lecture 4: chapter 7: NPV, IRR Flashcards
capital budgeting
the decision-making process for accepting or rejecting projects
true or false
The value of the firm rises by the NPV of the project
true
value additivity of a firm
the value of the firm is merely the sum of the values of the different projects, divisions, or other entities within the firm
the contribution of any project to a firm’s value is simply the NPV of the project
the discount rate on a risky project
the return that one can expect to earn on a financial asset of comparable risk
often referred to as an opportunity cost
–> corporate investment in the project takes away the shareholder’s opportunity to invest the dividend in a financial asset
NPV’s three attributes
- NPV uses cash flows
- NPV uses all the cash flows of the project (unlike other methods such as the payback period or the discounted payback period)
- NPV discounts the cash flows properly (unlike other methods such as the payback period)
why should earnings not be used in capital budgeting?
because they do not represent cash
they are an artificial construct useful to accountants
the payback period method
you see in how much time you recover the initial investment
we disregard the Pis of cashflows
we use a cut off time, in which projects that go over it are refused
Problems with the Payback Method
Problem 1: Timing of Cash Flows within the Payback Period
–> this shows that the payback method is inferior to NPV because, as we pointed out earlier, the NPV approach discounts the cash flows properly
Problem 2: Payments after the Payback Period
–> This flaw is not present with the NPV approach because, as we pointed out earlier, the NPV approach uses all the cash flows of the project
–> the payback method forces managers to have an artificially short-term orientation, which may lead to decisions not in the shareholders’ best interests
Problem 3: Arbitrary Standard for Payback Period
–>
when can we make decisions from the payback method without stressing?
for small decisions
Why would upper management condone or even encourage the payback method to its employees?
it is easy to make decisions using payback
desirable features of the payback method for managerial control
- we can evaluate the manager’s decision-making ability
–> Under the NPV method, a long time may pass before we can decide whether or not a decision was correct
- good for firms with good investment opportunities but no available cash
- a number of executives have told us that for the overwhelming majority of real-world projects, both payback and NPV lead to the same decision
the discounted payback period rule
same as payback period method, but cashflows are discounted
naturally, the period to payback the initial outflow is longer than the normal payback period
the average accounting return (AAR)
the average project earnings after taxes and depreciation, divided by the average book value of the investment during its life
these to find the AAR
Step 1: Determine the average net income
Step 2: Determine the average investment
Step 3: Determine the AAR
–> step 1 / step 2
what is wrong with the AAR method?
- It uses net income and book value of the investment, both of which come from the accounting books
–> Accounting numbers are somewhat arbitrary
–> affected by the accountant’s judgment.
–> Conversely, the NPV method uses cash flows (not affected by accountant’s judgment)
- takes no account of timing
–> the NPV approach discounts properly
- the AAR method offers no guidance on what the right targeted rate of return should be
is the AAR method employed in practice?
Like the payback method, the AAR (and variations of it) is frequently used as a backup to discounted cash flow methods
so yes
the most important alternative to the NPV approach
he internal rate of return, universally known as the IRR
the IRR
it tries to find a single number that summarizes the merits of a project
the rate of return that would make the NPV = 0
–> firms should accept the project when the discount rate is below the IRR
–> firms should reject the project when the discount rate is above the IRR
the basic IRR rule
Accept the project if IRR is greater than the discount rate
–> NPV is positive
Reject the project if IRR is less than the discount rate
–> NPV is negative
the link between a bond’s YTM and its IRR
the YTM is the bond’s IRR
An independent project
one whose acceptance or rejection is independent of the acceptance or rejection of other projects
mutually exclusive projects
You can accept project A or you can accept project B or you can reject both of them, but you cannot accept both of them
Two General Problems Affecting Both Independent
and Mutually Exclusive Projects With the IRR
Problem 1: Investing or Financing?
Problem 2: Multiple Rates of Return
the IRR and financing (we get funds for which we have to repay later (usually with interest))
The decision rule is exactly the opposite of our previous result
–> For this type of project, the rule is as follows:
—–> Accept the project when IRR is less than the discount rate
—–> Reject the project when IRR is greater than the discount rate
NPV is positively related to the discount rate
Problem 2: Multiple Rates of Return
when project’s cash flows exhibit two changes of sign
these flip-flops or changes in sign produce multiple IRRs
we should just rely on the NPV
Net Present Value Rule When We Have Multiple IRRs
when using the NPV, we should accept a project if the discount rate falls in between the changes of sign that create two IRRs
Modified Internal Rate of Return (MIRR)
an alternative to NPV rule
handles the multiple-IRR problem by combining cash flows until only one change in sign remains
clearly a function of the discount rate
–> it appears, at least to us, to violate the spirit of the IRR approach
problems dealing with the application of the IRR approach to mutually exclusive projects
The Scale Problem
The Timing Problem
The Scale Problem
the IRR ignores issues of scale
we use the incremental IRR to tackle this issue
how can we handle the scale problem between two mutually exclusive projects?
- Compare the NPVs of the two choices
- Compare the incremental NPV from making the large-budget movie instead of the small-budget movie
- Compare the incremental IRR to the discount rate
All three approaches always give the same decision
–> However, we must not compare the IRRs of the mutually exclusive projects
The Timing Problem With Mutually Exclusive Projects and IRR
we gotta compare in a graph two projects and see which is better
we see it with how their npvs increase or decrease with a change in discount rates
with the timing problem, how can we select the bette project from two mutually exclusive projects?
- Compare the NPVs of the two projects
- Compare the incremental IRR to the discount rate
–> do it in a way that the initial cash flow is negative and the rest is positive
- Calculate the NPV on incremental cash flows
Redeeming Qualities of the Internal Rate of Return
summarizes the information about a project in a single rate of return
–> provides people with a simple way of discussing projects
the profitability index (PI)
the ratio of the present value of the future expected cash flows after initial investment to the amount of the initial investment
we accept if ratio is above 1 and reject if ratio is below 1
The problem with the PI for mutually exclusive projects
how can we solve it?
the same as the scale problem with the IRR that we mentioned earlier
the PI ignores differences of scale for mutually exclusive projects
can be corrected using incremental analysis
capital rationing
when a firm does not have enough capital to fund all positive NPV projects
when can PI work as a way to rank projects we want to undertake?
when we face capital rationing
does the PI work if funds are limited beyond the initial time period?
nooo
which methods are companies using?
approximately three-quarters of Canadian companies use the NPV method
nearly 70 percent use the IRR method
Nearly 70 percent of these companies use the payback method
