Chapter 5
NET PRESENT VALUE AND OTHER INVESTMENT RULES
SLIDES
CHAPTER WEB SITES
Section Web Address
5.1 www.missouribusiness.net
CHAPTER ORGANIZATION
5.1 Key Concepts and Skills
5.2 Chapter Outline
5.3 Why Use Net Present Value?
5.4 The Net Present Value (NPV) Rule
5.5 Calculating NPV with Spreadsheets
5.6 The Payback Period Method
5.7 The Payback Period Method
5.8 The Discounted Payback Period
5.9 The Internal Rate of Return
5.10 Internal Rate of Return (IRR)
5.11 IRR: Example
5.12 NPV Payoff Profile
5.13 Calculating IRR with Spreadsheets
5.14 Problems with IRR
5.15 Mutually Exclusive vs. Independent
5.16 Multiple IRRs
5.17 Modified IRR
5.18 The Scale Problem
5.19 The Timing Problem
5.20 The Timing Problem
5.21 Calculating the Crossover Rate
5.22 NPV versus IRR
5.23 The Profitability Index (PI)
5.24 The Profitability Index
5.25 The Practice of Capital Budgeting
5.26 Example of Investment Rules
5.27 Example of Investment Rules
5.28 Example of Investment Rules
5.29 NPV and IRR Relationship
5.30 NPV Profiles
5.31 Summary – Discounted Cash Flow
5.32 Summary – Payback Criteria
5.33 Quick Quiz
5.1 Why Use Net Present Value?
5.2 The Payback Period Method
Defining the Rule
Problems with the Payback Method
Managerial Perspective
Summary of Payback
5.3 The Discounted Payback Period Method
5.4 The Internal Rate of Return
5.5 Problems with the IRR Approach
Definition of Independent and Mutually Exclusive Projects
Two General Problems Affecting Both Independent and Mutually Exclusive
Projects
Problems Specific to Mutually Exclusive Projects
Redeeming Qualities of IRR
A Test
5.6 The Profitability Index
Calculation of Profitability Index
5.7 The Practice of Capital Budgeting
ANNOTATED CHAPTER OUTLINE
Slide 5.0 Chapter 5 Title Slide
Slide 5.1 Key Concepts and Skills
Slide 5.2 Chapter Outline
Lecture Tip: A logical prerequisite to the analysis of investment
opportunities is the creation of investment opportunities. Unlike the field
of investments, where the analyst more or less takes the investment
opportunity set as a given, the field of capital budgeting relies on the work
of people in the areas of engineering, research and development,
information technology, and others for the creation of investment
opportunities. As such, it is important to remind students of the
importance of creativity in this area, as well as the importance of
analytical techniques.
1. Why Use Net Present Value?
Net present value – the difference between the present value of a project’s
future cash flows and its cost. Estimating cost is usually straightforward;
however, estimating future cash flows can be tricky.
Slide 5.3 Why Use Net Present Value?
Lecture Tip: You may wish to take the opportunity to use this example to
illustrate the interpretation of NPV and its relationship to organizational
form. Specifically, assume that, in order to raise the $50,000 needed to
buy and rehab a house, you had sold 50,000 shares of stock in the venture
for $1 apiece. Your father purchased 15,000 shares, your brother
purchased 15,000 shares, and you purchased the remaining 20,000 shares.
How much are the shares worth upon the sale of the house for $60,000?
Your father’s share of the selling price is $18,000 =(15,000/50,000)
(60,000), as is your brother’s. Your share is $24,000 =(20,000/50,000)
(60,000). In other words, the value created accrued to the owners of the
investment. This is the essence of the NPV approach: The NPV measures
the increase in firm value, which is also the increase in the value of what
the shareholders own. Thus, making decisions with the NPV rule
facilitates the achievement of our goal in Chapter 1 – making decisions
that will maximize shareholder wealth.
Lecture Tip: Although this point may seem obvious, it is often helpful to
stress the word “net” in net present value. It is not uncommon for some
students to carelessly calculate the PV of a project’s future cash flows and
fail to subtract out its cost (after all, this is what the programmers of
Lotus and Excel did when they programmed the NPV function). The PV of
future cash flows is not NPV; rather, NPV is the amount remaining after
offsetting the PV of future cash flows with the initial cost. Thus, the NPV
amount determines the incremental value created by undertaking the
investment.
Slide 5.4 The Net Present Value (NPV) Rule
Discounted cash flow (DCF) valuation – finding the market value of assets
or their benefits by taking the present value of future cash flows, i.e., by
estimating what the future cash flows would trade for in today’s dollars.
Lecture Tip: Here is another perspective on the meaning of NPV. If we
accept a project with a negative NPV of -$2,422, this is financially
equivalent to investing $2,422 today and receiving nothing in return.
Therefore, the total value of the firm would decrease by $2,422. This
assumes that the various components (cash flow estimates, discount rate,
etc.) used in the computation are correct.
The benefit of NPV is that it measures the magnitude, timing, and risk of
cash flows, which further illustrates its link to the firm’s stock price.
If NPV > 0, then accepting the project creates value. So, to maximize
value, choose projects with the highest NPV.
Lecture Tip: In practice, financial managers are rarely presented with
zero NPV projects for at least two reasons. First, in an abstract sense,
zero is just another of the infinite number of values the NPV can take; as
such, the likelihood of obtaining any particular number is small. Second,
and more pragmatically, in most large firms capital investment proposals
are submitted to the finance group from other areas for analysis. Those
submitting proposals recognize the ambivalence associated with zero
NPVs and are less likely to send them to the finance group in the first
place.
Conceptually, a zero-NPV project earns exactly its required return.
Assuming that risk has been adequately accounted for, investing in a zero-
NPV project is equivalent to purchasing a financial asset in an efficient
market. In this sense, one would be indifferent between the capital
expenditure project and the financial asset investment. Further, since firm
value is completely unaffected by the investment, there is no reason for
shareholders to prefer either one.
However, several real-world considerations make such comparisons
difficult. For example, adjusting for risk in capital budgeting projects can
be problematic. And, some investment projects may have benefits that are
difficult to quantify, but exist, nonetheless. Consider an investment with a
low or zero NPV that enhances a firm’s image as a good corporate citizen.
Additionally, the secondary market for most physical assets is less
efficient than the secondary market for financial assets. While, in theory,
you can adjust for differences in liquidity, it is problematic. Finally, all
else equal, some investors prefer larger firms to smaller; if true, investing
in any project with a nonnegative NPV may be desirable.
Slide 5.5 Calculating NPV with Spreadsheets – Click on the Excel icon to go
to an embedded spreadsheet to see the correct and incorrect ways to compute NPV
in a spreadsheet.
2. The Payback Period Method
A. Defining the Rule
Slide 5.6 The Payback Period Method
Ethics Note: Because a project is financially sound, it must be ethically
sound, right? Well … the question of ethical appropriateness is less
frequently discussed in the context of capital budgeting than that of
financial appropriateness.
Consider the following simple example. An ABC poll in the spring of
2004 found that one-third of students ages 12 – 17 admitted to cheating,
and the percentage increased as the students got older and felt more grade
pressure. You might pose the ethical question of whether it would be
proper for a publishing company to offer a new book “How to Cheat: A
User’s Guide.” The company has a cost of capital of 8% and estimates it
could sell 10,000 volumes by the end of year one and 5,000 volumes in
each of the following two years. The immediate printing costs for the
20,000 volumes would be $20,000. The book would sell for $7.50 per copy
and net the company a profit of $6 per copy after royalties, marketing
costs, and taxes. Year one net would be $60,000.
From a capital budgeting standpoint, is it financially wise to buy the
publication rights? What is the NPV of this investment? The year 0 cash
flow is -20,000, year 1 is 60,000 and years 2 and 3 are 30,000 each. Given
a cost of capital of 8%, the NPV is just over $85,000. It looks good, right?
Now ask the class if the publishing of this book would encourage cheating
and if the publishing company would want to be associated with this text
and its message. Some students may feel that one should accept these
profitable investment opportunities, while others might prefer that the
publication of this profitable text be rejected due to the behavior it could
encourage. Although the example is simplistic, this type of issue is not
uncommon and serves as a starting point for a discussion of the value of
“reputational capital.”
Payback period – length of time until the accumulated cash flows equal or
exceed the original investment.
Payback period rule – investment is acceptable if the calculated payback is
less than some prespecified number of years.
B. Problems with the Payback Method
Slide 5.7 The Payback Period Method
-No “real” discounting is involved (although, cash flows prior to the cutoff
are essentially discounted at a rate of zero, while cash flows after the
cutoff are discounted at an infinite rate)
-Does not consider risk differences
-How do we determine the cutoff point
-Bias toward short-term (liquid) investments
Redeeming Qualities of the Rule
-Simple to use
-Bias for short-term promotes liquidity
Lecture Tip: Interestingly, the payback period technique is used quite
heavily in determining the viability of certain investment projects in the
health care industry. Why?
Consider the nature of the health care industry: the technology is
rapidly changing, some of the equipment tends to be extremely expensive,
and the industry itself is increasingly competitive. What this means is that,
in many cases, an equipment purchase is complicated by the fact that,
while the machine may be able to perform its function for, say, 6 years or
more, new and improved equipment is likely to be developed that will
supersede the “old” equipment long before its useful life is over. Demand
from patients and physicians for “cutting-edge technology” can drive a
push for new investment. In the face of such a situation, many hospital
administrators then focus on how long it will take to recoup the initial
outlay, in addition to the NPV and IRR of the equipment.
C. Managerial Perspective
Lecture Tip: Teaching the payback rule seems to put one in a delicate
situation – as the text indicates, the rule is flawed as an indicator of
project desirability. Yet, past surveys suggest that practitioners often use it
as a secondary decision measure. How can we explain this apparent
discrepancy between theory and practice?
While the payback period is widely used in practice, it is rarely the
primary decision criterion. As William Baumol pointed out in the early
1960s, the payback rule serves as a crude “risk screening” device – the
longer cash is tied up, the greater the likelihood that it will not be
returned. The payback period may be helpful when mutually exclusive
projects are compared. Given two similar projects with different paybacks,
the project with the shorter payback is often, but not always, the better
project.
D. Summary of Payback
Advantages:
Easy to understand
Adjusts for the uncertainty of later cash flows
Biased towards liquidity
Disadvantages:
Ignores the time value of money
Requires an arbitrary cutoff point
Ignores cash flows beyond the cutoff date
Biased against long-term projects
Lecture Tip: The payback period can be interpreted as a naïve form of
discounting if we consider the class of investments with level cash flows
over arbitrarily long lives. Since the present value of a perpetuity is the
payment divided by the discount rate, a payback period cutoff can be seen
to imply a certain discount rate.
That is:
cost/annual cash flow = payback period cutoff
cost = annual cash flow times payback period cutoff
The PV of a perpetuity is: PV = annual cash flow / R. This illustrates the
inverse relationship between the payback period cutoff and the discount
rate.
Lecture Tip: Firms that have operations in countries with volatile
governments may also be concerned with quick paybacks. When there is
always a possibility that the government may seize your assets, you want
to make sure that you have recovered your investment as quickly as
possible.
3. The Discounted Payback Period Method
Discounted payback rule – An investment is acceptable if its discounted
payback is less than some prespecified number of years.