Some Alternative Investment

Rules

Session 5
The Balance–Sheet Model of the Firm
The Capital Budgeting Decision
Current
Current Liabilities
assets

Long- term
Fixed Assets Debt
What long-
1 Tangible term
2 Intangible investments
should the Shareholders’
firm engage Equity
in?
 Capital Budgeting Decisions &
Evaluation
 Estimate the cash flows involved with the
project
 Estimate a required rate of return or
discount rate for the project
 Apply a decision rule to determine if an
investment is good or bad
Capital Budgeting Techniques
 Net Present Value (NPV)
 Payback Period
 Discounted Payback Period
 Average Accounting Return
 Internal Rate of Return (IRR)
 Profitability Index (PI)

9
 Good Decision Criteria
 We need to ask ourselves the following
questions when evaluating decision criteria
– Does the decision rule adjust for the time value
of money?
– Does the decision rule adjust for risk?
– Does the decision rule provide information on
whether we are creating value for the firm?
 Project Example Information
 You are looking at a new project and you have
estimated the following cash flows:
– Year 0: CF = -165,000
– Year 1: CF = 63,120; Net Income = 13,620
– Year 2: CF = 70,800; Net Income = 3,300
– Year 3: CF = 91,080; Net Income = 29,100
– Average Book Value = 72,000
 Your required return for assets of this risk is 12%.
 Net Present Value (NPV)
 Net Present Value (NPV). Net Present Value is found by
subtracting the present value of the after-tax outflows from
the present value of the after-tax inflows.

Decision Criteria
If NPV > 0, accept the project
If NPV < 0, reject the project
If NPV = 0, indifferent
 Net Present Value
 NPV = CF0 + CF1 + CF2 + . . . + CFn
(1+R) (1+R)^2 (1+R)^n

CFn: is the expected net cash flow at period n

R: is the project’s cost of capital (required rate
of return)
n: is the life of the project
 Net Present Value
A new project that has a required rate of return
of 12% and estimated cash flows as follows:

Year Cash flows Discounted CF

0 -165,000 -165,000
1 63,120 56,357
2 70,800 56,441
3 91,080 64,829
 Payback Period
 The payback method simply measures how long it takes to
recover the initial investment.
 Decision rule: Accept if the payback period is less than
some preset limit
Year Cash flows
0 -165,000
1 63,120
2 70,800
3 91,080
 Discounted Payback
 Compute the present value of each cash flow and then determine how
long it takes to payback on a discount basis.
 Compare to a specified required period.
 Decision rule: Accept the project if it pays back on a discounted basis
within the specified time.
Year Cash flows Discounted CF
0 -165,000 -165,000
1 63,120 56,357
2 70,800 56,441
3 91,080 64,829
 Average Accounting Return
(AAR)
 AAR is:
– Average net income / average book value
– Note that the average book value depends on
how the asset is depreciated.
 Need to have a target cutoff rate
 Decision Rule: Accept the project if the
AAR is greater than a preset rate.
 Computing AAR For The
Project
 Assume we require an average accounting
return of 25%
 Average Net Income:
– (13,620 + 3,300 + 29,100) / 3 = 15,340
 AAR = 15,340 / 72,000 = .213 = 21.3%
 Do we accept or reject the project?
 Internal Rate of Return (IRR)
The IRR is the discount rate that will equate the present
value of the outflows with the present value of the inflows:

The IRR is the project’s intrinsic rate of return.

Decision Criteria
If IRR > R, accept the project
If IRR < R, reject the project
If IRR = R, indifferent
Internal Rate of Return (IRR)
 NPV = CF0 + CF1 + CF2 + . . . + CFn
(1+IRR) (1+IRR)^2 (1+IRR)^n

CFn: is the expected net cash flow at period n

IRR: is the project’s internal rate of return
n: is the life of the project
Internal rate of return (IRR)
Find the IRR of project S with the following CFs

Year Cash flows

0 -165,000
1 63,120
2 70,800
3 91,080
 NPV Profile For The Project
IRR = 16.13%
70,000
60,000
50,000
40,000
30,000
NPV

20,000
10,000
0
-10,000 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22

-20,000
Discount Rate
 NPV Vs. IRR
 NPV and IRR will generally give us the
same decision
 Exceptions
– Non-conventional cash flows – cash flow signs
change more than once
– Mutually exclusive projects
 Only ONE of several potential projects can be
chosen
 IRR and Non-conventional
Cash Flows
 When the cash flows change sign more than once,
there is more than one IRR
 When you solve for IRR you are solving for the
root of an equation and when you cross the x-axis
more than once, there will be more than one return
that solves the equation
 If you have more than one IRR, which one do you
use to make your decision?
 Another Example – Non-
conventional Cash Flows

 Suppose an investment will cost $90,000

initially and will generate the following
cash flows:
– Year 1: 132,000
– Year 2: 100,000
– Year 3: -150,000
 The required return is 15%.
 Should we accept or reject the project?
 NPV Profile
IRR = 10.11% and 42.66%
$4,000.00

$2,000.00

$0.00
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55
($2,000.00)
NPV

($4,000.00)

($6,000.00)

($8,000.00)

($10,000.00)
Discount Rate
 Summary of Decision Rules
 The NPV is positive at a required return of
15%, so you should Accept
 If you use the financial calculator, you
would get an IRR of 10.11% which would
tell you to Reject
 You need to recognize that there are non-
conventional cash flows and look at the
NPV profile
 IRR and Mutually Exclusive
Projects
 Mutually exclusive projects
– If you choose one, you can’t choose the other
– Example: You can choose to attend graduate school
next year at either Harvard or Stanford, but not both
 Intuitively you would use the following decision
rules:
– NPV – choose the project with the higher NPV
– IRR – choose the project with the higher IRR
 Example With Mutually Exclusive
Projects
Period Project A Project B
The required return
0 -17,000 -17,000 for both projects is
11%.
1 8,000 2,000

2 7,000 5,000 What is IRR and

NPV of each
3 5,000 9,000 project? Which
project should you
4 3,000 9,500 accept and why?
 Conflicts Between NPV and
IRR
 NPV directly measures the increase in value
to the firm
 Whenever there is a conflict between NPV
and another decision rule, you should
always use NPV
 IRR is unreliable in the following situations
– Non-conventional cash flows
– Mutually exclusive projects
 Modified IRR: MIRR
The MIRR is the return that equates the future value
of all the project’s cash flows reinvested at the cost
of capital to the present value of all those cash flows.

Decision Rule:
Undertake the project if the MIRR exceeds the
cost of capital.
 Modified IRR: MIRR
Find the MIRR of project S with the following CFs. Rate of return is 12%

Year Cash flows

0 -165,000
1 63,120
2 70,800
3 91,080

MIRR = 14.79% (IRR = 16.13%):

FV of Cash inflows = 249,553.7
N=3 PV=-165,000 PMT=0 FV=249,553.7 I=14.79%
 Profitability Index
 Measures the benefit per unit cost, based on
the time value of money
 A profitability index of 1.1 implies that for
every $1 of investment, we create an
additional $0.10 in value
 This measure can be very useful in
situations where we have limited capital
 Profitability Index

The profitability index which is also sometimes

called the benefit/cost ratio, is the ratio of the present
value of the inflows to the present value of the
outflows.
PI = PV Inflows
PV Outflows

Decision Criteria
If PI > 1, accept the project
If PI < 1, reject the project
If PI = 1, indifferent
 Qualitative Factors
 Qualitative factors may be important in
project selection
– company image
– social pressure
– union pressure
– customer satisfaction
 Quantitative analysis should be supported
by qualitative factors