flows to equal its initial cost
what is the discounted payback rule? based on the discounted payback rule, an investment is acceptable if it is discounted payback is less than some pre-specified number of years
Suppose we require 12.5% return on investments, we have an investment that cost $300 and has cash flows of $100 per year for 5 years, how do we get the discounted pay back? (100/1.1^4) + (100/1.1^3) + (100/1.1^2) + (100/1.1^) = $300.67with initial investment =300, the discounted payback is 4 years.The undiscounted pay back is 3 years.
How to interpret the discount payback? the time to “break even” in financial and economic terms
On a graph of future value of initial investment and a graph of future value of cash flows, where is the crossing point of the two lines? It meets/crosses each other at the discount payback period (for the example above its 3 years)the value of cash flows catches up and then passes the initial investment
using the discount payback period, what is true if the a project ever pays back on a discounted basis It must have a positive NPV. This is true because NPV is zero when sum of discount cash flows is equal to initial investmentwe don’t accidentally take projects with neg. NVP
Why is the discounted payback not used very often in practice? because it is not any easier to calculate then NPV.the cutoff is still arbitrarily set and we ignore cash flows past the cut off point –> may cause a project with positive NPV to be deem unacceptable
advantages to discounted payback? includes time value of moneyEasy to understandDoes not accept negative estimated NVP investmentsBiased toward liquidity
Disadvantages of discounted payback? may reject pos. NVP projectsrequires arbitrary cutoff pointIgnores cash flows beyond cutoff datebiased against long term projects, such as research and development and new projects
what is the average accounting return? AARsome measure of ave. accounting profit / some measure of ave. accounting valuean investment’s average net income divided by its average book value
Calculate average book value (book value beginning + book value end) / 2
Average net income Sum of the net incomes for n year / n
What is the average accounting return rule? Based on the average accounting return rule, a project is acceptable if its average accounting return exceeds a target average accounting return.
Drawback to AAR? it is not a true rate of return in any economic sense. It is a ratio of two accounting numbers. and is not comparable to the returns offered in financial marketsignores time value of money. Averaging treats future and present value as the same
What else is a drawback of AAR? it does not take into account the time value of money. When we average we say that the future values and present values the same wayThere is also no agreed upon way to determine the target AAR
What is the third drawback of AAR? it doesnt even look at the right things. Instead of cash flow and market value it uses net income and book value.These are poor substitutes. doesn’t tell us what effect the investment will have on share price
Advantages of AAR? Easy to calculateNeeded information will usually be available
Disadvantages of AAR? Not a true rate of return, time value of money is ignoreduses and arbitrary benchmark for cutoffBased on accounting information (book values) not cash flows and market values.
what is the most important alternative to NPV? The Internal rate of returnIRR
What can we find with IRR? a singe rate of return that summarizes the merits of the projectwant this rate to be internal rate in a sense that it depends only on the cash flows of the particular investment, not on rates offered elsewhere
Consider a project that cost 100 today and pays 110 in one year. Suppose i was asked “what is the return on the investment” what would I say? The return and IRR is 10% but we can’t determine if this return rate is good until we compare it to the required rate of return. if the required rate of return is less than 10% then this is a good investment.
What is the IRR rule? an investment is acceptable if the IRR exceeds the required return, otherwise reject it
Calculate NPV for the above investment? (100/.1) = 10 + 100 = 110 -100 = 10
How do we determine the break even discount rate? we set the NPV equal to zero and solve-100 + (110/R) = 0100 = 110/r100r=110r=0.1 or 10%
What is an important aspect to note bxt the relationship bxt IRR and NPV The IRR on an investment is the required return that results in a zero NPV when it is used as the discount rate
Why is the fact that the IRR is the discount rate that makes NPV important? it tells how to calculate the returns more on more complicated investments.
Suppose an investment cost $100 and has a cash flow of $60 per period for two years. What is the required return on investment? NPV = -100 + [60/1+IRR] + [60/1+IRR^2] = 0Now use trial and error=13.1% approxso if required return was less than 13.1 you would take this investment
What is another name for IRR? the discounted cash flows (DCF)
What is the easiest way to illustrate the relationship between NPV and IRR? plot the numbers on graphPlace NPV on vetical axis and IRR on horizontalsmooth curve results which represents the net present value profile
What is the net present value profile? a graphical representation of the relationship between an investment’s NPVs and the various discount rates
do NPV and IRR always lead to the same decision? yes as long as two very important conditions are met
what are the two conditions? 1. the projects cash flows must be conventional, meaning that the first cash flow is negative and the rest are positive2. the project must be independent meaning that the decision to accept or reject this investment does not affect the decision to accept or reject another.
What is the multiple rates of return problem? the possibility that more than one discount rate will make the NPV of an investment zero
How does the multiple rates of return problem occur? When the cash flows aren’t conventional, strange thing can happen to the IRR
How do we determine the maximum number of IRRS? The number of IRR there can be is equal to the number of signs changes there are throughout the investment
What are mutually exclusive investment decisions? when one investment prevents us from taking another investment
What are two projects that are not mutually exclusive? independent
In deciding between two mutually exclusive events, does the one with the bigger NPV always have the larger IRR? NO, it depends on the discount rate.An investment that has a higher IRR than the second may have a smaller NPV at certain discount ratesWe can find which one is better at certain discount rates by graohin NVP vs. Discount rates.
In deciding between two mutually exclusive events, should we look at IRR over NPV? no, looking at IRR can be misleading
What is the crossover rate? the discount rate that makes the npvs of the two projects equal.Can find this by taking the difference in the cash flows and calculating the IRR using the difference(A-B)
What is financing type cash? When we receive cash inflows before cash outflows on an investmentUpward sloping NPV graphThe IRR is the rate we are paying not receiving
When should we take on a project with financing cash flows? only if is is an inexpensive source of financing, meaning that is IRR is lower than the the required rate of return
Which is more popular in practice the IRR or the NPV? the IRR
Advantages of IRR closely related to NPV, often leading to the same decision.Easy to understand and communcatecan be estimated if return rate is not know for certain
Disadvantage of IRR? May result in multiple answers or not deal with non conventional cash flows. May lead to incorrect decisions in comparisons of mutually exclusive investment
What is the Modified Internal Rate of Return (MIRR) we modify the cash flows first and then calculate an IRR using the modified cash flows. Helps eliminate multiple IRR problem
What is the MIRR discounting approach? to discount all the negative cash flows to present value and add them to the initial costThen calculate the IRRleads to only on IRR
What is the MIRR reinvestment approach? we compound all cash flows (positive and negative) except the first to the end of the projects lifecalculate IRRwe “reinvest” cash flows and don’t take them out until projects end
What is the MIRR combination approach? blend the discounting and reinvesting approach,discount the negatives back to present and add to initial,then we compound all positive cash flows except the first to the end of the projects life
What are the controversies surrounding MIRR? 1. “meaningless internal rate of return”2.different ways to calculate and one model is not better then the other which leads to differences3.not clear how to is the rate of return on a modified form of cash flows NOT actual cash flows5.depends EXTERNALLY on discount rate (why not calculate the NPV then?)
What is the one issue with MIRR the text takes a stance on? the value of the project does NOT depend on what the firm does with the cash flows generated by that project. How cash is spent in the future does not effect its value today.
What is the profitability index? the present value of an investment’s future cash flows divided by its initial cost. Also called the benefit-cost ratio
If a project cost $200 and the present value of its future cash flows is $220, what is the the profitiablility index? what is the NVP $200/$220 = 1.1-200 +220 = $20
What is true of the present value of future cash flows if the NVP is positive? the present value of future cash flows is greater then the initial investmentthe profitability index is greater then one.
What is true of the present value of future cash flows if the NVP is negative? the present value of future cash flows is less then the initial investmentthe profitability index is less then one.
What does the profitability index tell us, for example, what does a PI of 1.1 mean? per dollar invested, $1.10 in value of $0.10 in NPV results”bang for your buck”value created per dollar invested
What is PI proposed as? a measure of performance for government or other not-for-profit investments. Also, when capital is scarce, it may make sense to allocate it to projects with the highestest PIs.
Consider an investment that costs $5 and has a $10 present value and an investment that costs $100 with a $150 value. what are the NPVs? what are the PIs? -5 + 10 = $5-100 + 150 = $50$10/$5 = 2150/100 = 1.5 In this casethe second one is preferred even though it has a lower PI
Advantages of PI? Closely related to NPV, generally leading to identical decisionseasy to understand and communicateMay be useful when available investment funds are limited
Disadvantages of PI? may lead to incorrect decisions in comparisons of mutually exclusive investments
why does a business use more than one technique in order to determine whether or not to invest? 1. the future is unpredictable and leads to “soft” understanding of how the investment will work out2. the amount of money that is on the line for capital budgeting is VERY significant3. sometimes techniques contradict each other, so in order to get the best overall picture you should test more than one.

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