I H C HOA SEN Khoa Kinh t Thng m i

KHOA KINH T THNG M I

CORPORATE FINANCE
ThS. Nguy n T ng Minh Email: minh.nguyentuong@yahoo.com.vn

CORPORATE FINANCE
CHAPTER 5 NET PRESENT VALUE and OTHER INVESTMENT CRITERIA
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References
Fundamentals of Corporate Finance, Brealey et al., McGraw Hill, 5th edition, USA, 2007. Foundation of Financial Management, Block & Hirt, McGraw Hill, 12th edition,USA, 2008. Other relevant materials.

Chapter 5: NET PRESENT VALUE and OTHER INVESTMENT CRITERIA

Main Contents:
1. 2. 3. 4. 5. Net Present Value Other Investment Criteria Examples of mutually exclusive projects Capital rationing A last look
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I. NET PRESENT VALUE

An investor intends to invest a project which has a following cash flow: $400,000

-$350,000 ??? Should he invest in this project ? Assuming that he could invest in a 1 year-US Treasury note of 7% calculate NPV PV = $373,832 NPV = PV of cash flow required investment ACCEPT the project
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NPV = $23,832

I. NET PRESENT VALUE (contd)

1 year-US Treasury note of 7% Opportunity cost of capital

NPV present value of cash flows minus required investment

I. NET PRESENT VALUE (contd)

Risk and Present Value the investment is more risky than investing a 1 year-treasury note of 7% the investment is as risky as investing a stock with rate of return of 12% $400,000

-$350,000 NPV with rate of return of 12% = $7,143 < $23,832 A risky dollar is worth less than a safe one
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I. NET PRESENT VALUE (contd)

I. NET PRESENT VALUE (contd)

Value long-lived projects the investment with an opportunity cost of capital of 7% and has a cash flow: $466,000 $16,000 0 $16,000

-$350,000

NPV = ?
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I. NET PRESENT VALUE (contd)

Value long-lived projects (contd)

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I. NET PRESENT VALUE (contd)

Value long-lived projects (contd) In case that the investor decides to sell this project by selling 1,000 stocks What is the price of one stock ? $466 $16 0 $16

Price per share: $409.3 -$350,000 Net gain: ~ $59,300

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I. NET PRESENT VALUE (contd)

Using NPV rule to choose among projects Select the project whose NPV is higher!!

What would I choose ?

Project A

Project A and B are Mutual exclusive projects

Project B

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I. NET PRESENT VALUE (contd)

Using NPV rule to choose among projects (contd)

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II. OTHER INVESTMENT CRITERIA

Payback period time until cash flows recover the initial investment in the project Payback rule a project should be accepted if its payback period is less than a specified cutoff period

WHAT IF ?

Project A NPV > 0, the payback period = 1 NPV > 0, the payback period = 2

Project B NPV > 0, the payback period = 2 NPV < 0, the payback period = 1

Select A or B ?? A or B15 ??

II. OTHER INVESTMENT CRITERIA

Payback period (contd)

Which project should you choose if you dont care NPV ?

calculate Discounted Payback

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II. OTHER INVESTMENT CRITERIA

Payback period (contd) Discounted Payback How long must the project last in order to offer a positive NPV ?

Steps to calculate Discounted Payback 1 2 Calculate the PV of the cash flow Add each PV up to be equal with initial investment

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II. OTHER INVESTMENT CRITERIA

Internal rate of return (IRR) IRR is the discount rate at which NPV = 0 selecting project whose IRR is higher than the opportunity cost of capital

??? How to calculate the IRR ?

Setting NPV = 0 and calculate the IRR

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II. OTHER INVESTMENT CRITERIA

Internal rate of return (IRR) IRR > opportunity cost of capital NPV is POSITIVE

IRR < opportunity cost of capital

NPV is NEGATIVE

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II. OTHER INVESTMENT CRITERIA

Internal rate of return (IRR)

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II. OTHER INVESTMENT CRITERIA

Internal rate of return (IRR) Supposing that you have a project with the following relevant cash flow:

calculate IRR

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II. OTHER INVESTMENT CRITERIA

Some pitfalls with the IRR

is not the opportunity cost

is the profitability of a project

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II. OTHER INVESTMENT CRITERIA

Some pitfalls with the IRR Pitfall 1: Lending or Borrowing

???D and E have the same attraction ? Not exactly !!!!! D What paid today is received more and more tomorrow You are in lending with high interest rate E What received today is repaid more and more tomorrow
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You are in borrowing with high interest rate

II. OTHER INVESTMENT CRITERIA

Some pitfalls with the IRR (contd) Pitfall 2: Multiple Rate of Return
Cash flow C0 -$22 C1 +$15 C2 +$15 C3 +$15 C4 +$15 C5 -$40

the project has two IRRs

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II. OTHER INVESTMENT CRITERIA

Some pitfalls with the IRR (contd) Pitfall 2: Multiple Rate of Return (contd) Solution Modified IRR

Steps to calculate modified IRR (applied for a 4-year project): 1 2 3 4 Combining last two cash flows into one PV of year 4 If the PV is negative, combining last three cash flows into one PV of year 3 If the PV is still negative, combining last four cash flows into one PV of year 2 and so on If the PV is positive, making a new modified cash flow and calculate the25 modified IRR

II. OTHER INVESTMENT CRITERIA

Some pitfalls with the IRR (contd) Pitfall 2: Multiple Rate of Return (contd)

r = 10%

15 10.98 22 + + =0 2 1 + IRR (1 + IRR )

IRR = 12.53%
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II. OTHER INVESTMENT CRITERIA

Some pitfalls with the IRR (contd) Pitfall 3: Mutually exclusive projects

the higher IRR does not mean the higher NPV

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II. OTHER INVESTMENT CRITERIA

Some pitfalls with the IRR (contd)

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II. OTHER INVESTMENT CRITERIA

Some pitfalls with the IRR (contd) Pitfall 4: Mutually exclusive projects involving different outlays Misranking as comparing projects with the same lives but different outlays IRR mistakenly favor small projects with high rates of return but low NPVs

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III. EXAMPLES OF MUTUALLY EXCLUSIVE PROJECTS

Timing decision

Replacement decision Long and short lived equipment

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III. EXAMPLES OF MUTUALLY EXCLUSIVE PROJECTS (contd)

Investment timing
Not now, next year

Not now. Next years computer will be cheaper!!!

Not now, next year

Financial Manager Several years later, the project cannot be launched, the business of company

NPV >0, invest in new computer system now, madam ?

When should the company invest in new computer system ?

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III. EXAMPLES OF MUTUALLY EXCLUSIVE PROJECTS (contd)

Investment timing (contd)

A new computer system can last for 4 years

choosing an investment time that results in the highest NPV today

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III. EXAMPLES OF MUTUALLY EXCLUSIVE PROJECTS (contd)

Investment timing (contd)

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III. EXAMPLES OF MUTUALLY EXCLUSIVE PROJECTS (contd)

Long versus short lived equipment selecting two machines with the same function:

Which machine should Samsung choose ? calculating the Equivalent Annual Annuity and select the machine that has the lowest Equivalent Annual Annuity

the cash flow per period with the same PV as the cost of buying and operating a machine

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III. EXAMPLES OF MUTUALLY EXCLUSIVE PROJECTS (contd)

Long versus short lived equipment (contd) selecting two machines with the same function:

Machine F should be selected

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III. EXAMPLES OF MUTUALLY EXCLUSIVE PROJECTS (contd)

Replacing an Old Machine

CURRENT MOTO will be last in 2 more years cost $12,000 per year to operate Which moto should you choose ?

NEW MOTO will be last in 5 years cost $8,000 per year to operate
Higher than 12

Continue using 36 the current moto

III. EXAMPLES OF MUTUALLY EXCLUSIVE PROJECTS (contd)

Replacing an Old Machine (contd)

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IV. CAPITAL RATIONING

Capital rationing
Limit set on the amount of funds available for investment

Soft rationing constrains on spending under certain circumstances can be violated or even viewed as constituting targets rather than absolute limits
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IV. CAPITAL RATIONING (contd)

Hard rationing a capital budget must be adhered applied as company has limited resources

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IV. CAPITAL RATIONING (contd)

Hard rationing (contd) Companys total resources: $20 million Opportunity cost of capital : 10% Company has the following project proposals:

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V. LAST LOOK

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Thank you for your attention !

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