Slide 5.8 The Discounted Payback Period
Lecture Tip: The discounted payback period is the length of time until
accumulated discounted cash flows equal or exceed the initial
investment. Use of this technique entails all the work of NPV, but
its decision rule is arbitrary. Redeeming features of this approach
are that (1) the time value of money is accounted for and (2) if the
project pays back on a discounted basis, it has a positive NPV
(assuming no large negative cash flows after the cut-off period).
Advantages
-All those of the simple payback rule, plus, the time value of
money is taken into account (at least for cash flows prior to the
cutoff)
-If a project pays back on a discounted basis, and has all positive cash flows
after the initial investment, then it must have a positive NPV
Disadvantages
-The arbitrary cut-off period may eliminate projects that would
increase firm value
-If there are negative cash flows after the cut-off period, the rule
may indicate acceptance of a project that has a negative NPV
5.1. The Internal Rate of Return
Slide 5.9 –
Slide 5.10 The Internal Rate of Return
Internal Rate of Return (IRR) – the rate that makes the present
value of the future cash flows equal to the initial cost or
investment. In other words, the discount rate that gives a project a
$0 NPV.
IRR decision rule – the investment is acceptable if its IRR exceeds
the required return.
Ethics Note: Assume that to comply with the Air Quality Control
Act of 1989, a company must install three smoke stack scrubber
units to its ventilation stacks at an installed cost of $350,000 per
unit. An estimated $100,000 per unit in fines (after tax) could be
saved each year over the five-year life of the ventilation stacks.
The cost of capital is 14% for the firm. The analysis of the
investment results in a NPV of -$6,691.
Despite the financial assessment dictating rejection of the
investment, public policy might suggest acceptance of the project.
Should the firm exceed the minimum legal limits and be
responsible for the environment, even if this responsibility leads to
a wealth reduction for the firm? Is environmental damage merely a
cost of doing business? Could investment in a healthier working
environment result in lower long-term costs in the form of lower
future health costs? If so, might this decision result in an increase
in shareholder wealth? Notice that if the answer to this second
question is yes, it suggests that our original analysis omitted some
side benefits to the project.
Slide 5.11 IRR Example
Slide 5.12 NPV Payoff Profile
Net present value profile – plot of an investment’s NPV at various
discount rates.
Slide 5.13 Calculating IRR With Spreadsheets – Click on the Excel icon
to go to an embedded spreadsheet that illustrates how to compute IRR.
5.2. Problems with the IRR Approach
Slide 5.14 Problems with IRR
.A Definition of Independent and Mutually Exclusive Projects
Slide 5.15 Mutually Exclusive vs. Independent
Mutually exclusive investment decisions – taking one project means another
cannot be taken
Independent – a given project can be taken in conjunction with
other projects. Accept all that meet the minimum criteria.
Lecture Tip: A good introduction to mutually exclusive projects
and non-conventional cash flows is to provide examples that
students can relate to. An excellent example of mutually exclusive
projects is the choice of which college or university to attend. Most
students apply and are accepted to more than one college, yet they
cannot realistically attend more than one at a time. Consequently,
they have to decide between mutually exclusive projects.
.B Two General Problems Affecting Both Independent and Mutually
Exclusive Projects
Problem 1: Investing or Financing?
If the cash flows are of loan type, meaning money is
received at the beginning and paid out over the life of the
project, then the IRR is really a borrowing rate, and lower
is better.
Problem 2: Multiple IRRs
Slide 5.16 Multiple IRRs
Non-conventional cash flows – the sign of the cash flows changes more than
once (or, as above, the cash inflow comes first and outflows come
later).
Lecture Tip: Non-conventional cash flows and multiple IRRs
occur when there is a net cost to shutting down a project. The most
common examples deal with collecting natural resources. After the
resource has been harvested, there is generally a cost associated
with restoring the environment.
If cash flows change sign more than once, then you will have
multiple internal rates of return. This is problematic for the IRR
rule; however, the NPV rule still works fine.
Slide 5.17 Modified IRR
One method for eliminating multiple IRRs is to use the Modified
Internal Rate of Return (MIRR). Discount all cash outflows to the
present, and compound all cash inflows to the last period of the
project. Then, find the rate that equates the values. The discounting
and compounding can be done at different borrowing and
investment rates, respectively.
The alternative approach discussed in the text is to discount cash
flows over a single period (or subset of time), then combine them
as necessary to eliminate any sign differences.
.C Problems Specific to Mutually Exclusive Projects
Problem 1: Scale
IRR does not account for the amount of total value created, only a
percentage return.
Slide 5.18 The Scale Problem
Problem 2: Timing
Slide 5.19 –
Slide 5.20 The Timing Problem
Slide 5.21 Calculating the Crossover Rate
The crossover rate is where two projects have the same IRR (and
NPV). With timing issues, the NPV ranking may be different
above and below this rate.
.D Redeeming Qualities of IRR
-People seem to prefer talking about rates of return rather than dollars of value
-NPV requires a market discount rate; IRR relies only on the project cash
flows, although you do need an estimate of a required return to
make the final decision
Slide 5.22 NPV versus IRR
NPV and IRR comparison: If a project’s cash flows are
conventional (costs are paid early and benefits are received over
the life), and if the project is independent, then NPV and IRR will
give the same accept or reject signal.
.E A Test
5.3. The Profitability Index
.A Calculation of Profitability Index
Slide 5.23 –
Slide 5.24 The Profitability Index (PI)
Profitability index – present value of future cash flows divided by the initial
investment
Technically, this is true only if the initial investment is the only outflow. If
there are additional outflows after year 0, then the profitability
index = PV of inflows / PV of outflows.
If a project has a positive NPV, then the PI will be greater than 1.
5.4. The Practice of Capital Budgeting
Slide 5.25 The Practice of Capital Budgeting
It is common among large firms to employ a discounted cash flow technique
such as IRR or NPV along with a technique such as the payback
period. It is suggested that this is one way to resolve the
considerable uncertainty over future events that surrounds the
estimation of NPV.
Lecture Tip: While uncertainty about inputs and interpretation of the outputs
helps explain why multiple criteria are used to judge capital
investment projects in practice, another reason is managerial
performance assessment. When managers are judged and
rewarded primarily on the basis of periodic accounting figures,
there is an incentive to evaluate projects with methods such as
payback or average accounting return. On the other hand, when
compensation is tied to firm value, it makes more sense to use NPV
as the primary decision tool.
Ethics Note: The use of various financial incentives to induce firms to locate
in a given municipality raises some interesting issues in the capital
budgeting area. From the viewpoint of the firm’s analysts, how do
you estimate the impact of such incentives? A reduction in the
initial outlay? Increases in future cash inflows? And, what
discount rate should be assigned to these tax reductions? Are these
promises riskless?
And, what about the municipal officials who offer such
incentives? Stated reasons are typically related to “employment
growth” or “increased economic activity.” But, from a capital
budgeting standpoint, have you ever seen a fully developed cash
flow analysis of the stated benefits relative to the costs?
Consider this example from a Federal Reserve publication:
“Alabama offered Mercedes-Benz a package valued at
more than the cost of the plant itself. To lure the
$300 million plant, with about 1,500 jobs, the state
promised to buy the site for $30 million, and lease it
to Mercedes for $100. Surrounding communities
will contribute an additional $5 million each, and
the University of Alabama will offer German
language and culture classes to the children of
plant employees. On top of this, the state will
provide a package of tax breaks valued at more
than $300 million, which will, among other things,
allow the plant to be paid for with money that
would have been paid to the state.”
Several incentives described above directly affect the costs and benefits of the
proposed project and would be accounted for in the capital
budgeting analysis performed by Mercedes. However, the state
officials should perform their own capital budgeting analysis –
they, too, are incurring economic costs in the hope of future
benefits. But at least one aspect is different: when a corporation makes a poor
investment, shareholders suffer. When states make poor decisions,
all of the residents of the state suffer. Thus, the ethics of the capital
budgeting decision come into play more clearly in the latter case.
Slide 5.26 –
Slide 5.28 Example of Investment Rules
Slide 5.29 NPV and IRR Relationship
Slide 5.30 NPV Profiles
Slide 5.31 Summary – Discounted Cash Flow
Slide 5.32 Summary – Payback Criteria
Slide 5.33 Quick Quiz