1 / 16

Critique of NPV

Critique of NPV. 04/29/08 Ch. 6. Merits and Flaws of NPV. We will examine issues that are sometimes problematic for NPV Project Interactions – Mutually Exclusive Unequal Lives Replacement Decisions Capital Rationing Side Costs Synergy Embedded Options But it is still the best model….

bethany-king
Download Presentation

Critique of NPV

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Critique of NPV 04/29/08 Ch. 6

  2. Merits and Flaws of NPV • We will examine issues that are sometimes problematic for NPV • Project Interactions – Mutually Exclusive • Unequal Lives • Replacement Decisions • Capital Rationing • Side Costs • Synergy • Embedded Options • But it is still the best model…

  3. Project Interactions • Mutually Exclusive Projects • Definition: Accepting one project means rejecting another project • Example: When two projects require the same scare resource • Scare resource, plot of land • Projects, build restaurant or build service station • Assumes you can not acquire a similar scarce resource, another plot of land • Assumes you can not have a dual use of the land…Taco Bell Express at a Service Station • NPV does a nice job of picking the right project but IRR may not...diagram to explain…

  4. Unequal Lives • If two or more projects have different lives, the NPV model favors the longer lived project • Can you correct for this bias? • Extend shorter project to match life of longer project • Assumptions are that you can “invest” at the termination of the short-term project in a very similar project, the cost of capital has not changed and you do not have access to additional capital at start of the project • Compute NPV for the short project and the extension • Compute Equivalent Annuities • Equivalent Annuity = NPV x (r / [1-(1+r)-n] • Problem 3, Heating System for a Building

  5. Unequal Lives – Equivalent Annuity • Problem 3 • Solar Heating, Cost $12,000 with annual costs of $500, infinite life • Gas Heating, Cost $5,000 with annual costs of $1,000, and will last twenty years • Oil Heating, Cost $3,500 with annual costs of $1,200 and will last fifteen years • Compute present value of costs at 10% cost of capital • (1) Solar $17,000 (2) Gas $13,514 (3) Oil $12,627 • Compute Equivalent Annuities • (1) Solar $1,700 (2) Gas $1,587 (3) Oil $1,659 • Pick the lowest equivalent annuity…Gas • Issues with this approach?

  6. Replacement Decision • Fits Mutually Exclusive as we only want one choice…either keep current system, immediately replace current system, or wait and replace later (which is keep current system) • Issues that are important -- • Salvage Value • Let’s re-examine this and how we deal with salvage value • Example…replace delivery truck with new delivery truck • Old truck (five years old)…original cost $38,000 • New truck (expected life is eight years) …cost of $64,000 • Old truck depreciation life was five year life (MACRS), book value is 5.76% x $38,000 = $2,189 • What if “blue book” is $1,200 for old truck • What if “blue book” is $2,189 for old truck • What if “blue book” is $4,800 for old truck • Does replacement lower future costs? Does replacement increase future revenues? Why replace now?

  7. Solutions to Salvage Value • Book Value of Truck is 38,000 x 0.0576 = $2,189 • At sales price of $1,200 • Loss on Disposal is $1,200 - $2,189 = $989 • Tax Credit (40% tax rate) $989 x 0.40 = $396 • Cash Flow at Disposal = $1,200 + $396 = $1,596 • At sales price of $2189 • No loss or gain • Cash Flow at Disposal = $2,189 • At sales price of $4,800 • Gain on Disposal is $4,800 - $2,189 = $2,611 • Tax (40% tax rate) $989 x 0.40 = $1,044 • Cash Flow at Disposal = $4,800 - $1,044 = $3,756

  8. Profitability Index Example • Problem #1 ($150 million max on spending) Project Initial Inv. NPV PI A $25 $10 0.40 B $30 $25 0.83 C $40 $20 0.50 D $10 $10 1.00 E $15 $10 0.67 F $60 $20 0.33 G $20 $10 0.50 H $25 $20 0.80 I $35 $10 0.28 J $15 $ 5 0.33

  9. Ranking by NPV vs PI Outlay $ Rank by NPV Outlay $ Rank by PI $ 30 B $ 10 D $ 65 C & H* $ 30 B $ 45 D, G & E $ 25 H $140 $ 15 E * Can’t pick F as it puts $ 60 C and G you over the $150 $140 Total NPV $95 $95 With a portfolio approach both give the same answer!

  10. Problems with PI • Assumes capital rationing applies to the current period only and that projects can only be done during current period… • Assumes all investment is up front • Projects with cash outflow in future periods will be overstated with PI • Future cash outflow will constrain future periods • PI may not spend all current capital – so other combinations may produce higher NPV

  11. Side Costs and Sunk Costs • Should be included as part of the incremental costs of a project but may be difficult to quantify • Opportunity costs • Project must “carry” the lost revenues of other uses • People – taken for new project • Resources – taken for new project • Sunk Costs • Do not include if truly sunk costs • Erosion – Substitute Products • Include if truly eroding other products

  12. Synergy, 2+2 = 5 • When adding new projects in the whole is greater than the parts, you get synergies • Often used for mergers • Firm A Value + Firm B Value < Firm (A+B) Value • Where does synergy come from? • Reduction in duplicate costs • Using excess capacity • Complementary Products • Timing of synergy…immediate or much later?

  13. Embedded Options • Not a problem with NPV… • But, difficulty to quantify and properly add into the expected future cash flow • There is an element of probability here…the probability that this project will lead to additional projects • Option to delay…projects always compete with themselves over time…again, just need to find the NPV today versus the NPV tomorrow

  14. Embedded Options • Expansion • Once a project has been completed additional projects become available • How do you incorporate this into the original NPV decision of the initial project? • What happens if you do not take on the additional projects? • Abandonment • Is this an option for every project? • How do you incorporate abandonment value in the future cash flow of a project?

  15. NPV remains the Best • The problem with NPV is not in theory but in practice • Problems with finding the right WACC for the project • Problems with finding the right future cash flows for the project • Usually the only comfortable number in cash flow is the initial outflow • Other models all have these same cash flow estimation problems…plus other issues

  16. Weekly Homework for Thursday • Problem 4 – Replacement, unequal lives • Problem 5 – Unequal lives • Problem 7 – Salvage Value • Problem 15 – Capital Rationing • Problem 16 – Opportunity costs • Problem 18 – Lease option • Problem 21 – Opportunity cost

More Related