FINA 4315 - EXAM 1

Payback Period

Number of years to recover initial costs

Payback Period Rule:

Accept the project if it pays back within the specified time

Ranking Criteria

Choose project with the shortest payback period

Payback Period Disadvantages

Ignores the time value of money

Ignores cash flows after the payback period

A project rejected based on the payback criteria

may have a positive NPV (Biased against long-term projects)

A project accepted based on the payback criteria may not have a positive NPV

Requires an arbitrary acceptance criteria

Advantages:

Easy to understand and use

Discounted Payback Period:

number of years to recover initial costs taking the time value of money into account.

Minimum Acceptance Criteria for DPP

Accept the project if it pays back on a discounted basis within the specified time. (The specified time is set by management)

Estimating NPV:

1. Estimate future cash flows: how much? and when?
2. Estimate discount rate
3. Estimate initial costs

NPV Rule:

Minimum Acceptance Criteria: Accept if NPV > 0

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Ranking Criteria: Choose the highest NPV

IRR:

the discount rate that sets NPV to zero

IRR Rule:

Minimum Acceptance Criteria: – Accept if the IRR exceeds the required return.

• Ranking Criteria: – Select alternative with the highest IRR

• Reinvestment assumption: All future cash flows assumed reinvested at the IRR.

IRR Disadvantages

– Does not distinguish between investing and borrowing.

– IRR may not exist or there may be multiple IRR

IRR Advantages

Easy to understand and communicate

Mutually Exclusive Projects:

Only ONE of several potential projects can be chosen, e.g. acquiring an accounting system.

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– If a capital budgeting decision involves mutually exclusive projects, then when one project is taken on, the others must be rejected. Only one mutually exclusive project can be chosen, even if they are all acceptable. – RANK all (acceptable) alternatives and select the best one.

Independent Projects:

Accepting or rejecting one project does not affect the decision of the other projects.

* All independent projects can be chosen if they are all \\n acceptable.
* Must exceed a MINIMUM acceptance criteria.

Problems with the IRR Approach

For both independent and mutually exclusive projects:

Are we investing or financing? (page \\n 145) \\n - Multiple IRRs.

For mutually exclusive projects only:

The Scale Problem.

The Timing Problem.

“Investing type” of investment project:

Negative cashflow

“Financing type” of investment project:

Positive initial cashflow

The Scale Problem

Would you rather make 100% or 50% return on your investments?

What if the 100% return is on a $1 investment while the 50% return is on a $1,000 \\n investment?

The Timing Problem

The preferred project in this case depends on the discount rate, not the IRR.

Cash flows

Matter. Not accounting earnings

Incremental cash flows

Matter

Sunk costs

Don’t matter

Opportunity costs

Matter

Erosion and synergy

Matter

Taxes

Matters. We want incremental after-tax cash flows

\n Inflation

Matters

\n Sunk costs (already occurred) are not relevant

Just because “we have come this far” does not mean that we should continue to throw good money after bad.

Opportunity costs (lost revenue from the best alternative project) do matter.

Just because a project has a positive NPV that does not mean that it should also have automatic acceptance.

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Specifically if another project with a higher NPV would have to be passed up we should not proceed.

Side effects ( on other parts of the firm) matter.

If our new product causes existing customers to demand less (more) of current products, we need to recognize that.

Erosion:

a new project reduces the cash flows of existing products.

\n Synergy:

a new project increases the cash flows of existing products

Consider the relationship between interest rates and inflation, often referred to as the Fisher relationship:

(1 + Nominal Rate) = (1 + Real Rate) × (1 + Inflation Rate)

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While the nominal rate in the U.S. has fluctuated with inflation, most of the time the real rate has exhibited far less variance than the nominal rate.

\n Real cash flows

must be discounted at the real rate.

Nominal cash flows

must be discounted at the nominal rate.

There are times when application of the NPV rule can lead to the wrong decision. Consider a factory which must have an air cleaner.

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The \n equipment is mandated by law, so there is no “doing without”.

There are two choices:

The “Cadillac cleaner” costs $4,000 today, has annual \\n operating costs of $100 and lasts for 10 years.

The “Cheapskate cleaner” costs $1,000 today, has annual operating costs of $500 and lasts for 5 years.

\n Assumption:

Both projects can and will be repeated.

Matching Cycle

Repeat projects until they begin and end at the same time—like we just did with the air cleaners.

Compute NPV for the “repeated projects”.

The Equivalent Annual Cost Method

The Equivalent Annual Cost is the value of the level payment annuity that has the same PV as our original set of cash flows.

\n NPV = EAC × ArT

Where ArT is the present value of $1 per period for T periods when the discount rate is r.

For example, the EAC for the Cadillac air cleaner is $750.98

The EAC for the cheaper air cleaner is $763.80 which confirms our earlier decision to reject it.