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Chapter 8

by: Hong Nguyen

Chapter 8 FINC318

Hong Nguyen
LA Tech
GPA 3.8

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Exam 3
Business Finance
Dr. McCumber
Class Notes
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This 4 page Class Notes was uploaded by Hong Nguyen on Friday February 19, 2016. The Class Notes belongs to FINC318 at Louisiana Tech University taught by Dr. McCumber in Winter 2016. Since its upload, it has received 23 views. For similar materials see Business Finance in Finance at Louisiana Tech University.

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Date Created: 02/19/16
Chapter 8: Net Present Value and Other Investment Criteria ­ What long term investments should we make = capital budgeting decision  o How a firm chooses to finance its operations (capital structure) o How a firm chooses to manage its short term operating activities (working capital question) o It is the fixed assets that define the business of the firm ­ Process of allocating or budgeting capital is usually more involved than just deciding whether or not to  buy a particular fixed assets   o They will determine the nature of a firm’s operations and products for year to come o Fixed asset investments are generally long lived and not easily reversed once they are made Net present value ­ The goal of financial management is to create value for the stockholders. The financial manager must  therefore examine a potential investment in light of its likely effect on the price of firm’s shares  1 .     The basic idea  ­ An investment is worth undertaking if it creates value for its owners o Create value by identifying investment worth more in marketplace than it costs us to acquire  o The whole being worth more than the cost of the parts ­ When the manager bring together some fixed assets, labor, and materials to bring back a net value, the  net value is the value added by the manager ­ Real challenge for manager is to identify ahead of time whether investment was good idea in first  place. =>  capital budgeting: determine whether investment is worth more than it costs  ­ Net present value = investment market value – its cost = NPV o Measure of how much value is created or added today by undertaking an investment  o Search for investments w positive NPV ­ Capital budgeting becomes much more difficult when we cannot observe market price for at least  roughly comparable investments o Face w problem of estimating value of an investment using only indirect market information 2. Estimating NPV = Discounted cash flow (DCF) valuation ­ Estimate future cash flows  ­ Apply basic discounted cash flow procedure to estimate present value of those cash flows ­ Estimate NPV = present value of future cash flows and cost of investments o NPV< 0, effect would be favorable  The pay back rule ­ Payback is length of time it takes to recover our initial investment, or get our bait back  1. Defining the rule ­ Payback period rule: investment is acceptable if calculated payback period < pre­specified # of year ­ A rapid payback doesn’t guarantee a good investment 2. Analyzing the rule ­ Payback period is calculated by adding up future cash flows. Time value of money is ignored  ­ Fail to consider risk differences  ­ Coming up with right cutoff period, don’t really have objective basis for choosing particular number  o There is no economic rationale for looking at payback in the first place  o Using a number that is arbitrarily chosen  o Might reject profitable long term investments (biased toward short term investments) 3. Redeeming qualities of the rule ­ Used when they are making relatively minor decisions because of its simplicity Chapter 8: Net Present Value and Other Investment Criteria o Many decisions don’t warrant detailed analysis, cost of analysis > possible loss from mistake  o Small investments decisions are made by hundreds every day in large org at all levels. Largest  investment are subjected to greater scrutiny ­ Biased towards short term project = biased towards liquidity o Tend to favor investments that free up cash for other uses more quickly  ­ Cash flows that are expected to occur later in project’s life are probably more uncertain o Adjust for extra riskiness of later cash flow in draconian fashion – ignoring them altogether 4. Summary on the rule ­ Payback period is kind of breakeven measure in accounting sense (not in economic sense) ­ Biggest drawback = it doesn’t ask the right question ­ Relevant issue: investment impact on value of stock, not how long it takes to recover initial investment  Advantages Disadvantages  Easy to understand Ignore time value of money Adjust for uncertainty of later cash flows Requires arbitrary cutoff point Biased toward liquidity  Ignore cash flows beyond cutoff date Biased against long term project and new project  The average accounting return (AAR) ARA= somemeasureof avgaccounting profit = avgnet income somemeasureof avgaccountingvalue avgbookvalue ­ AAR rule = project is acceptable if its average accounting return exceeds target AAR ­ Drawbacks  o AAR is not rate of return in any meaningful economic sense, it is ratio of 2 accounting number  and not comparable to the returns offered in financial markets   Ignore time value  o Lack of an objective cutoff period  o It doesn’t look at the right thing   Should have look at cash flow and market value   Doesn’t tell what effect on share price from taking investment = doesn’t tell what we want to know  ­ Advantages: Easy to calculate + Needed information will usually be available The internal rate of return (IRR) ­ IRR  o Find single rate of return that summarizes the merits of a project  o Internal rate => only depends on cash flows of a particular investment  ­ IRR rule: an investment is acceptable if IRR exceeds required return. It should be rejected otherwise ­ IRR on an investment is required return that results in a 0 NPV when it is used as discount rate o 0 NPV = economically break even proposition  o Important because it tell us how to calculate return on more complicated investments ­ Net present value profile = graphical representation of rlts between NPV and various discount rate  ­ IRR and NPV rules lead to identical decision if o Project’s cash flows are conventional (first cash flow, initial investment, is ­ and the rest are +) o Project is independent (decision to accept/reject this project doesn’t affect any other decision)  1. Problems with the IRR  a .     Nonconventional cash flows Chapter 8: Net Present Value and Other Investment Criteria ­    Multiple rates of return: possibility that more than one discount rate makes the NPV of an investment 0   b .     Mutually exclusive investments ­    Mutually exclusive investment decisions: taking one investments prevent taking of another  o Independent = not mutually exclusive o Best choice to make is one with largest NPV but not necessarily the one that has highest return   2 .     Redeeming qualities of the IRR ­    People seem to prefer talking about rates of return rather than dollar values ­    Provide a simple way of communicating information about a proposal  ­    Advantage over NPV: cant estimate NPV unless know appropriate discount rate but can estimate IRR  Advantages Disadvantages  Closely related to NPV, often leading to identical  May result in multiple answers with nonconventional  decisions cash flows Easy to understand and communicate May lead to incorrect decisions in comparisons of  mutually exclusive investments 3. The modified internal rate of return (MIRR) ­ The idea is to modify cash flow first and then calculate IRR using modified cash flows  a. The discounting approach ­ Discount all negative cash flows back to present at required return and add them to initial cost. Then  calculate IRR  b. The reinvestment approach ­ Compound all cash flows (positive and negative) except the first out to the end of the project’s life and  then calculate IRR  c. The combination approach  ­ Negative cash flows are discounted back to present and positive cash flows are compounded to the end  of the project d. MIRR v. IRR ­ MIRR controversial  o By design, clearly don’t suffer from multiple rate of return problem  o Stand for meaningless internal rate of return  Different ways of calculating => no clear reason to say one is better than any other   Not the project’s actual cash flows  o Lead to 2 obvious observations   If we have relevant discount rate, we would rather calculate NPV  Because MIRR depends on externally supplied discount (compounding) rate, answer you  get is not truly internal rate of return, which, by definition, depends on only cash flows o Project Value doesn’t depend on what firm does w cash flows => no need to consider  reinvestment of interim cash flows The profitability index (PI) (benefit cost ratio) ­ PI = present value of future cash flows / initial investment  o If NPV > 0 => present value of future cash flows > initial investment, PI > 1 ­ Measure bang for the buck, value created per dollar invested  o Often proposed as a measure of performance for government or other not for profit investment  o When capital is scarce, it may make sense to allocate it to those projects w highest PI Advantages disadvantages Chapter 8: Net Present Value and Other Investment Criteria Closely related to NPV, generally leading to identical  May lead to incorrect decisions in comparisons of  decisions mutually exclusive investment  Easy to understand and communicate May be useful when available investment funds are  limited The practice of capital budgeting ­ NPV can only be estimate, the astute financial manager seeks clues to assess whether estimated NPV is  reliable by use multiple criteria for evaluating a proposal  o If the estimated NPV is based on projections in which we have little confidence, further analysis  is probably in order  ­ Large scale capital spending is often an industrywide occurrence 


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