The Basic Idea An investment is "good" if it creates value for its owners. In corporate finance, a good investment creates value for the shareholders. In a nutshell, the Net Present Value (NPV) is the difference between the present value of the inflows and the present value of the outflow of an investment. True or False: Net present value is a measure of how much value is created or added today by undertaking an investment. CONCEPT CHECK
Estimating Net Present Value The process of estimating a net present value is called Discounted Cash Flow (DCF) (KEY TERM) valuation. The process is summarized here
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. Decision rule: A project is acceptable if its NPV is greater than zero.
Defining the Rule The Payback Period is defined as the number of years necessary to recoup the original outlay for the project. According to this rule, an investment is acceptable if its calculated payback period is less than some prespecified number of years.
Analyzing the Rule The Payback Period rule is an imperfect decision-making tool because: (1) there is no objective basis for determining the optimal cutoff period, (2) the time value of money is ignored, and (3) cash flows beyond the cutoff date are ignored. True or False: Reliance on the payback rule is likely to bias the decision-maker towards shorter-term investments. CONCEPT CHECK
Redeeming Qualities of the Rule Conversely, the payback rule has a number of positive features: (1) it is easy to use and, therefore, useful for projects that are too small to warrant more detailed analysis, (2) it is biased toward liquidity, (3) it (crudely) adjusts for the increased riskiness of later project cash flows.
Summary of the Rule
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The payback period rule can be thought of as a kind of "break-even" measure because it is the length of time needed for a project to break even in an accounting (although not necessarily an economic) sense.
The Average Accounting Return
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The Average Accounting Return (AAR) is defined as: Average Project Net Income/Average Project Book Value. According to the decision rule, a project is acceptable if its expected AAR exceeds a target AAR. Like the payback period technique, the AAR technique has both advantages and disadvantages
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Defining the Rule The Internal Rate of Return (IRR) is the discount rate that equates the present value of a project's inflows and its cost; i.e., the rate that results in a NPV of zero. The decision rule is: An investment is acceptable if the IRR exceeds its required return.
Problems with the IRR
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The IRR technique is not without its problems.
Nonconventional Cash Flows
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- If an investment's cash flows are not "conventional" (i.e., an outflow followed by a series of inflows), it is possible to compute more than one mathematically correct IRR.
Mutually Exclusive Investments
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If two investments, X and Y, are mutually exclusive, then taking one means forgoing investment in the other. One technique for analyzing mutually exclusive investments is the NPV Profile (KEY TERM). True or False: Mutually exclusive projects must be evaluated together (i.e., at the same time). CONCEPT CHECK
Redeeming Qualities of the IRR Although problems can arise with the use of the IRR technique, it is widely used in practice because it is closely related to NPV, and it is easy to understand and communicate. True or False: All else equal, an investment that is acceptable under the NPV Rule will be also be acceptable under the IRR rule. CONCEPT CHECK
The Profitability Index
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The Profitability Index (PI) is the ratio of the present value of the inflows of the investment to its cost. Decision rule: An investment is acceptable if its PI exceeds 1.0. The PI is useful because it can be used when comparing projects of different size, and when one wishes to rank mutually exclusive projects. True or False: All else equal, an investment that is acceptable under the NPV Rule will be also be acceptable under the IRR rule, and under the PI rule. CONCEPT CHECK
The Practice of Capital Budgeting
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It should be remembered that an NPV or IRR computed prior to undertaking the project is only an estimates of the true NPV or IRR, because the latter can't be known until the project's life is over. Thus, decision-makers will use multiple analytical techniques in evaluating investments.
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