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1、Chapter 9Net Present Value and Other Investment CriteriaMcGraw-Hill/IrwinCopyright 2013 by The McGraw-Hill Companies,Inc.All rights reserved.Key Concepts and Skills Be able to compute payback and discounted payback and understand their shortcomings Understand accounting rates of return and their sho
2、rtcomings Be able to compute internal rates of return(standard and modified)and understand their strengths and weaknesses Be able to compute the net present value and understand why it is the best decision criterion Be able to compute the profitability index and understand its relation to net presen
3、t value9-2Chapter Outline Net Present Value The Payback Rule The Discounted Payback The Average Accounting Return The Internal Rate of Return The Profitability Index The Practice of Capital Budgeting9-3Good Decision Criteria We need to ask ourselves the following questions when evaluating capital bu
4、dgeting decision rules: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?9-4Net Present Value The difference between the market value of a project and its cost How
5、much value is created from undertaking an investment?The first step is to estimate the expected future cash flows.The second step is to estimate the required return for projects of this risk level.The third step is to find the present value of the cash flows and subtract the initial investment.9-5Pr
6、oject Example Information You are reviewing a new project and have estimated the following cash flows: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 level is 12%.9-6NPV Decision
7、 Rule If the NPV is positive,accept the project A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners.Since our goal is to increase owner wealth,NPV is a direct measure of how well this project will meet our goal.9-7Computing
8、NPV for the Project Using the formulas:NPV=-165,000+63,120/(1.12)+70,800/(1.12)2+91,080/(1.12)3=12,627.41 Using the calculator:CF0=-165,000;C01=63,120;F01=1;C02=70,800;F02=1;C03=91,080;F03=1;NPV;I=12;CPT NPV=12,627.41 Do we accept or reject the project?9-8Decision Criteria Test-NPV Does the NPV rule
9、 account for the time value of money?Does the NPV rule account for the risk of the cash flows?Does the NPV rule provide an indication about the increase in value?Should we consider the NPV rule for our primary decision rule?9-9Calculating NPVs with a Spreadsheet Spreadsheets are an excellent way to
10、compute NPVs,especially when you have to compute the cash flows as well.Using the NPV function The first component is the required return entered as a decimal The second component is the range of cash flows beginning with year 1 Subtract the initial investment after computing the NPV9-10Payback Peri
11、od How long does it take to get the initial cost back in a nominal sense?Computation Estimate the cash flows Subtract the future cash flows from the initial cost until the initial investment has been recovered Decision Rule Accept if the payback period is less than some preset limit9-11Computing Pay
12、back Assume we will accept the project if it pays back within two years.Year 1:165,000 63,120=101,880 still to recover Year 2:101,880 70,800=31,080 still to recover Year 3:31,080 91,080=-60,000 project pays back in year 3 Do we accept or reject the project?9-12Decision Criteria Test-Payback Does the
13、 payback rule account for the time value of money?Does the payback rule account for the risk of the cash flows?Does the payback rule provide an indication about the increase in value?Should we consider the payback rule for our primary decision rule?9-13Advantages and Disadvantages of Payback Advanta
14、ges Easy to understand Adjusts for uncertainty of later cash flows Biased toward liquidity 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 projects9-1
15、4Discounted Payback Period Compute the present value of each cash flow and then determine how long it takes to pay back on a discounted basis Compare to a specified required period Decision Rule:Accept the project if it pays back on a discounted basis within the specified time9-15Computing Discounte
16、d Payback Assume we will accept the project if it pays back on a discounted basis in 2 years.Compute the PV for each cash flow and determine the payback period using discounted cash flows Year 1:165,000 63,120/1.121=108,643 Year 2:108,643 70,800/1.122=52,202 Year 3:52,202 91,080/1.123=-12,627 projec
17、t pays back in year 3 Do we accept or reject the project?9-16Decision Criteria Test Discounted Payback Does the discounted payback rule account for the time value of money?Does the discounted payback rule account for the risk of the cash flows?Does the discounted payback rule provide an indication a
18、bout the increase in value?Should we consider the discounted payback rule for our primary decision rule?9-17Advantages and Disadvantages of Discounted Payback Advantages Includes time value of money Easy to understand Does not accept negative estimated NPV investments when all future cash flows are
19、positive Biased towards liquidity Disadvantages May reject positive NPV investments Requires an arbitrary cutoff point Ignores cash flows beyond the cutoff point Biased against long-term projects,such as R&D and new products9-18Average Accounting Return There are many different definitions for avera
20、ge accounting return The one used in the book 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 rate9-19Computing AAR Assume we requi
21、re 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?9-20Decision 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 th
22、e AAR rule provide an indication about the increase in value?Should we consider the AAR rule for our primary decision rule?9-21Advantages and Disadvantages of AAR Advantages Easy to calculate Needed information will usually be available Disadvantages Not a true rate of return;time value of money is
23、ignored Uses an arbitrary benchmark cutoff rate Based on accounting net income and book values,not cash flows and market values9-22Internal Rate of Return This is the most important alternative to NPV It is often used in practice and is intuitively appealing It is based entirely on the estimated cas
24、h flows and is independent of interest rates found elsewhere9-23IRR Definition and Decision Rule Definition:IRR is the return that makes the NPV=0 Decision Rule:Accept the project if the IRR is greater than the required return9-24Computing IRR If you do not have a financial calculator,then this beco
25、mes a trial and error process Calculator Enter the cash flows as you did with NPV Press IRR and then CPT IRR=16.13%12%required return Do we accept or reject the project?9-25NPV Profile for the ProjectIRR=16.13%9-26Decision Criteria Test-IRR Does the IRR rule account for the time value of money?Does
26、the IRR rule account for the risk of the cash flows?Does the IRR rule provide an indication about the increase in value?Should we consider the IRR rule for our primary decision criteria?9-27Advantages of IRR Knowing a return is intuitively appealing It is a simple way to communicate the value of a p
27、roject to someone who doesnt know all the estimation details If the IRR is high enough,you may not need to estimate a required return,which is often a difficult task9-28Calculating IRRs With A Spreadsheet You start with the cash flows the same as you did for the NPV You use the IRR function You firs
28、t enter your range of cash flows,beginning with the initial cash flow You can enter a guess,but it is not necessary The default format is a whole percent you will normally want to increase the decimal places to at least two9-29Summary of Decisions for the ProjectSummaryNet Present Value AcceptPaybac
29、k Period RejectDiscounted Payback Period RejectAverage Accounting Return RejectInternal Rate of Return Accept9-30NPV vs.IRR NPV and IRR will generally give us the same decision Exceptions Nonconventional cash flows cash flow signs change more than once Mutually exclusive projects Initial investments
30、 are substantially different(issue of scale)Timing of cash flows is substantially different9-31IRR and Nonconventional 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
31、 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?9-32Another Example:Nonconventional Cash Flows Suppose an investment will cost$90,000 initially and will generate the following cash flows:Year 1:132,0
32、00 Year 2:100,000 Year 3:-150,000 The required return is 15%.Should we accept or reject the project?9-33NPV ProfileIRR=10.11%and 42.66%9-34Summary 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%
33、which would tell you to Reject You need to recognize that there are non-conventional cash flows and look at the NPV profile9-35IRR and Mutually Exclusive Projects Mutually exclusive projects If you choose one,you cant choose the other Example:You can choose to attend graduate school at either Harvar
34、d 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 IRR9-36Example With Mutually Exclusive ProjectsPeriod Project AProject B0-500-4001 325 3252 325 200IRR 19.43%22.17%NPV 64.05 60.74The re
35、quired return for both projects is 10%.Which project should you accept and why?9-37NPV ProfilesIRR for A=19.43%IRR for B=22.17%Crossover Point=11.8%9-38Conflicts Between NPV and IRR NPV directly measures the increase in value to the firm Whenever there is a conflict between NPV and another decision
36、rule,you should always use NPV IRR is unreliable in the following situations Nonconventional cash flows Mutually exclusive projects9-39Modified IRR Calculate the net present value of all cash outflows using the borrowing rate.Calculate the net future value of all cash inflows using the investing rat
37、e.Find the rate of return that equates these values.Benefits:single answer and specific rates for borrowing and reinvestment9-40Profitability 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 add
38、itional$0.10 in value This measure can be very useful in situations in which we have limited capital9-41Advantages and Disadvantages of Profitability Index Advantages Closely related to NPV,generally leading to identical decisions Easy to understand and communicate May be useful when available inves
39、tment funds are limited Disadvantages May lead to incorrect decisions in comparisons of mutually exclusive investments9-42Capital Budgeting In Practice We should consider several investment criteria when making decisions NPV and IRR are the most commonly used primary investment criteria Payback is a
40、 commonly used secondary investment criteria9-43Summary DCF Criteria Net present value Difference between market value and cost Take the project if the NPV is positive Has no serious problems Preferred decision criterion Internal rate of return Discount rate that makes NPV=0 Take the project if the
41、IRR is greater than the required return Same decision as NPV with conventional cash flows IRR is unreliable with nonconventional cash flows or mutually exclusive projects Profitability Index Benefit-cost ratio Take investment if PI 1 Cannot be used to rank mutually exclusive projects May be used to
42、rank projects in the presence of capital rationing9-44Summary Payback Criteria Payback period Length of time until initial investment is recovered Take the project if it pays back within some specified period Doesnt account for time value of money,and there is an arbitrary cutoff period Discounted p
43、ayback period Length of time until initial investment is recovered on a discounted basis Take the project if it pays back in some specified period There is an arbitrary cutoff period9-45Summary Accounting Criterion Average Accounting Return Measure of accounting profit relative to book value Similar
44、 to return on assets measure Take the investment if the AAR exceeds some specified return level Serious problems and should not be used9-46Quick Quiz Consider an investment that costs$100,000 and has a cash inflow of$25,000 every year for 5 years.The required return is 9%,and required payback is 4 y
45、ears.What is the payback period?What is the discounted payback period?What is the NPV?What is the IRR?Should we accept the project?What decision rule should be the primary decision method?When is the IRR rule unreliable?9-47Ethics Issues An ABC poll in the spring of 2004 found that one-third of stud
46、ents age 12 17 admitted to cheating and the percentage increased as the students got older and felt more grade pressure.If a book entitled“How to Cheat:A Users Guide”would generate a positive NPV,would it be proper for a publishing company to offer the new book?Should a firm exceed the minimum legal
47、 limits of government imposed environmental regulations and be responsible for the environment,even if this responsibility leads to a wealth reduction for the firm?Is environmental damage merely a cost of doing business?Should municipalities offer monetary incentives to induce firms to relocate to t
48、heir areas?9-48Comprehensive Problem An investment project has the following cash flows:CF0=-1,000,000;C01 C08=200,000 each If the required rate of return is 12%,what decision should be made using NPV?How would the IRR decision rule be used for this project,and what decision would be reached?How are the above two decisions related?9-49End of Chapter9-50