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CHAPTER 7 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA

By Peter Hamilton,2014-08-11 23:10
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CHAPTER 7 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA

    CHAPTER 7: NET PRESENT VALUE AND OTHER INVESTMENT

    CRITERIA

A. OVERVIEW

    Motivation How do we evaluate long-term projects? How do we choose among various

    long-term investment projects? What criteria would you use?

    Definition Capital budgeting refers to the process of evaluating and selecting long-term investment projects that achieve the goal of maximizing owners’ wealth.

    Definition A capital expenditure is an outlay of funds that is expected to produce benefits over a period of time longer than one year.

     An operating expenditure is an outlay of funds that is expected to

    produce benefits over a period of time shorter than one year.

Motives: affects the way we identify cash flows

     Expansion

     Replacement

     Renewal

     Others

Process of capital budgeting

     Generate proposal

     Review and analysis

     Make decision

     Implement

     Follow-up

B. TERMINOLOGY

     Types of projects:

     Independent : Cash flows are unrelated

     Accepting one project does not eliminate others

Example Purchase a computer network and install air-conditioning in the building

     Mutually exclusive: Competing projects (substitutes)

     Accepting one project would eliminate others

Example Acquire a firm (backward integration) vs. contract out the production to the

    backward linkage, choose among from other suppliers

Funding constraint:

     Unlimited funds : No funding constraint (no capital rationing)

     Can accept any independent projects that meet the decision criteria

     Implication Can use accept/reject approach to make

    investment decision

     Capital rationing: Constrained by amount of funds available

     Firm must ration its funds to allocate among projects that maximize share value

     Implication Use the ranking approach to help select

     the best projects

C. COMPONENTS OF CASH FLOW

    1. Initial investment / incremental cost / incremental investment

     Relevant cash outflows now to embark on a capital budgeting project

    2. Operating cash inflows

     The incremental after-tax cash inflows resulting from a project during

    its life

    3. Terminal cash flow

     The after-tax non-operating cash flow at the final year of the project

    (liquidation of the project)

D. APPROACH 1: PAYBACK PERIOD

    Definition: The length of time in years it takes for a project’s yearly incremental after-tax cash flows to recover the incremental investment in the project

Formula: Incremental investment Payback period Constant cash flow

    Decision rule: A project should be accepted if its payback period is less than a specified cutoff period.

    Note: If cash flow is a mixed stream, payback period is the year when cash flow just recovers the incremental investment.

    Example The incremental investment is $25,000. If cash flow is a constant amount of $5,000 per year. The payback period is 5.

    Example If cash flow is $5,000 for the first year, $6,000 for the second year, $3,000 for the third year, and $4,000 for subsequent years, then the payback period is between 5 to 6 years.

    Example Consider the following two projects. Which one would you choose, using the payback period approach?

     Year 0 1 2 3

    Project A -2000 1500 300 200

    Project B -2000 200 300 1500

    Example Consider the following two projects. The cutoff period is 2 years. Which one would you choose?

     Year 0 1 2 3

    Project A -2000 1000 1000 5000

Project B -2000 1000 1000 3000

Summary:

     Easy to communicate / calculate

     A quick measure of “risk exposure”

     No mention of CF after the payback period

     Ignore the time value of money

E. APPROACH 2: DISCOUNTED PAYBACK PERIOD

    Definition: The length of time in years it takes for a project’s discounted yearly incremental after-tax cash flows to recover the incremental investment in the project

    Decision rule: A project should be accepted if its discounted payback period is less than a specified cutoff period.

    Example Consider the following two projects. The cutoff period is 2 years. Which one would you choose, using the discounted payback period approach with a discount rate of 10%?

     Year 0 1 2 3

    Project A -2000 500 1500 1000

    Project B -2000 1500 500 1000

F. APPROACH 3: BOOK RATE OF RETURN

    Definition: Book rate of return is the accounting income divided by book value. Also called accounting rate of return.

Formula:

    Book income Book rate of return Book assets

Decision rule: Accept the project if book rate of return > required return

    Example (p. 219). A company invests $90,000 in a machine, which will increase cash flow by $50,000 a year for 3 years. Allowance for depreciation is $30,000 a year. Find the book rate of return.

Book value Book value

    (begin) Net income (end) Return

    90 50-30=20 60 22.2

    60 50-30=20 30 33.3

    30 50-30=20 0 66.7

G. APPROACH 4: NET PRESENT VALUE

    Definition: Net Present Value (NPV) is the present value of the sum of discounted cash flows minus initial investment.

Formula:

     n NPVCF(1;T)*PVIF;IC,ttk (a1t

Decision rule: Accept the project if NPV > 0.

Note:

     Use opportunity cost of capital (expected rate of return of the best alternative

    investment)

    Example (p.204-5) Real estate investment in an office building costs $50,000 for land and $300,000 for construction. You can sell the office building a year later for$400,000. Suppose the T-bill offers an interest rate of 7%. Would you invest in the real estate project?

    Example