FIN222 Lecture Notes - Lecture 6: Net Present Value

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30 May 2018

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LECTURE 6. INVESTMENT

DECISION RULES

Investment Decisions

Objective

To select investments in real asets that will increase the value

of the firm.

Net Present Value (NPV)

Apply the concept of Valuation Principle:

𝑁𝑃𝑉 = 𝑃𝑉(𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠) – 𝑃𝑉(𝐶𝑜𝑠𝑡𝑠)

NPV Decision Rule:

• If mutually exclusive, choose the one with highest

positive NVP

• If independent:

o Accept positive NPV

o Reject negative NPV

As long as NPV is positive, the

decision will increase value of the firm

and is a good decision

Advantage: Correspond directly to the

impact of the project on the firm’s

value:

• positive NVP = $ increase

• negative NPV = $ decrease

Disadvantage: Relies on an accurate

estimation of the discount rate (r)

Payback Period

Payback Investment Rule: you should only accept a project if

its CFs pay back its initial investment within a pre-specified

period (aka cut-off point):

• If mutually exclusive, choose the one with shortest

payback period (that is less than cut-off point)

• If independent:

o Accept when shorter than cut-off point

o Reject when longer than cut-off point

Standard Payback Period:

1. calculate payback period: the amount of time it takes

to pay back the initial investment

Advantage:

• Simple to compute

• Favour liquidity

Disadvantage: Payback rule is not as

reliable as the NPV rule because:

• It ignores the time value of

money

• It ignores CFs after the

payback period

• No guidance on the right

payback cut-off

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Document Summary

To select investments in real asets that will increase the value of the firm. If mutually exclusive, choose the one with highest positive nvp. If independent: accept positive npv, reject negative npv. Payback investment rule: you should only accept a project if its cfs pay back its initial investment within a pre-specified period (aka cut-off point): If mutually exclusive, choose the one with shortest payback period (that is less than cut-off point) If independent: accept when shorter than cut-off point, reject when longer than cut-off point. Standard payback period: calculate payback period: the amount of time it takes to pay back the initial investment. As long as npv is positive, the decision will increase value of the firm and is a good decision. Advantage: correspond directly to the impact of the project on the firm"s value: positive nvp = $ increase, negative npv = $ decrease. Disadvantage: relies on an accurate estimation of the discount rate (r)

Related Questions

You have just completed your undergraduate degree, and one of your favorite courses was "Today's Entrepreneurs." In fact, you enjoyed it so much you have decided you want to "be your own boss." While you were in the program, your grandfather died and left you $300,000 to do with as you please. You are not an inventor, and you do not have a trade skill that you can market; however, you have decided that you would like to purchase at least one established franchise in the fast foods area, maybe two (if profitable). The problem is that you have never been one to stay with any project for too long, so you figure that your time frame is three years. After three years you will sell off your investment and go on to something else. You have narrowed your selection down to two choices; (1) Franchise L: Lisa's Soups, Salads, & Stuff and (2) Franchise S: Sam's Fabulous Fried Chicken. The net cash flows shown below include the price you would receive for selling the franchise in Year 3 and the forecast of how each franchise will do over the three-year period.

Franchise L's cash flows will start off slowly but will increase rather quickly as people become more health conscious, while Franchise S's cash flows will start off high but will trail off as other chicken competitors enter the marketplace and as people become more health conscious and avoid fried foods. Franchise L serves breakfast and lunch, while Franchise S serves only dinner, so it is possible for you to invest in both franchises. You see these franchises as perfect complements to one another: you could attract both the lunch and dinner crowds and the health conscious and not so health conscious crowds without the franchises' directly competing against one another. Here are the net cash flows (in thousands of dollars):

	Expected
	net cash flows
Year	Franchise S	Franchise L
0	($100)	($100)
1	70	10
2	50	60
3	20	80

Depreciation, salvage values, net working capital requirements, and tax effects are all included in these cash flows.

You also have made subjective risk assessments of each franchise, and concluded that both franchises have risk characteristics that require a return of 10 percent. You must now determine whether one or both of the projects should be accepted.

In order to do so please answer the following questions fully. Make sure to show a time line, the formula to be used, the steps taken to solve the problem (calculator or excel) and the final numerical answer when appropriate.

Questions:

Define the term net present value (NPV).

What is each franchise's NPV? Make sure to show the formula, steps and final answer.

Based on your answer which franchise would you select? Why?

Would your answer be different if the projects are independent or mutually exclusive? Why or why not?

Would the NPVs change, and therefore your answer, if the cost of capital changed? Why or why not?

Internal Rate of Return (IRR) â you may use a financial calculator or excel. (Worth 8 points)

What is the logic/idea behind the IRR method?

Calculate the IRR for each project. Make sure to show the formula, calculator or excel steps and final answer.

According to IRR, which franchise should be accepted if they are independent? Mutually exclusive? Why?

Would the franchises' IRRs change if the cost of capital changed? Why or why not?

Define the term modified IRR (MIRR).

Find the MIRRs for Franchise L and S. Make sure to show the formula, steps and final answer.

What are the MIRR's advantages and disadvantages vis-a-vis the regular IRR? What are the MIRR's advantages and disadvantages vis-a-vis the NPV?

What is the rationale for the payback method?

Calculate the payback period for each franchise. Make sure to show the formula, steps and final answer.

Calculate the discounted payback period for each franchise. Make sure to show the formula, steps and final answer.

According to the payback criterion, which franchise or franchises should be accepted if the firm's maximum acceptable payback is 2 years, and if Franchise L and S are independent? If they are mutually exclusive? Why?

What is the difference between the regular and discounted payback periods? Make sure to mention the advantage and disadvantage of each.

Based on the results obtained and everything that you have described above, which franchise would you ultimately choose if the projects are mutually exclusive? Explain in detail your decision and why you chose the model you did to make your final decision.

FIN222 Lecture Notes - Lecture 6: Net Present Value

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