Ch 9-NPV Flashcards
WHAT IS NPV
difference between investment market value and investment cost
it is a measure of how much value is cerated or added by undertaking an investmetn
what is capital budgeting all about
determining whether an investment is worthwile
capital budgeting and npv relationship
capital budgeting is looking for investments with positive npvs
when do we have to estimate npv
when there is no market to compare to (no housing market to compare house prices with etc)
how do we estimat npvs?
- estimate the future cash flows that we expect to recieve “discounted cash flow valuation”
if the NPV is negative, the effect on share value would be
unfavourable. If the NPV is positive, the effect would be favourable.
if npv posititve: accept
if npv negative: reject
how to do a basic discounted cf valuation?
- draw a number line, and write out the cash inflow from each year
- discount them all to year one using number line method if varying cf, or the pv annuity formula if constant cf
- compare to cost
- if cost> cf= -npv
if cost < cf= + npv
Payback meaning
the legnth of time it takes to recover og investment
How many years do we have
to wait until the accumulated cash flows from this investment equal or exceed the cost of the investment?
HOW LONG TILL WE BREAK EVEN
IF an investment pays itself back in 2 years what is the payback period
2 years
payback period rule
an investment is acceptable is payback is less than x amount of years
shortcomings of payback period rule
- no objective basis to choose the x amount of years
- no discounting involved so tvm is ignord
- doesnt consider risk differences (payback would be the same for risk and non risk prohects)
- requires arbitarry cutoff point and ignroes cash flows beyond the cutoff point
using a payback period rule tends to bias us toward shorter-term investments
pros of payback rule
- good for ppl w no knowledge
- used whwen cost of doing analysis is extra
- it is good for general rules: like all investments less than 10k should have a 2 year payback
- biased to liquidity
payback rule is biased towards short term projects, what does this imply?
it is biased towards liquidity!!!
and arguably it takes into account the risk of long term projects because only the more recent ones are guaranteed!!
. Because time value is ignored, you
can think of the payback period as the length of time it takes to break even in an accounting sense, but not
in an economic sense
discounted payback rule: modified payback rule
an inveestment is acceptable if its discounted payback is less than x amount of years
how to apply discounted payback rule?
- discount each years cash flow back
- create a new column called accuulated cash flow and add them up
- see when you have pacyback total
yr|cf(undisc)|cf(disc)|accf|(undisc)|acccf(disc)
payback rule
discounted payback rule
tells u when u break even accounting wise
tells u when u break even economic/financial wise
discounted payback is a compromise between a regular payback and NPV that
lacks the simplicity of the first and the conceptual rigour of the second
average accounting return
some measure of average acct proft/ some measure of avg acct value
AAR= average net income/ average book value
Based on the average accounting return rule, a project is acceptable if its average accounting return
exceeds a target average accounting return
cons of aar method
- not a rate of return in any meaningful sense
- it is the ratio of two acct numbers
-ignores tvm
- arbitrary way of choosing target AAR
- doesnt look at the right things (no focus on cash flow and market value, uses net income and book value)
pros ofAAR
EASY TO CALCULATE
required info is usually available
IRR
internal rate of return- single rate summarizing merits of a project
internal: focused only on the cf of a given investment no external rates
Based on the IRR rule, an investment is acceptable if the IRR exceeds the required return. It should be
rejected otherwise.
link between IRR nad NPV
IRR is the rate that results in NPV being 0 when IRR=r
net present value profile.
the graph shows how NPV changes as the discount rate used changes.
when the npv is above x axis, it is all the discount rates wehre npv is positive
when the npv is below x axis it is all the discount rate where npv is negative
when npv crosses x axis it is the IRR
DOES npv and irr always give the same decisions?
only if:
1. projects cash flow are conentional (first cf is negative) and the rest are positive
- project is independant and unrelated to other
non conventional cash flows: when signs change more than once
This is because the NPV curve crosses the x axis twice=-> there are two IRRs
when more than one sign change: there are multiple rates of return
basically this happens when tehre is an initial negative outlay (cost to start up) and also negative outlay at the end
USE NPV RULE
irr problems
1 two sign changes
#2 mutually exclusive investment decisions
irr problem- mutually exclusive investment decisions
if u have two investments and u can only pick 1, you would pick th eone with the highest npv always, but NOT ALWAYS THE ONE WITH THE HIGHER IRR
any time we are comparing investments to determine which is best, IRRs can
be misleading
MUTUALLY EXCLUSIVE INVESTMENTS- CROS SOVER RATE + HOW TO FIND IT
crossover rate= the discount rate that makes the npvs of both project equal
method #1: too calculate: compute IRR on the difference of the cash flows
1. set up a new column (inv a-inv b)
2. if the sign changes only once then calculate IRR!!!
3. you can figure out where IRR is by using the IRR funciton
method #2:
NPV(B-A) = -(extra money to invest in B) + (extra cf in b year 1)/1+r + (extra cf in b year 2)/(1+r)^2
set NPV(B-A)= 0 solve for IRR
why do people choose IRR
- people like talking about rates of return
- easy to get
cons of IRR
may result in mulitple answers/no answers with non conventional cf
may lead to incorrect decisions when comparing mutually exclusive investments
profitiability index= beneft/cost ratio
PV of future cf/ initial investment
pros and cons of profitbaility index
pros:
-similar to NPV, has same diecisions usually
-easy to get
- useful when avialble investment funds are limited
cons:
- may lead to wrong decision in comparing mutually exlcusive investments
6 ways to do capital budgting6
- npv
- irr
- payback epriod
- discounte payback
- arr
- profitbaility index
capitol rationing
complication in capital budgeting!
exsits when profitable (positive NPV) BUT we dont have the money to invest
so we do capital rationing
soft rationing
when business units have x fixed amount of money every year
company as awhole isnt short on capitol, and more can be raised!
if this is a once in a while problem, try to choose projects with biggest NPV and highest PI index!
if this is achronic porblme something is up
HARD rationing
company as a whole is short on money and cant raise any money under any circumstances
DCF analysis breaks down and no best course of action; if our requried rate of return is 20%, we usually take projects with greater return but if we have hard dationing we cant take any porjcets!!!
AAR formula
AVERAGE NET INCOME/ AVERAGE BOOK VALUE
AVERAGE BOOK VALUE depends on how an asset is depreciated
Modified IRR
3 methods:
1) DISCOUNTING APPROACH:
- discount all negative cf back to the present at the required return
-add them to the inital cost
:::::move all the negative cf to Y0
2) REINVESTMENT APPROACH:
-compound all cash flows (+ and -) except the first out to the end and then calc IRR
- CALCULATE THE FV
::::: move all the positive cf to Ylast
3) COMBO APPROACH:
-negative cf discounted to the present and positive cash flows are compounded to the end
::::move all the negative cf to Y0 and move all the positive cf to Ylast
MIRRs and IRR
- TOUGH bc diff ways to calculate IRR and no one knows which is better
-ALSO you use an external rate which is no longer internal!!!
