Chapter 9: Net Present Value and Other Investing Criteria Flashcards
When evaluating each method and determining which to use, ask yourself these:
1) Does the decision rule adjust for the time value of money?
2) Does the decision rule adjust for risk?
3) Does the decision rule provide information on whether we are creating value for the firm?
A good decision rule will adjust for both the time value of money and risk, and will determine whether value has been created for the firm, and thus its shareholders.
Net Present Value definition
This is also known as discounted cash flow valuation
The difference between an investment’s market value and its cost.
In other words, net present value is a measure of how much value is created or added today by undertaking an investment.
Example: Buying a house for $100,000, fixing it up with $50,000, then selling it off for $250,000. You have created $100,000 in value
Capital budgeting process
can be viewed as a search for investments with positive net present values
Discounted cash flow (DCF) valuation
This is another term for net present value
The process of valuing an investment by discounting its future cash flows.
If NPV is negative
The effect on share value would be unfavourable.
AKA you need NPV to be positive to raise share price
Net Present Value Rule
AKA when to accept and when to reject
An investment should be accepted if the net present value is positive and rejected if it is negative.
Two assumptions for NPV
1) We will always know the cash revenues and costs
- This can be very difficult to figure out in the real world so assume these are accurate estimates in the book
2) The value of NPV calculated is simply an estimate, it really could be higher or lower.
- The only way to get a true NPV would be to sell the investment and see what you get for it
To calculate NPV
The Run Down / Over View
Basically we need to convert everything into the present value to see if we should either accept or reject the investment
1) Look at your case facts. We need to pull out an ‘r’ value and also the number we need to present value
2) Begin to present value everything. Our ‘r’ in this example is 10% For example look for something like “the project will be $2,000 in the first two years, $4,000 in the next two”.
2a) To present value these: (2000 / (1.10)^1) + (2000 / (1.10)^2) + (4000 / (1.10) ^3) + (4000 / (1.10) ^4) = 9, 208.38
3) Now look to see what the cost will be. In this example the cost is $10,000 to begin production
4) Take our costs + expected sales / revenue. -10,000 + 9,208.38 = -791.62
5) Should we accept or reject? Because we are in the negatives we need to reject this
The Payback
The length of time it takes to recover our initial investment
Payback period
The amount of time required for an investment to generate cash flows to recover its initial cost.
Example: the initial investment is $50,000. After the first year, the firm has recovered $30,000, leaving $20,000. The cash flow in the second year is exactly $20,000, so this investment pays for itself in exactly two years
Payback period rule
Based on the payback rule, an investment is acceptable if its calculated payback is less than some pre-specified number of years.
The payback period with fractions
For example, suppose the initial investment is $60,000, and the cash flows are $20,000 in the first year and $90,000 in the second. The cash flows over the first two years are $110,000, so the project obviously pays back sometime in the second year. After the first year, the project has paid back $20,000, leaving $40,000 to be recovered. To figure out the fractional year, note that this $40,000 is $40,000 / $90,000 = 4/9 of the second year’s cash flow. Assuming that the $90,000 cash flow is paid uniformly throughout the year, the payback would thus be 1 4/9 years, or 1.44 years (Year + fraction)
Criticisms / limitations / problems with the payback period rule
1) There is no economic rationale for looking at payback in the first place, so we have no guide as to how to pick the cutoff. As a result, we end up using a number that is arbitrarily chosen.
2) the payback period is calculated by simply adding the future cash flows. There is no discounting involved, so the time value of money is ignored
3) Additionally, the payback rule does not consider risk differences. The payback rule would be calculated the same way for both very risky and very safe projects.
Does the payback period rule bias short term or long term invesments?
More generally, using a payback period rule tends to bias us toward shorter-term investments; it is biased toward liquidity
Who uses the payback period rule?
is often used by small businesses whose managers lack financial skills.
It is also used by large and sophisticated companies when making relatively small decisions
Disadvantages of the Payback rule
Ignores the time value of money.
Requires an arbitrary cutoff point.
Ignores cash flows beyond the cutoff point.
Biased against long-term projects, such as research
and development, and new projects.
Ignores any risks associated with projects.
Advantages of the payback rule
Easy to understand.
Adjusts for uncertainty of later cash flows.
Biased toward liquidity.
Discounted payback period
The length of time required for an investment’s discounted cash flows to equal its initial cost.
The discounted payback rule
An investment is acceptable if its discounted payback is less than some prescribed number of years.
Advantages of the Discounted Payback Period Rule
Includes time value of money.
Easy to understand.
Does not accept negative estimated NPV investments.
Biased toward liquidity.
Disadvantages of the Discounted Payback Period Rule
May reject positive NPV investments.
Requires an arbitrary cutoff point.
Ignores cash flows beyond the cutoff date.
Biased against long-term projects, such as research and development, and new projects.
Average accounting return (AAR)
An investment’s average net income divided by its average book value.
However, in one form or another, the AAR is always defined as follows:
Some measure of average accounting profit / Some measure of average accounting value
