University:
California State University, Northridge
Course:
FIN 452 | Investment Analysis
Academic year:

2024
Views:

38

Pages:

21
Author:

foltmedrcwq

Key Concepts and Skills • Understand: – The payback rule and its shortcomings – Accounting rates of return and their problems – The internal rate of return and its strengths and weaknesses – The net present value rule and why it is the best decision criteria – The modified internal rate of return – The profitability index and its relation to NPV 8.1 8.2 8.3 8.4 8.5 8.6 Chapter Outline Net Present Value The Payback Rule The Average Accounting Return The Internal Rate of Return The Profitability Index The Practice of Capital Budgeting Capital Budgeting • Analysis of potential projects • Long-term decisions • Large expenditures • Difficult/impossible to reverse • Determines firm’s strategic direction Good Decision Criteria • All cash flows considered? • TVM considered? • Risk-adjusted? • Ability to rank projects? • Indicates added value to the firm? Net Present Value How much value is created from undertaking an investment? Step 1: Estimate the expected future cash flows. Step 2: Estimate the required return for projects of this risk level. Step 3: Find the present value of the cash flows and subtract the initial investment to arrive at the Net Present Value. Net Present Value Sum of the PVs of all cash flows n NPV = ∑ t=0 CFt (1 + R)t NOTE: t=0 Initial cost often is CF0 and is an outflow. n NPV = ∑ t=1 CFt - CF0 t (1 + R) NPV – Decision Rule • If NPV is positive, accept the project • NPV > 0 means: – Project is expected to add value to the firm – Will increase the wealth of the owners • NPV is a direct measure of how well this project will meet the goal of increasing shareholder wealth. Sample Project Data • You are looking at a new project and have estimated the following cash flows, net income and book value data: – – – – – Year 0: CF = -165,000 Year 1: CF = 63,120 NI = 13,620 Year 2: CF = 70,800 NI = 3,300 Year 3: CF = 91,080 NI = 29,100 Average book value = $72,000 • Your required return for assets of this risk is 12%. • This project will be the example for all problem exhibits in this chapter. Computing NPV for the Project • Using the formula: CFt NPV = ∑ t + ( 1 R ) t =0 n NPV = -165,000/(1.12)0 + 63,120/(1.12)1 + 70,800/(1.12)2 + 91,080/(1.12)3 = 12,627.41 Capital Budgeting Project Year 0 1 2 3 CF (165,000.00) 63,120.00 70,800.00 91,080.00 Required Return = Formula =(-165000)/(1.12)^0 = =(63120)/(1.12)^1 = =(70800)/(1.12)^2 = =(91080)/(1.12)^3 = NPV 12% Disc CFs (165,000.00) 56,357.14 56,441.33 64,828.94 12,627.41 Net Present Value Sum of the PVs of all cash flows. CFt NPV = ∑ t t = 0 (1 + R ) n << CALCULATOR CFt NPV = ∑ − CF0 t t =1 (1 + R ) n << EXCEL Rationale for the NPV Method • NPV = PV inflows – Cost NPV=0 → Project’s inflows are “exactly sufficient to repay the invested capital and provide the required rate of return” • NPV = net gain in shareholder wealth • Rule: Accept project if NPV > 0 NPV Method – Meets all desirable criteria •Considers all CFs •Considers TVM •Adjusts for risk •Can rank mutually exclusive projects – Directly related to increase in VF – Dominant method; always prevails Payback Period • How long does it take to recover the initial cost of a project? • Computation – Estimate the cash flows – Subtract the future cash flows from the initial cost until initial investment is recovered – A “break-even” type measure • Decision Rule – Accept if the payback period is less than some preset limit Computing Payback for the Project Capital Budgeting Project Year 0 1 2 3 $ $ $ $ CF (165,000) 63,120 70,800 91,080 Payback = Payback = Cum. CFs $ (165,000) $ (101,880) $ (31,080) $ 60,000 year 2 + + (31080/91080) 2.34 years • Do we accept or reject the project? Decision Criteria Test Payback • Does the payback rule: – Account for the time value of money? – Account for the risk of the cash flows? – Provide an indication about the increase in value? – Permit project ranking? • Should we consider the payback rule for our primary decision rule? Advantages and Disadvantages of Payback • Advantages – Easy to understand – Adjusts for uncertainty of later cash flows – Biased towards liquidity ASKS THE WRONG QUESTION! • Disadvantages – Ignores the time value of money – Requires an arbitrary cutoff point – Ignores cash flows beyond the cutoff date – Biased against long-term projects, such as research and development, and new projects Average Accounting Return • Many different definitions for average accounting return (AAR) • In this book: Average Net Income AAR = Average Book Value – Note: Average book value depends on how the asset is depreciated. • Requires a target cutoff rate • Decision Rule: Accept the project if the AAR is greater than target rate. Computing AAR for the Project • Sample Project Data: – – – – – Year 0: CF = -165,000 Year 1: CF = 63,120 NI = 13,620 Year 2: CF = 70,800 NI = 3,300 Year 3: CF = 91,080 NI = 29,100 Average book value = $72,000 • Required average accounting return = 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? Decision Criteria Test - AAR • Does the AAR rule account for the time value of money? • Does the AAR rule account for the risk of the cash flows? • Does the AAR rule provide an indication about the increase in value? • Should we consider the AAR rule for our primary decision criteria? Advantages and Disadvantages of AAR • Advantages – Easy to calculate – Needed information usually available • Disadvantages – Not a true rate of return – Time value of money ignored – Uses an arbitrary benchmark cutoff rate – Based on accounting net income and book values, not cash flows and market values

Net Present Value and Other Investment Criteria, Part 1

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