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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….

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Critique of NPV

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  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

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