Chapter 8

1. Chapter 8 Evaluating Investment Projects Shapiro and Balbirer: Modern Corporate Finance: A Multidisciplinary Approach to Value Creation Graphics by Peeradej Supmonchai

2. Learning Objectives • Describe capital budgeting as a management process and its integration into a company’s strategic plans. • List ways in which projects can be categorized. • Calculate a project’s NPV and IRR and use these measures to make investment decisions. • Explain the similarities and differences between the net present value (NPV) and internal rate of return (IRR) method, and discuss why NPV is the preferred criterion for making investment decisions.

3. Learning Objectives (Cont.) • Indicate the problems in using non-discounted cash flow techniques such as payback and accounting rate of return to make capital budgeting decisions. • Describe the use of capital budgeting techniques in practice and explain why managers use other methods than NPV to make investment decisions. • Indicate how the equivalent annual cost method can be used to evaluate projects with different economic lives.

4. Capital Budgeting as a Management Process • Development of a strategic plan • Generation of potential investment opportunities • Estimation of a project’s cash flows • Acceptance or rejection • Project post-audit

5. Classification of Investment Projects • Size • Type of Benefit Expected • By Degree of Dependence

6. Classification by Benefit Type • Cost Reduction • Expansion Project • New Product Introduction • Mandated Projects

7. Classification by Degree of Dependence • Independent Projects • Mutually Exclusive Projects • Contingent Projects

8. Net Present Value (NPV) Decision Criterion Calculate the present value of the expected cash flows from an investment using an appropriate discount rate. Subtract from this the present value of the initial net cash outlay for the project to get the NPV. If the NPV is positive, accept the project. If it is negative, reject it. If two projects are mutually exclusive, choose the one with the highest NPV.

9. Mathematical Representation of NPV Where: St = the cash flow in time period t I0 = the initial investment outlay in time zero k = the required rate of return on the project N = the project’s economic life in periods

10. Calculating A Project’s IRR-An Example Quickie Enterprises is considering the construction of a microprocessor plant costing $400 million. Cash flows will increase by $10 million a year from $100 million in the first year to $140 million in five years. At the end of 5 years, the plant will be obsolete and have no value. What’s the plant’s NPV if Quickie’s required rate of return is 12 %?

11. Calculating A Project’s NPV- An Example Quickie Enterprise’s Microprocessor Plant Cash Flows in $ million Year Cash Flow PVIF@12% Present Value 0 -$400 1.0000 -$400.00 1 100 0.8929 89.29 2 110 0.7972 87.69 3 120 0.7118 85.41 4 130 0.6355 82.62 5 140 0.5674 79.44 NPV = $24.45

12. Internal Rate of Return (IRR) Decision Criterion The IRR is the discount (or interest) rate that equates the present value of the cash flows with the initial investment. If a project’s IRR exceeds the required rate of return accept it; otherwise reject it. If two projects are mutually exclusive, choose the investment with the highest IRR.

13. Mathematical Representation of IRR Where: St = the cash flow in time period t I0 = the initial investment outlay in time zero N = the project’s economic life in periods

14. Calculating A Project’s IRR- An Example Quickie Enterprise’s Microprocessor Plant Cash Flows in $ million $100 $110 $120 $130 $140 $400 = ——— + ———— + ———— + ———— + ———— (1+IRR) (1+IRR)2 (1+IRR )3 (1+IRR )4 (1+IRR )5 IRR = 14.30%

15. Similarities between NPV and IRR • Both are DCF techniques that focus on the amount and timing of a project’s cash flows. • Both can accommodate differences in risk by adjusting the project’s required rate of return. • Both give the same accept-reject decision for independent projects.

16. Differences between NPV and IRR • NPV is an absolute measure of project worth; IRR measures the return per dollar invested. • NPV assumes the cash flows are reinvested at the required rate of return; IRR assumes the cash flows are reinvested at the IRR. • The NPV is unique for a given required rate of return; with an unconventional cash flow pattern, there may be multiple IRRs.

17. NPV Profile The NPV profile is the relationship between the NPV of a project and the discount rate used to calculate that NPV. Since the IRR is the discount rate that makes a project’s NPV zero, the NPV profile also identifies a project’s IRR.

18. Graphical Illustration of the NPV Profile

19. Payback Period • Length of time it take a project’s cash flows to recover its initial investment. • Projects whose paybacks are shorter than some maximum cutoff period are accepted; those with longer paybacks are rejected. • Under the payback method, projects with shorter payback periods are preferred to longer ones.

20. Limitations of the Payback Method • Ignores the time value of money. • Does not consider cash flows beyond the payback period. • No connection between the maximum acceptable payback period and shareholder required rates of return.

21. Accounting Rate of Return (ARR) The accounting rate of return (ARR) is the ratio of the average after-tax profits to the average book value of the investment.

22. Limitations of the ARR • Ignores the time value of money • Based on accounting profits, not cash flow • Difficult to establish target rates of return

23. Capital Budgeting in Practice • Most large firms use either IRR and/or NPV for making decisions • IRR appears to be more popular than NPV • Payback is used heavily as a secondary method