6- 1

Chapter 7
NPV and its Competitors The Payback Period Book Rate of Return Internal Rate of Return Profitability Capital Rationing

CFO Decision Tools

Survey Data on CFO Use of Investment Evaluation Techniques

6- 2

NPV, 11 %

IRR, 77 %

Payback, 11 %

Book rate of return, 77 % Profitability Index, 11 % 1 % 1% 1 1% 1 1% 1 1% 1 11 1%

SOURCE: Graham and Harvey, The Theory and Practice of Finance: Evidence from the Field, Journal of Financial Economics 61 (2001), pp. 187-243.

Book Rate of Return

Book Rate of Return - Average income divided by average book value over project life. Also called accounting rate of return.

6- 3

book income Book rate of return = book assets

Managers rarely use this measurement to make decisions. The components reflect tax and accounting figures, not market values or cash flows.

Payback
The payback period of a project is the number of years it takes before the cumulative forecasted cash flow equals the initial outlay. The payback rule says only accept projects that payback in the desired time frame.

6- 4

Payback
Example Examine the three projects and note the mistake we would make if we insisted on only taking projects with a payback period of 2 years or less.
Payback Period

6- 5

Project A B C

C1

C1

C1

C1

NPV@ 1% 1

- 11 11 11 11 11 1 1 11 - 11 11 11 11 1 11 1 - 11 11 11 11 11 1 1

Payback
Example Examine the three projects and note the mistake we would make if we insisted on only taking projects with a payback period of 2 years or less.
Payback

6- 6

Project A B C

Period - 11 11 11 11 11 1 1 11 1 - 11 11 11 11 1 11 1 1 - 11 11 11 11 11 1 1 1

C1

C1

C1

C1

NPV@ 1% 1 +77 ,77 -1 1 +1 1

Payback
This method is flawed, primarily because it ignores later year cash flows and the present value of future cash flows.

6- 7

Internal Rate of Return

The rate of return is actually the rate of discount that makes NPV=0. It is actually the (one period) rate of return defined in chapter 2.

6- 8

Internal Rate of Return

Example You can purchase a turbo powered machine tool gadget for $4,000. The investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment?

6- 9

Internal Rate of Return

Example You can purchase a turbo powered machine tool gadget for $4,000. The investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment?

6- 10

11 ,11 11 ,11 NPV = 1 1 + ,11 + =1 1 1 (1 IRR ) (1 IRR ) + +

IRR = 1.1% 11

Internal Rate of Return

11 11 11 11 11 11 NPV (,111 s) 11 11 11 1 1
1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1

6- 11

IRR=28%

-111

-1111 -1111 -1111 Discount rate (%)

Internal Rate of Return

In chapter 2, we noted that the NPV rule is equivalent to the rate of return rule---accept investment offering rates of return in excess of their opportunity costs of capital. However, this interpretation is not always easy for long-lived investment opportunities.

6- 12

Internal Rate of Return

Pitfall 1 - Lending or Borrowing?
With some cash flows (as noted below) the NPV of the project increases s the discount rate increases. This is contrary to the normal relationship between NPV and discount rates.

6- 13

Project A B

C1 C1 IRR 1 1 + 1 1 + 1% ,11 ,11 1 + 1 1 1 1 + 1% ,11 ,11 1

NPV @ 1% 1 + 11 1 11 1

Internal Rate of Return

Pitfall 2 - Multiple Rates of Return
Certain cash flows can generate NPV=0 at two different discount rates. The following cash flow generates NPV=$A 3.3 million at both IRR % of (-44%) and +11.6%. Cash Flows (millions of Australian dollars)

6- 14

C1 C1 ...... ......C1 C1 1 11 11 77 11 1 1 7 1

Internal Rate of Return

Pitfall 2 - Multiple Rates of Return
Certain cash flows can generate NPV=0 at two different discount rates. The following cash flow generates NPV=$A 3.3 million at both IRR% of 44%) and +11.6%. NPV 600 300 0 -30 -600 IRR=-44% IRR=11.6% Discount Rate (-

6- 15

Internal Rate of Return

Whenever the cash-flow stream is expected to change sign more than once, the company typically sees more than one IRR.

6- 16

Internal Rate of Return

Pitfall 2 - Multiple Rates of Return
It is possible that IRR does not exist. (see irr1.xls)

6- 17

Project C

C1

C1

C1

IRR

NPV @ 1% 1 + 11 1

+ 1 1 1 1 + 1 1 None ,11 ,11 ,11

Internal Rate of Return

Pitfall 3 - Mutually Exclusive Projects (scale) IRR sometimes ignores the magnitude of the project. The following two projects illustrate that problem.

6- 18

Project D E

C1 C1 IRR NPV @ 1% 1 1,11 + 1,11 11 11 1 1 1% +11 ,11 1,11 + 1,11 + 1% 11 11 1 + 1,11 11

Internal Rate of Return

Pitfall 3 - Mutually Exclusive Projects (time pattern. See IRR.xls)

6- 19

Internal Rate of Return

Many managers prefer F to G anyways because of its rapid payback. The opportunity cost of capital is very important when using the NPV rule.

6- 20

Internal Rate of Return

Pitfall 4 - Term Structure Assumption We assume that discount rates are stable during the term of the project. Whenever the term structure of interest rates become important, IRR can not be applied.

6- 21

Internal Rate of Return

However, why so many managers still use IRR?
See IRR2.xls

6- 22

Capital Rationing
When resources are limited, the profitability index (PI) provides a tool for selecting among various project combinations and alternatives. net present value Profitabil ity index = investment

6- 23