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Rushen Chahal
CHAPTER 9
CHAPTER OUTLINE
I. Methods for evaluating projects A. The payback period method 1. The payback period of an investment tells the number of years required to recover the initial investment. The payback period is calculated by adding the cash inflows up until they are equal to the initial fixed investment. Although this measure does, in fact, deal with cash flows and is easy to calculate and understand, it ignores any cash flows that occur after the payback period and does not consider the time value of money within the payback period. To deal with the criticism that the payback period ignores the time value of money, some firms use the discounted payback period method. The discounted payback period method is similar to the traditional payback period except that it uses discounted free cash flows rather than actual undiscounted free cash flows in calculating the payback period. The discounted payback period is defined as the number of years needed to recover the initial cash outlay from the discounted free cash flows.
2.
3.
4.
226
t =1
FCFt (1 + k) t
- IO
b.
The advantage of this approach is that it takes the time value of money into consideration in addition to dealing with cash flows.
2.
The profitability index is the ratio of the present value of the expected future free cash flows to the initial cash outlay, or profitability index = a.
t =1
FCFt (1 + k) t IO
b. c.
The advantages of this method are the same as those for the net present value. Either of these present-value methods will give the same accept-reject decisions to a project.
227
t =1
FCFt (1 + IRR) t
The acceptance-rejection criteria are: accept if IRR required rate of return reject if IRR < required rate of return The required rate of return is often taken to be the firm's cost of capital.
2.
The advantages of this method are that it deals with cash flows and recognizes the time value of money; however, the procedure is rather complicated and time-consuming. The net present value profile allows you to graphically understand the relationship between the internal rate of return and NPV. A net present value profile is simply a graph showing how a projects net present value changes as the discount rate changes. The IRR is the discount rate at which the NPV equals zero. The primary drawback of the internal rate of return deals with the reinvestment rate assumption it makes. The IRR implicitly assumes that the cash flows received over the life of the project can be reinvested at the IRR while the NPV assumes that the cash flows over the life of the project are reinvested at the required rate of return. Since the NPV makes the preferred reinvestment rate assumption it is the preferred decision technique. The modified internal rate of return (MIRR) allows the decision maker the intuitive appeal of the IRR coupled with the ability to directly specify the appropriate reinvestment rate. a. To calculate the MIRR we take all the annual free tax cash inflows, ACIFt's, and find their future value at the end of the project's life compounded at the required rate of return - this is called the terminal value or TV. All cash outflows, ACOFt, are then discounted back to present at the required rate of return. The MIRR is the discount rate that equates the present value of the free cash outflows with the present value of the project's terminal value. If the MIRR is greater than or equal to the required rate of return, the project should be accepted.
3.
b.
228
9-2.
These final two advantages are the major reasons why it is used frequently. 9-3. Yes. The payback period eliminates projects whose returns do not materialize until later years and thus emphasizes the earliest returns, which in a country experiencing frequent expropriations would certainly have the most amount of uncertainty surrounding the later returns. In this case, the payback period could be used as a rough screening device to filter out those riskier projects, which have long lives. The three, discounted cash flow capital budgeting criteria are the net present value, the profitability index, and the internal rate of return. The net present value method gives an absolute dollar value for a project by taking the present value of the benefits and subtracting out the present value of the costs. The profitability index compares these benefits and costs through division and comes up with a measure of the project's relative valuea benefit/cost ratio. On the other hand, the internal rate of return tells us the rate of return that the project earns. In the capital budgeting area, these methods generally give us the same accept-reject decision on projects but many times rank them differently. As such, they have the same general advantages and disadvantages, although the calculations associated with the internal rate of return method can become quite tedious and it assumes cash flows over the life of the life of the project are reinvested at the IRR. The advantages associated with these discounted cash flow methods are: (1) They deal with cash flows rather than accounting profits. (2) They recognize the time value of money. (3) They are consistent with the firm's goal of shareholder wealth maximization.
9-4.
229
230
9-3A. (a)
$2,000 (1 + IRR)1
$8,000 (1 + IRR) 3
= = =
$2,000(0.847) + $5,000 (0.718) + $8,000 (0.609) $1,694 + $3,590 + $4,872 $10,156 $2,000 (0.840) + $5,000 (0.706) + $8,000 (0.593) $1,680 + $3,530 + $4,744 $9,954 approximately 19% $5,000 $2,000 + + (1 + IRR)1 (1 + IRR) 2 (1 + IRR) 3 $8,000 (0.769) + $5,000 (0.592) + $2,000 (0.455) $6,152 + $2,960 + $910 $10,022 $8,000 (0.763) + $5,000 (0.583) + $2,000 (0.445) $6,104 + $2,915 + $890 $9,909 approximately 30% $8,000
(b)
= = =
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t =1
$2,000 (1 + IRR) t
$5,000 (1 + IRR )6
$450,000 (1 + .09) t
- $1,950,000
$450,000 (4.486) - $1,950,000 $2,018,700 - $1,950,000 = $68,700 $2,018,700 $1,950,000 1.0352 $450,000 [PVIFAIRR%,6 yrs] PVIFAIRR%,6 yrs about 10% (10.1725%)
232
Year 0 1 2 3 4 5 6
Discounted Payback Period = 5.0 + 4,200/11,280 = 5.37 years. (b) NPV = = = (c) PI = = (d) $80,000 4.000 IRR 9-6A. (a) NPVA = = = = = = NPVB = = =
t =1
$20,000 (1 + .10) t
- $80,000
$20,000 (4.355) - $80,000 $87,100 - $80,000 = $7,100 $87,100 $80,000 1.0888 $20,000 [PVIFAIRR%,6 yrs] PVIFAIRR%,6 yrs about 13% (12.978%)
t =1 6
$12,000 (1 + .12) t
- $50,000
$13,000 (1 + .12) t
- $70,000
233
Neither project should be accepted. 9-7A. (a) Project A: Payback Period = 2 years + $100/$200 = 2.5 years Project A: Discounted Payback Period Calculations: Undiscounted Cash Flows PVIF10%,n -$1,000 600 300 200 100 500 1.000 .909 .826 .751 .683 .621 Discounted Cash Flows -$1,000 545 248 150 68 311 Cumulative Discounted Cash Flows -$1,000 -455 -207 -57 11 322
Year 0 1 2 3 4 5
234
Year 0 1 2 3 4 5
Discounted Payback Period = 3.0 + 724/2,049 = 3.35 years. Project C: Payback Period = 3 years + $1,000/$2,000 = 3.5 years Project C: Discounted Payback Period Calculations: Year 0 1 2 3 4 5 Undiscounted Cash Flows -$5,000 1,000 1,000 2,000 2,000 2,000 PVIF10%,n 1.000 .909 .826 .751 .683 .621 Discounted Cash Flows -$5,000 909 826 1,502 1,366 1,242 Cumulative Discounted Cash Flows -$5,000 -4,091 -3,265 -1,763 -397 845
235
9-8A. NPV9%
= = =
t =1
- $5,000,000
NPV11%
= = =
$1,000,000 (1 + .11) t
- $5,000,000
NPV13%
= = =
NPV15%
= = =
$1,000,000 (1 + .15) t
- $5,000,000
$20,000 (1 + IRR A )3
$25,000 (1 + IRR A )
$30,000 (1 + IRR A )5
236
$10,000(.813) + $15,000(.661) + $20,000(.537) + $25,000(.437) + $30,000(.355) $8,130 + $9,915 + $10,740 + $10,925 + $10,650 $50,360 $10,000(.806) + $15,000(.650) +$20,000(.524) + $25,000(.423) + $30,000(.341) $8,060 + $9,750 + $10,480 + $10,575 + $10,230 $49,095 just over 23% $25,000 [PVIFAIRR%,5 yrs] PVIFAIRR%,5 yrs 8%
= = = =
$18,000 (1 + .10) t
- $100,000
$18,000 (1 + .15) t
- $100,000
If the required rate of return is 10% the project is acceptable as in part (a).
237
= = =
$18,000 [PVIFAIRR%,10 yrs] PVIFAIRR%,10 yrs Between 12% and 13% (12.41%)
t =0 n
ACOFt (1 + k) t
t =0
$10,000,000 $10,000,000 $10,000,000 MIRR (b) $10,000,000 $10,000,000 $10,000,000 MIRR (c) $10,000,000 $10,000,000 $10,000,000 MIRR
= = = = = = = = = = = =
$3,000,000 (FVIFA10%10years ) $3,000,000(15.937 ) (1 + MIRR )10 $47,811,000 (1 + MIRR )10 16.9375% $3,000,000 (FVIFA12%10years ) (1 + MIRR)10 $3,000,000(17.549) (1 + MIRR )10 $52,647,000 (1 + MIRR )10 18.0694% $3,000,000(FVIFA14%10 years ) (1 + MIRR )10 $3,000,000(19.337 ) (1 + MIRR )10 $58,011,000 (1 + MIRR )10 19.2207%
238
2.
3.
2.75 years
Project B should be accepted while project A should be rejected. 4. The disadvantages of the payback period are: 1) ignores the time value of money, 2)ignores cash flows occurring after the payback period, 3)selection of the maximum acceptable payback period is arbitrary. Discounted Payback Period Calculations, Project A: Undiscounted Cash Flows -$110,000 20,000 30,000 40,000 50,000 70,000 Discounted Cash Flows -$110,000 17,860 23,910 28,480 31,800 39,690 Cumulative Discounted Cash Flows -$110,000 -92,140 -68,230 -39,750 -7,950 31,740
5.
Year 0 1 2 3 4 5
239
Year 0 1 2 3 4 5
Discounted Payback Period = 3.0 + 13,920/25,440 = 3.55 years. Using the discounted payback period method and a 3-year maximum acceptable project hurtle, neither project should be accepted. 6. The major problem with the discounted payback period comes in setting the firm's maximum desired discounted payback period. This is an arbitrary decision that affects which projects are accepted and which ones are rejected. Thus, while the discounted payback period is superior to the traditional payback period, in that it accounts for the time value of money in its calculations, its use should be limited due to the problem encountered in setting the maximum desired payback period. In effect, neither method should be used. NPVA = =
7.
t =1
FCFt (1 + k) t
- IO
$20,000(PVIF12%, 1 year) + $30,000 (PVIF12%, 2 years) + + $40,000(PVIF12%, 3 years) + $50,000 (PVIF12%, 4 years) $70,000(PVIF12%, 5 years) - $110,000 (.636) + $70,000 (.567) - $110,000
= = = = NPVB = = = =
$20,000(.893) + $30,000 (.797) + $40,000 (.712) + $50,000 $17,860 + $23,910 + $28,480 + $31,800 + $39,690 - $110,000 $141,740-$110,000 $31,740 $40,000(PVIFA12%, 5 years) - $110,000 $40,000(3.605) - $110,000 $144,200-$110,000 $34,200
240
9.
PIA
= = PIB = = 10.
Both projects should be accepted The net present value and the profitability index always give the same accept reject decision. When the present value of the benefits outweighs the present value of the costs the profitability index is greater than one, and the net present value is positive. In that case, the project should be accepted. If the present value of the benefits is less than the present value of the costs, then the profitability index will be less than one, and the net present value will be negative, and the project will be rejected. For both projects A and B all of the costs are already in present dollars and, as such, will not be affected by any change in the required rate of return or discount rate. All the benefits for these projects are in the future and thus when there is a change in the required rate of return or discount rate their present value will change. If the required rate of return increased, the present value of the benefits would decline which would in turn result in a decrease in both the net present value and the profitability index for each project. IRRA IRRB 13. = = 20.9698% 23.9193%
11.
12.
The required rate of return does not change the internal rate of return for a project, but it does affect whether a project is accepted or rejected. The required rate of return is the hurdle rate that the project's IRR must exceed in order to accept the project. The net present value assumes that all cash flows over the life of the project are reinvested at the required rate of return, while the internal rate of return implicitly assumes that all cash flows over the life of the project are reinvested over the
14.
241
ACOFt (1 + k) t
t =0
t =0
ACIFt (1 + k) n t (1 + MIRR) n
$110,000
$20,000(FV IF12% , 4 years) + $30,000(FV IF12% , 3 years) + $40,000(FV IF12% , 2 years) + $50,000(FV IF12% , 1 year) + $70,000 (1 + MIRR A ) 5 $20,000(1.574) + $30,000(1.405) + $40,000(1.254) + $50,000(1.120) + $70,000 (1 + MIRR A ) 5 $31,480 + $42,150 + $50,160 + $56,000 + $70,000 (1 + MIRR A ) 5 $249,790 (1 + MIRR A )5 17.8247%
$110,000
= = =
$40,000(FV IFA12% ,5years ) (1 + MIRR B )5 $40,000(6. 353) (1 + MIRR B )5 $254,120 (1 + MIRR B )5 18.2304%
$110,000
$110,000 MIRRB
= =
Both projects should be accepted because their MIRR exceeds the required rate of return. The modified internal rate of return is superior to the internal rate of return method because MIRR assumes the reinvestment rate of cash flows is the required rate of return.
242
Thus, IRR = (c) $10,000 0.083 Thus, IRR (d) $10,000 0.519 Thus, IRR 9-2B. (a) IO $10,000 4.66 Thus, IRR (b) $10,000 5.102 Thus, IRR (c) $10,000 7.163 Thus, IRR (d) $10,000 3.128 Thus, IRR = = = = = = = = = = = = = = = = = = =
243
$3,000 (1 + IRR)
1
$5,000 (1 + IRR)
2
$7,500 (1 + IRR) 3
$3,000(0.826) + $5,000 (0.683) + $7,500 (0.564) $2,478+ $3,415 + $4,230 $10,123 $3,000 (0.820) + $5,000 (0.672) + $7,500 (0.551) $2,460 + $3,360 + $4,132.50 $9,952.50 approximately 22% $9,000 (1 + IRR)
1
= =
$6,000 (1 + IRR)
2
$2,000 (1 + IRR) 3
$9,000 (0.800) + $6,000 (0.640) + $2,000 (0.512) $7,200 + $3,840 + $1,024 $12,064
t =1
$2,000 (1 + IRR)
t
$5,000 (1 + IRR) 6
244
$750,000 (1 + .11) t
- $2,500,000
$750,000 (4.231) - $2,500,000 $3,173,250 - $2,500,000 $673,250 $3,173,250 $2,500,000 1.2693 $750,000 [PVIFAIRR%,6 yrs] PVIFAIRR%,6 yrs about 20% (19.90%)
Yes, the project should be accepted. Payback Period = $160,000/$40,000 = 4 years NPV = = =
t =1
$40,000 (1 + .10) t
- $160,000
$40,000 (4.355) - $160,000 $174,200 - $160,000 = $14,200 $174,200 $160,000 1.0888 $40,000 [PVIFAIRR%,6 yrs] PVIFAIRR%,6 yrs about 13% (12.978%)
t =1 6
(c)
PI
= =
(d)
= = = = = =
9-6B. (a)
NPVA
$12,000 (1 + .12) t
- $45,000
NPVB
= =
$14,000 (1 + .12) t
- $70,000
245
$57,554 - $70,000 = -$12,446 $49,332 $45,000 1.0963 $57,554 $70,000 0.822 $12,000 [PVIFAIRR%,6 yrs] PVIFAIRR%,6 yrs 15.34% $14,000 [PVIFAIRR%,6 yrs] PVIFAIRR%,6 yrs 5.47%
= = = = = =
Project A should be accepted. = = = 2 years 2 years + $1,000/$3,000 = 2.33 years 3 years + $1,000/$2,000 = 3.5 years Payback Period Method Accept Accept Reject $2,500,000 (1 + .09) t
9-8B. NPV9%
= = =
t =1
- $10,000,000
NPV11% =
$2,500,000 (1 + .11) t
- $10,000,000
246
$2,500,000 (1 + .13) t
- $10,000,000
$2,500,000 (1 + .15) t
- $10,000,000
$25,000 (1 + IRR A )
$30,000 (1 + IRR A )5
247
t =1
$25,000 (1 + .15) t
- $150,000
If the required rate of return is 9% the project is acceptable in part (a). It should be rejected in part (b) with a negative NPV. $150,000 = 6.000 IRR = = ACOFt (1 + k) t $25,000 [PVIFAIRR%,10 yrs] PVIFAIRR%,10 yrs Between 10% and 11% (10.558%) =
t =0 n-t ACIFt (1 + k) n
9-11B. (a)
t= 0
(1 + MIRR) n (1 + MIRR) 8
= = = = =
$2,000,000 (FVIFA10% ,8years ) $2,000,000 (11.436) (1 + MIRR)8 $22,872000 (1 + MIRR) 8 14.0320% $2,000,000 (FVIFA12% ,8years ) (1 + MIRR) 8
248
FORD'S PINTO (Ethics in Capital Budgeting) OBJECTIVE: To force the students to recognize the role ethical behavior plays in all areas of Finance. Easy
With ethics cases there are no right or wrong answers - just opinions. Try to bring out as many opinions as possible without being judgmental.
249