Chapter 11
Investment
Decision Criteria
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Slide Contents
• Learning Objectives
• Principles Used in This Chapter
1.
2.
3.
4.
An Overview of Capital Budgeting
Net Present Value
Other Investment Criteria
A Glance at Actual Capital Budgeting Practices
• Key Terms
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11-2
Learning Objectives
1. Understand how to identify the sources
and types of profitable investment
opportunities.
2. Evaluate investment opportunities using
net present value and describe why net
present value provides the best measure
for evaluating investments.
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11-3
Learning Objectives (cont.)
3. Use the profitability index, internal rate of
return, and payback criteria to evaluate
investment opportunities.
4. Understand current business practice with
respect to the use of capital budgeting
criteria.
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11-4
Principles Used in This Chapter
• Principle 3: Cash Flows Are the Source of
Value.
– We value an investment opportunities by
evaluating its expected cash flows.
• Principle 1: Money Has a Time Value.
– While evaluating investment opportunities, we
discount all cash flows back to the present.
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11-5
Principles Used in This Chapter
(cont.)
• Principle 2: There is a Risk-Reward
Tradeoff.
– While evaluating investment opportunities, we
incorporate risk into the analysis by increasing
the discount rate while calculating the present
value of cash flows.
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11-6
Principles Used in This Chapter
(cont.)
• Principle 4: Market Prices Reflect
Information.
– The risk adjusted discount rate used to
calculate the present values of project’s cash
flows depends upon the market prices that
reflect information.
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11-7
11.1 An Overview
of Capital
Budgeting
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Three Lessons from Disney
• Disney’s decision to invest $17.5 million to
build Disneyland park in California is an
example of capital budgeting decision.
• Subsequently, Disney opened theme parks
in Orlando, Tokyo, Paris and most recently
invested $3.5 billion to build a theme park
in Hong Kong. Today parks and resorts
account for over 30% of Disney’s Revenue.
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11-9
Three Lessons from Disney
1. Capital budgeting decisions are critical in
defining a company’s success.
2. Very large investments are frequently the
result of many smaller investment
decisions that define a business strategy.
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11-10
Three Lessons from Disney (cont.)
3. Successful investment choices lead to the
development of managerial expertise and
capabilities that influence the firm’s
choice of future investments.
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11-11
The Typical Capital Budgeting
Process
• Phase I: The firm’s management identifies
promising investment opportunities.
• Phase II: The value creating potential of
various opportunities are thoroughly
evaluated.
• So the goal is to identify promising
opportunities and select those that will
create the most value for the firm’s
common stockholders.
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11-12
What Are the Sources of Good
Investment Projects?
• It is not easy to find profitable investment
opportunities in competitive markets.
• Good investments are most likely to be
found in markets that are less competitive
where barriers to new entrants are
sufficiently high to keep out would-be
competitors.
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11-13
Types of Capital Investment
Projects
1) Revenue enhancing Investments (for
example, entering a new market)
2) Cost-reduction investments (for example,
installing a more efficient equipment)
3) Mandatory investments that are a result
of government mandate (for example,
installing mandatory safety features in a
car)
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11-14
Types of Capital Investment
Projects (cont.)
• Before an investments is made, the firm will like
to ensure that it will create value. To determine
the desirability of investment proposals, we can
use several analytical tools such as: Net Present
Value (NPV), Equivalent Annual Cost (EAC), the
Profitability Index (PI), the Internal Rate of
Return (IRR), the Modified Internal Rate of Return
(MIRR), the payback period, and discounted
payback period.
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11-15
11.2 Net Present
Value
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Net Present Value
• The net present value (NPV) is the
difference between the present value of
cash inflows and the cash outflows. NPV
estimates the amount of wealth that the
project creates.
• Decision Criteria: Investment projects
should be accepted if the NPV of project is
positive and should be rejected if the NPV
is negative.
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11-17
Calculating an Investment’s NPV
• The NPV of an investment proposal can be
defined as follows:
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11-18
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11-19
Independent Versus Mutually
Exclusive Investment Projects
• An independent investment project is
one that stands alone and can be
undertaken without influencing the
acceptance or rejection of any other
project.
• A mutually exclusive project prevents
another project from being accepted.
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11-20
Evaluating an Independent
Investment Opportunity
• It will require two steps:
1. Calculate NPV;
2. Accept the project if NPV is positive and reject
if it is negative.
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11-21
Checkpoint 11.1
Calculating the NPV for Project Long
Project Long requires an initial investment of $100,000 and is
expected to generate a cash flow of $70,000 in year one,
$30,000 per year in years two and three, $25,000 in year
four, and $10,000 in year 5.
The discount rate (k) appropriate for calculating the NPV of
Project Long is 17 percent. Is Project Long a good investment
opportunity?
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11-22
Checkpoint 11.1
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11-23
Checkpoint 11.1
Step 3 cont.
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11-24
Checkpoint 11.1
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11-25
Checkpoint 11.1
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11-26
Checkpoint 11.1: Check Yourself
• Saber Electronics provides specialty
manufacturing services to defense contractors
located in the Seattle, WA area. The initial outlay
is $3 million and, management estimates that the
firm might generate cash flows for years one
through five equal to $500,000; $750,000;
$1,500,000; $2,000,000; and $2,000,000. Saber
uses a 20% discount rate for projects of this
type. Is this a good investment opportunity?
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11-27
Step 1: Picture the Problem
k=20%
0
1
2
3
4
5
Years
Cash flows
(in $ millions)
-$3M
+$0.5M
+$0.75M +$1.5M
$2M
$2M
Net
Present
Value =?
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11-28
Step 2: Decide on a Solution
Strategy
• We need to analyze if this is a good
investment opportunity. We can do that by
computing the Net Present Value (NPV),
which requires computing the present
value of all cash flows.
• We can compute the NPV by using a
mathematical formula, a financial
calculator or a spreadsheet.
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11-29
Step 3: Solve
• Using Mathematical Formula
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11-30
Step 3: Solve (cont.)
• NPV = -$3m + $.5m/(1.2) + $.75m/(1.2)2 +
$1.5m/(1.2)3 + $2m/(1.2)4 + $2m/(1.2)4
• NPV = -$3,000,000 + $416,666.67 +
$520,833.30 + $868,055.60 + $964,506 +
$803,755.10
• NPV = $573,817
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11-31
Step 3: Solve (cont.)
• Using an Excel Spreadsheet
• NPV = NPV (discount rate, CF1-5 ) + CF0
= NPV(.20, 500000, 750000, 1500000,
2000000,2000000) - 3000000
= $573,817
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11-32
Step 4: Analyze
• The project requires an initial investment
of $3,000,000 and generates futures cash
flows that have a present value of
$3,573,817. Consequently, the project
cash flows are $573,817 more than the
required investment.
• Since the NPV is positive, the project is an
acceptable project.
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11-33
Evaluating Mutually Exclusive
Investment Opportunities
• There are times when a firm must choose
the best project or set of projects from the
set of positive NPV investment
opportunities. These are considered
mutually exclusive opportunities as the
firm cannot undertake all positive NPV
projects.
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11-34
Evaluating Mutually Exclusive
Investment Opportunities (cont.)
• Following are two situations where firm is
faced with mutually exclusive projects:
1.Substitutes – Where firm is trying to pick
between alternatives that perform the
same function. For example, a new
machinery for the new project. While there
might be many good machines, the firm
needs only one.
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11-35
Evaluating Mutually Exclusive
Investment Opportunities (cont.)
2. Firm Constraints – Firm may face
constraints such as limited managerial
time or limited financial capital that may
limit its ability to invest in all the positive
NPV opportunities.
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11-36
Choosing Between Mutually
Exclusive Investments
1. If mutually exclusive investments have
equal lives, we will calculate the NPVs and
choose the one with the higher NPV.
2. If mutually exclusive investments do not
have equal lives, we must calculate the
Equivalent Annual Cost (EAC), the cost
per year. We will then select the one that
has a lower EAC.
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11-37
Choosing Between Mutually
Exclusive Investments (cont.)
• Computation of EAC requires two steps:
1. Compute NPV
2. Compute EAC as per equation 11-2
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11-38
Checkpoint 11.2
Calculating the Equivalent Annual Cost (EAC)
Suppose your bottling plant is in need of a new bottle capper. You are
considering two different capping machines that will perform equally well, but
have different expected lives. The more expensive one costs $30,000 to buy,
requires the payment of $3,000 per year for maintenance and operation
expenses, and will last for 5 years. The cheaper model costs only $22,000,
requires operating and maintenance costs of $4,000 per year, and lasts for only
3 years. Regardless of which machine you select, you intend to replace it at the
end of its life with an identical machine with identical costs and operating
performance characteristics. Because there is not a market for used cappers,
there will be no salvage value associated with either machine. Let’s also assume
that the discount rate on both of these machines is 8 percent.
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11-39
Checkpoint 11.2
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11-40
Checkpoint 11.2
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Step 3 cont.
11-41
Checkpoint 11.2
Step 3 cont.
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11-42
Checkpoint 11.2
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11-43
Checkpoint 11.2
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11-44
Checkpoint 11.2: Check Yourself
• What is the EAC for a machine that costs
$50,000, requires payment of $6,000 per year for
maintenance and operation expense, and lasts for
6 years? You may assume that the discount rate is
9% and there will be no salvage value associated
with the machine. In addition, you intend to
replace this machine at the end of its life with an
identical machine with identical costs.
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11-45
Step 1: Picture the Problem
k=9%
Years
Cash flows
(in $, thousands)
0
-$50
1
2
3
-$6
-$6
-$6
4
-$6
5
-$6
6
$6
EAC =?
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11-46
Step 2: Decide on a Solution
Strategy
• Here we need to calculate the EAC, which
will tell us the annual cost for a machine
that lasts 6 years.
• EAC can be computed using mathematical
formula or calculator.
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11-47
Step 3: Solve
• Using Mathematical Formula
• It requires 2 steps:
– Computation of NPV
• Here the cash inflows are equal so we can use the
annuity equation to determine the PV of cash inflows.
– Computation of EAC
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11-48
Step 3: Solve (cont.)
NPV = -$50,000 + PV of $6,000 each year
= -$50,000 + -$6,000 (PV of Annuity Factor)
[
= -$50,000 + -$6,000 { 1-(1/(1.09)6
]÷
(.06)}
= -$50,000 + -$6,000 {4.4859) = -$76,915
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11-49
Step 3: Solve (cont.)
• EAC = NPV ÷ Annuity Factor
= -$76,915 ÷ 4.4859
= -$17,145.95
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11-50
Step 3: Solve (cont.)
• Using a Financial Calculator
• Data and Key Input
CF; -50000; ENTER
;-6000; ENTER
;6; ENTER
NPV;8; ENTER
CPT
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Display
CFO=-50000
CO1=-6000
FO1=6.00
i=8
NPV=-77,372
11-51
Step 3: Solve (cont.)
Enter
–
–
–
–
–
N=6
1/y = 9
PV = -76915
FV = 0
PMT = -17,145.86
Thus EAC = $-17,145.86
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11-52
Step 4: Analyze
• Here EAC is equal to $17,145.86.
• EAC indicates the annual cost that is
adjusted for time value of money.
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11-53
11.3 Other
Investment
Criteria
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Profitability Index
• The profitability index (PI) is a costbenefit ratio equal to the present value of
an investment’s future cash flows divided
by its initial cost:
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11-55
Profitability Index (cont.)
• Decision Criteria:
– If PI is greater than one, it indicates that the
present value of the investment’s future cash
flows exceeds the cost of making the
investment and the investment should be
accepted. If PI is greater than one, the NPV will
be positive.
– If PI is less than one, the project should be
rejected. If PI is less than one, the NPV will be
negative.
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11-56
Checkpoint 11.3
Calculating the Profitability Index for Project Long
Project Long is expected to provide five years of cash inflows and to
require an initial investment of $100,000. The discount rate that is
appropriate for calculating the PI of Project Long is 17 percent. Is Project
Long a good investment opportunity?
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11-57
Checkpoint 11.3
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11-58
Checkpoint 11.3
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11-59
Checkpoint 11.3
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11-60
Checkpoint 11.3: Check Yourself
• PNG Pharmaceuticals is considering an investment
in a new automated materials handling system
that is expected to reduce its drug manufacturing
costs by eliminating much of the waste currently
involved in its specialty drug division. The new
system will require an initial investment of
$50,000 and is expected to provide cash savings
over the next six-year period as shown on next
slide.
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11-61
The Problem (cont.)
Year
Expected Cash
Flow
0
-$50,000
1
$15,000
2
$8,000
3
$10,000
4
$12,000
5
$14,000
6
$16,000
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11-62
Step 1: Picture the Problem
k=10%
0
1
-$50
+$15
2
3
4
5
6
Years
Cash flows
(in $, thousands)
+$8
+$10
+$12
+$14
+$16
PI =?
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11-63
Step 2: Decide on a Solution
Strategy
• The PI for a project is equal to the present
value of the project’s expected cash flows
for years 1-6 divided by the initial outlay.
• PI = PV of expected cash flows ÷ -Initial
outlay
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11-64
Step 3: Solve
• We can proceed in two steps:
1. Compute PV of expected cash flows by
discounting the cash flows from Year 1 to Year
6 at 10%.
PVt = CFt÷(1.09)t
2. Compute PI
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11-65
Step 3: Solve (cont.)
• Step 1: Computing PV of Cash Inflows
Year
Expected Cash
flow
Present Value at 10%
discount rate
1
$15,000
$13,636.36
2
$8,000
$6,611.57
3
$10,000
$7,513.14
4
$12,000
$8,196.16
5
$14,000
$8,692.90
6
$16,000
$9,031.58
NPV of Expected Cash flows,
Years 1-6
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$53,681.72
11-66
Step 3: Solve (cont.)
• Step 2: Compute the PI
• PI = PV of expected CF1-6 ÷ Initial Outlay
= $53,681.72 ÷ $50,000
= 1.073
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11-67
Step 4: Analyze
• PNG Pharmaceuticals requires an initial
investment of $50,000 and provides future
cash flows that have a present value of
$53,681.72. Thus, the future cash flows
are worth 1.073 times the initial
investment or PI is equal to 1.073.
• It is an acceptable project since PI is
greater than 1.
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11-68
Internal Rate of Return
• The internal rate of return (IRR) of an
investment is analogous to the yield to
maturity (YTM) of a bond defined in
Chapter 9.
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11-69
Internal Rate of Return (cont.)
• Decision Criteria: Accept the project if the
IRR is greater than the discount rate used
to calculate the net present value of the
project, and reject it otherwise.
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11-70
Checkpoint 11.4
Calculating the IRR for Project Long
Project Long is expected to provide five years of cash inflows and to
require an initial investment of $100,000. The required rate of return or
discount rate that is appropriate for valuing the cash flows of Project
Long is 17 percent. What is Project Long’s IRR, and is it a good
investment opportunity?
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11-71
Checkpoint 11.4
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11-72
Checkpoint 11.4
Step 3 cont.
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11-73
Checkpoint 11.4
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Step 3 cont.
11-74
Checkpoint 11.4
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11-75
Checkpoint 11.4
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11-76
Checkpoint 11.4: Check Yourself
• Knowledge Associates is a small consulting
firm in Portland, Oregon, and they are
considering the purchase of a new copying
center for the office that can copy, fax,
and scan documents. The new machine
costs $10,010 to purchase and is expected
to provide cash flow savings over the next
four years of $1,000; $3,000; $6,000; and
$7,000.
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11-77
The Problem (cont.)
• The employee in charge of performing
financial analysis of the proposed
investment has decided to use the IRR as
her primary criterion for making a
recommendation to the managing partner
of the firm. If the discount rate the firm
uses to value the cash flows from office
equipment purchases is 15%, is this a
good investment for the firm?
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11-78
Step 1: Picture the Problem
0
1
2
3
4
Years
Cash flows
-$10,010
+$1,000
+$3,000 +$6,000 +$7,000
IRR =?
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11-79
Step 2: Decide on a Solution
Strategy
• Here we have to calculate the project’s
IRR. IRR is equal to the discount rate that
makes the present value of the future cash
flows (in years 1-4) equal to the initial
cash outflow of $10,010.
• We can compute the IRR using trial &
error, financial calculator or an excel
spreadsheet.
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11-80
Step 3: Solve
• Using Mathematical Formula
– This will require finding the rate at which NPV
is equal to zero.
– We compute the NPV at different rates to
determine the range of IRR.
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11-81
Step 3: Solve (cont.)
• This table suggests that IRR is between 15
and 20%.
Discount Rate
Computed NPV
0%
$6,990
5%
$4,605
10%
$2,667
15%
$1,075
20%
-$245
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11-82
Step 3: Solve (cont.):
Using Financial Calculator
• Data and Key Input
Display
CF; -100000; ENTER
1000; ENTER
;1; ENTER
;3000; ENTER
;1; ENTER
;6000; ENTER
; 1; ENTER
; 7000; ENTER
1; ENTER
IRR; CPT
CFO=-100000
CO1=1000
FO1=1.00
C02=3000
FO2=1.00
C03=6000
FO3=1.00
CO4 = 7000
FO4 =1.00
IRR = 19%
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11-83
Step 3: Solve (cont.)
• Using an Excel Spread sheet
Rows
in
Excel
Column A
in Excel
Column B in
Excel
1
Year
Annual Cash
flow
2
0
-$10,010
3
1
$1,000
4
2
$3,000
5
3
$6,000
6
4
$7,000
IRR
19%
Enter:
IRR(b2:b6)
7
8
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11-84
Step 4: Analyze
• The new copying center requires an initial
investment of $10,010 and provides future
cash flows that offer a return of 19%.
Since the firm has decided 15% as the
minimum acceptable return, this is a good
investment for the firm.
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11-85
Complications with IRR:
Unconventional Cash Flows
• For a typical investment, an initial outlay is
followed by a period of cash inflows. In such
cases, the NPV will always be positive if IRR is
greater than 1.
• However, if the cash flow pattern is the
reverse i.e. cash inflow followed by a series of
cash outflows (as in the case of a loan), NPV
greater than zero indicates that IRR is less
than the discount rate used to calculate the
NPV.
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11-86
Complications with IRR:
Unconventional Cash Flows (cont.)
• NPV leads to the appropriate decision in
both conventional and unconventional cash
flow pattern. Thus it is prudent to use NPV
while evaluating projects with
unconventional cash flow pattern.
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11-87
Complications with IRR: Multiple
Rates of Return
• Although any project can have only one
NPV, a single project can, under certain
circumstances, have more than one IRR.
• Checkpoint 11.5 illustrates a case of
multiple IRRs.
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11-88
Checkpoint 11.5
The Problem of Multiple IRRs for Projects
Descartes’ Rule of Signs tells us that there can be as many IRRs for
an investment project as there are changes in the sign of the cash
flows over its n-year life. To illustrate the problem, consider a project
that has three cash flows: a $235,000 outlay in year 0, a $540,500
inflow in year 1, and a $310,200 outflow at the end of year 2.
Calculate the IRR for the investment.
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11-89
Checkpoint 11.5
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11-90
Checkpoint 11.5
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11-91
Checkpoint 11.5
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11-92
Checkpoint 11.5: Check Yourself
• McClary Custom Printers is considering whether to
purchase a printer. The printer costs $200,000 to
purchase, and McClary expects it can earn an
additional $1.2 million in cash flows in the printer’s
first year of use. However, there is a problem with
purchasing the printer today because it will require a
very large expenditure in year 2, such that year 2’s
cash flow is expected to be -$2.2million. Finally, in
year 3, the printer investment is expected to produce
a cash flow of $1.2 million. Use the IRR to evaluate
whether the printer purchase will be worthwhile.
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11-93
Step 1: Picture the Problem
0
1
2
3
Years
Cash flows
-$200,000
+$1.2m
-$2.2m
+$1.2m
IRR =?
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11-94
Step 2: Decide on a Solution
Strategy
• To solve the problem, we can construct an
NPV profile that reports the NPV at several
discount rates.
• We will use discount rates of 0 to 200% in
increments of 50% to compute the NPV.
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11-95
Step 3: Solve
• The NPV profile on next slide is based on
various discount rates. For example, NPV
at discount rate of 50% is computed as
follows:
• NPV = -$200,000 + $1,200,000/(1.5)1 +
-2,200,000/(1.5)2 + $1,200,000/(1.5)3
= -$22,222.22
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Step 3: Solve (cont.)
Discount Rate
NPV
0%
$0
50%
-$22,222.22
100%
$0
150%
$4,800
200%
$0
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Step 4: Analyze
• There are three IRRs for this project 0%,
100% and 200%. At all of these rates, NPV
is equal to zero.
• However, NPV will be a better decision tool
to use under this situation as it is not
subject to multiple answers like IRR.
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Using the IRR with Mutually
Exclusive Investments
• When we are comparing two mutually
exclusive projects, IRR and NPV may
not lead to the same conclusion. For
example, we may be selecting between
2 projects and both IRR and NPV values
may suggest that the projects are
financially feasible. However, the
ranking of two projects may not be the
same using NPV and IRR.
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Using the IRR with Mutually
Exclusive Investments (cont.)
• Figure 11-2 shows that if we use NPV,
project AA+ is better while if we use IRR,
project BBR is better.
• How to select under such circumstances?
– Use NPV as it will give the correct ranking for
the projects.
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Figure 11.2 cont.
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Figure 11.2 cont.
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Modified Internal Rate of Return
• Modified Internal Rate of Return
(MIRR) deals with the problem of multiple
IRRs.
• This is done by rearranging the cash flows
so that there is only one change of sign of
the cash flows over the life of the project.
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Modified Internal Rate of Return
(cont.)
• MIRR Process: 2 Steps
1.Modify the project’s cash flow stream by
discounting the negative future cash flows
back to the present using the same
discount rate that is used to calculate the
project’s NPV.
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Modified Internal Rate of Return
(cont.)
• MIRR Process: 2 Steps
2.Calculate the MIRR as the IRR of the
modified cash flow stream.
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Checkpoint 11.6
Calculating the Modified Internal Rate of Return (MIRR)
Reconsider the investment project in Checkpoint 11.5. The project we analyze
has three cash flows: a $235,000 outlay in year 0, a $540,500 cash inflow in
year 1, and a $310,200 outflow at the end of year 2. Our analysis in Checkpoint
11.5 indicated that this investment has two IRRs, 10% and 20%. One way to
reduce the number of IRRs to only one is to use the MIRR method, which moves
negative cash flows backward discounting them using the required rate of return
or discount rate for the project which is 12%.
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Checkpoint 11.6
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Checkpoint 11.6
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Checkpoint 11.6
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Checkpoint 11.6: Check Yourself
Analyze the MIRR for the preceding problem
where the required rate of return used to
discount the cash flows is 8%. What is the
MIRR?
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Step 1: Picture the Problem
i=8%
0
Years
Cash flows
-$235,000
First
Sign
change
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1
$540,500
2
-$310,200
Second
Sign
change
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Step 2: Decide on a Solution
Strategy
• There are two sign changes in the cash
flow stream. If we use IRR, we will get
multiple IRRs.
• We can use MIRR by doing the following:
– First, discount the year 2 negative cash flows
back to year 0 using the 8% discount rate.
– Second, calculate the MIRR of the resulting
cash flows for years 0 and 1.
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Step 3: Solve
• Discount the year 3 negative cash flows to
year 0.
0
1
2
Years
Cash flows
-$235,000
$540,500
-$310,200
-$265,947
-$500,947
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Step 3: Solve (cont.)
• The modified cash flow stream are as
follows:
0
1
2
$540,500
-$0
Years
Cash flows
-$500,947
• Calculating the IRR for the above modified cash flows
produces MIRR equal to 7.9%
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Step 4: Analyze
• We were able to compute IRR by
eliminating the second sign change and
thus modifying the cash flows.
• Since IRR is based on modified cash flows,
it is referred to as MIRR.
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Step 4: Analyze (cont.)
• MIRR is not the same as IRR as modified
cash flows are discounted based on the
discount rate used to calculate NPV (which
is not the same as IRR). If we change the
discount rate, MIRR will also change.
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Payback Period
• The Payback period for an investment
opportunity is the number of years needed
to recover the initial cash outlay required
to make the investment.
• Decision Criteria: Accept the project if the
payback period is less than a pre-specified
number of years.
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Limitations of Payback Period
1. It ignores the time value of money
2. The payback period ignores cash flows
that are generated by the project beyond
the end of the payback period.
3. There is no clear-cut way to define the
cutoff criterion for the payback period
that is tied to the value creation potential
of the investment.
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Discounted Payback Period
• Discounted payback period is similar to
payback period except it uses discounted
cash flows to calculate the discounted
period. The discount rate is the same as
the one used for calculating the NPV.
• Decision Criteria: Accept the project if its
discounted payback period is less than the
pre-specified number of years.
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Attractiveness of Payback Methods
1. Both payback and discounted payback are
more intuitive and relatively easier to
understand compared to NPV or IRR.
2. Payback period can be seen as a crude
indicator of risk as payback favors initial
year cash flows, which, in general, are
less risky than more distant cash flows.
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Attractiveness of Payback Methods
(cont.)
3. Discounted payback is used as a
supplemental analytical tool in cases
where obsolescence is a risk and the
emphasis is on getting the money back
before the market disappears or the
product becomes obsolete.
4. Payback method is useful when capital is
being rationed and managers would like
to know how long a project will tie up
capital.
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11.4 A Glance at
Actual Capital
Budgeting
Practices
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A Glance at Actual Capital Budgeting
Practices
• Figure 11-3 shows the results of a survey
of CFOs of large US firms, showing the
popularity of the payback, discounted
payback, NPV, PI, and IRR methods for
evaluating capital investment
opportunities.
• The results show that NPV and IRR
methods are the most popular although
many firms use Payback method too.
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Key Terms
•
•
•
•
•
•
•
Capital rationing
Discounted payback
Equivalent annual cost (EAC)
Independent investment project
Internal rate of return (IRR)
Modified internal rate of return (MIRR)
Mutually exclusive investments
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Key Terms (cont.)
•
•
•
•
Net present value (NPV)
Net present value profile
Payback period
Profitability index
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