NET PRESENT VALUE
Mod. 4.3 VCM
Net Present Value
The difference between the market value of a
project and its cost
How much value is created from undertaking an
investment?
🞑 The first step is to estimate the expected future cash flows.
🞑 The second step is to estimate the required return for
projects of this risk level.
🞑 The third step is to find the present value of the cash flows
and subtract the initial investment.
Project Example Information
You are reviewing a new project and have
estimated the following cash flows:
🞑 Year 0: CF = -165,000
🞑 Year 1: CF = 63,120; NI = 13,620
🞑 Year 2: CF = 70,800; NI = 3,300
🞑 Year 3: CF = 91,080; NI = 29,100
🞑 Average Book Value = 72,000
Your required return for assets of this risk level is
12%.
NPV – Decision Rule
If the NPV is positive, accept the project
A positive NPV means that the project is
expected to add value to the firm and will
therefore increase the wealth of the owners.
Since our goal is to increase owner wealth, NPV is a
direct measure of how well this project will meet
our goal.
Computing NPV for the Project
Using the formulas:
🞑 NPV = -165,000 + 63,120/(1.12) + 70,800/(1.12)2 +
91,080/(1.12)3 = 12,627.41
Do we accept or reject the project?
Discount Cash Flows not Profit
Calculate net present value you need
to discount cash flows, not accounting profits
For example, suppose that you are analyzing an
investment proposal. It costs $2,000 and is expected to bring in a cash
flow of
$1,500 in the first year and $500 in the second. You think that the
opportunity cost of capital is 10%
Discount Cash Flows not Profit
Payback Period
How long does it take to get the initial cost back in
a nominal sense?
Computation
🞑 Estimate the cash flows
🞑 Subtract the future cash flows from the initial cost until the
initial investment has been recovered
Decision Rule – Accept if the payback period
is less than some preset limit
Computing Payback for the Project
Assume we will accept the project if it pays back
within two years.
🞑 Year 1: 165,000 – 63,120 = 101,880 still to recover
🞑 Year 2: 101,880 – 70,800 = 31,080 still to recover
🞑 Year 3: 31,080 – 91,080 = -60,000 project pays back
in year 3
Do we accept or reject the project?
Advantages and Disadvantages of
Payback
Advantages Disadvantages
🞑 Easy to understand 🞑 Ignores the time value
of money
🞑 Requires an arbitrary
🞑 Adjustsfor cutoff point
uncertainty of later 🞑 Ignores cash flows
cash flows beyond the cutoff date
🞑 Biased against long- term
projects, such as
research and
development, and new
projects
Discounted Payback Period
Compute the present value of each cash flow and
then determine how long it takes to pay back on
a discounted basis
Compare to a specified required period
Decision Rule - Accept the project if it pays
back on a discounted basis within the
specified time
Computing Discounted Payback for the
Project
Assume we will accept the project if it pays back on a
discounted basis in 2 years.
Compute the PV for each cash flow and determine the
payback period using discounted cash flows
🞑 Year 1: 165,000 – 63,120/1.121 = 108,643
🞑 Year 2: 108,643 – 70,800/1.122 = 52,202
🞑 Year 3: 52,202 – 91,080/1.123 = -12,627 project pays
back
in year 3
Do we accept or reject the project?
Advantages and Disadvantages of
Discounted Payback
Advantages Disadvantages
🞑 Includes time value 🞑May reject positive NPV
of money investments
🞑 Easy to understand 🞑 Requires an arbitrary
🞑 Does not accept cutoff point
negative estimated 🞑 Ignores cash flows
NPV investments beyond the cutoff point
when all future cash 🞑 Biased against long- term
flows are positive projects, such as R&D
and new products
Internal Rate of Return
This is the most important alternative to NPV
It is often used in practice and is intuitively
appealing
It is based entirely on the estimated cash flows and
is independent of interest rates found elsewhere
IRR – Definition and Decision Rule
Definition: IRR is the return that makes the
NPV = 0
Decision Rule: Accept the project if the
IRR is greater than the required return
Computing IRR for the Project
Rate of Return= profit/investment
=C-investment/investment
You planned to invest $350,000 to get back a
cashflow of C=$400,000 in 1 year. Calculate rate
of return?
Do we accept or reject the project?
Advantages of IRR
Knowing a return is intuitively appealing
It is a simple way to communicate the value of a
project to someone who doesn’t know all the
estimation details
If the IRR is high enough, you may not need to
estimate a required return, which is often a
difficult task
Summary of Decisions for the
Project
Summary
Net Present Value Accept
Payback Period Reject
Discounted Payback Period Reject
Internal Rate of Return Accept
NPV Rule v/s Rate of Return Rule
NPV rule: Invest in any project that has a positive
NPV when cashflows are discounted at the
opportunity cost of capital (expected rate of
return).
Rate of Return rule: Invest in any project
offering a rate of return that is higher than the
opportunity cost of capital.
NPV vs. IRR
NPV and IRR will generally give us the same
decision
🞑 NPV=Initialinvestment + Cashflow(year1)/1+r
🞑 -$350,000+$400,000/1+1.143=0
Exceptions
🞑 Mutually exclusive projects
Initial investments are substantially different (issue of
scale)
Timing of cash flows is substantially different
IRR and Mutually Exclusive
Projects
Mutually exclusive projects
🞑 If you choose one, you can’t choose the other
🞑 Example: You can choose to attend graduate
school at either Harvard or Stanford, but not
both
Intuitively, you would use the following
decision rules:
🞑 NPV – choose the project with the higher
NPV
🞑 IRR – choose the project with the higher
IRR
Example With Mutually
Exclusive Projects
Period Project Project
The required return
A B
for both projects is
0 -500 -400 10%.
1 325 325
2 325 200 Which project
should you accept
IRR 19.43% 22.17% and why?
NPV 64.05 60.74
NPV Profiles
IRR for A =
$160.00
$140.00 19.43% IRR for B
$120.00
$100.00 = 22.17%
$80.00
Crossover Point = A
NPV
$60.00
$40.00
11.8%
B
$20.00
$0.00
0.05 0.1 0.15 0.2 0.25 0.3
($20.00) 0
($40.00)
Discount Rate
Conflicts Between NPV and IRR
NPV directly measures the increase in value to the
firm
Whenever there is a conflict between NPV and
another decision rule, you should always use
NPV
IRR is unreliable in the following situations
🞑 Nonconventional cash flows
🞑 Mutually exclusive projects
Profitability Index
Measures the benefit per unit cost, based on the
time value of money
A profitability index of 1.1 implies that for every
$1 of investment, we create an additional
$0.10 in value
This measure can be very useful in situations in
which we have limited capital
Profitability Index
Profitability Index (PI)= Net Present Value/ Initial
Invt
Project PV Invt NPV PI
J $4 $3 $1 1/3=0.33
K $6 $5 $1 1/5=0.20
L $ 10 $7 $3 3/7=0.43
M $8 $6 $2 2/6=0.33
N $5 $4 $1 ¼=0.25
Which project to be opted first?
🞑 Project L, J, M
The End