Corporate Finance2010--6

= -1,100 + 500/1.1 + 700/1.12 + (-500)/1.13 + 1,200/1.14
= $377.02 > 0
2 The Payback Period Rule
How long does it take the project to “pay back” its initial investment? Payback Period = number of years to recover initial costs Minimum Acceptance Criteria:
Does not distinguish between investing and borrowing. IRR may not exist or there may be multiple IRR Problems with mutually exclusive investments Easy to understand and communicate
• Discounted payback period is just under 3 years
4 The Average Accounting Return Rule
AAR Average Net Income Average Book Value of Investent
Another attractive but fatally flawed approach. Ranking Criteria and Minimum Acceptance Criteria set by management Disadvantages:
$2,200 2,700
(500)
Cash flow
$700
Cash flow $1,200
$700 x
1 1.10 2 - $500 x 1 1.10 3 $1,200 x
1
1.10 4
+819.62
+$377.02
= NPV
The NPV Rule : Example (continued)
NPV = -C0 + PV0(Future CFs) = -C0 + C1/(1+r) + C2/(1+r)2 + C3/(1+r)3 + C4/(1+r)4
The Net Present Value (NPV) Rule
Net Present Value (NPV) = Total PV of future CF‟s + Initial Investment Estimating NPV:
1. Estimate future cash flows: how much? and when? 2. Estimate discount rate 3. Estimate initial costs
The NPV Rule : Example (continued)
0
1
Revenues Expenses
2 $2,000 1,300
3 Revenues Expenses
Cash flow
4 Revenues Expenses $2,600 1,400
Initial Revenues $1,000 outlay Expenses 500 ($1,100) Cash flow $500 – $1,100.00 $500 x +454.54 +578.51 -375.66 1 1.10
1 Why Use Net Present Value?
Accepting positive NPV projects benefits shareholders. NPV uses cash flows NPV uses all the cash flows of the project NPV discounts the cash flows properly
Initial outlay -$1,100 Required return = 10%
•
Annual cash revenues and expenses are as follows: Year Revenues Expenses 1 $1,000 $500 2 2,000 1,300 3 2,200 2,700 4 2,600 1,400
Reinvestment assumption: the NPV rule assumes that all cash flows can be reinvested at the discount rate.
The NPV Rule : Example
•
– –
Assume you have the following information on Project X:
Advantages:
Easy to understand Biased toward liquidity
3 The Discounted Payback Period Rule
How long does it take the project to “pay back” its initial investment taking the time value of money into account? By the time you have discounted the cash flows, you might as well calculate the NPV.
The Average Accounting Return Rule: Example
• You want to invest in a machine that produces squash balls • The machine costs $90,000 • The machine will „die‟ after 3 years • Assuming straight line depreciation, the annual depreciation is $30,000 • The estimate cash flows for the life of the project: Year 1 Year 2 Year 3 Sales 140 160 200 Expenses 120 100 90
Ignores the time value of money Uses an arbitrary benchmark cutoff rate Based on book values, not cash flows and market values
Advantages:
The accounting information is usually available Easy to calculate
Corporate Finance
Lecture 6 Some Alternative Investment Rules
Chapter Outline
1 Why Use Net Present Value? 2 The Payback Period Rule 3 The Discounted Payback Period Rule 4 The Average Accounting Return 5 The Internal Rate of Return 6 Problems with the IRR Approach 7 The Profitability Index 8 The Practice of Capital Budgeting 9 Summary and Conclusions
Select alternative with the highest IRR Accept if the IRR exceeds the required return.
Reinvantages: Advantages:
All future cash flows assumed reinvested at the IRR.
The Average Accounting Return Rule: Example (continued)
We calculate: (i) Average NI
6 18 48 3 20
(ii) Average book value (BV) of the investment (machine): time-0 time-1 time-2 time-3 BV of investment:
set by management
Ranking Criteria:
set by management
The Payback Period Rule (continued)
Disadvantages:
Ignores the time value of money Ignores cash flows after the payback period Biased against long-term projects Requires an arbitrary acceptance criteria A project accepted based on the payback criteria may not have a positive NPV
•
Conclusion If target AAR < 44.44% => accept If target AAR > 44.44% => reject
The Internal Rate of Return (IRR) Rule
IRR: the discount that sets NPV to zero Minimum Acceptance Criteria: Ranking Criteria: