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Chapter 11 Investment Decision Criteria

Chapter 11 Investment Decision Criteria. Slide Contents. Learning Objectives Principles Applied in This Chapter An Overview of Capital Budgeting Net Present Value Other Investment Criteria A Glance at Actual Capital-Budgeting Practices Key Terms. Learning Objectives.

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Chapter 11 Investment Decision Criteria

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  1. Chapter 11Investment Decision Criteria

  2. Slide Contents • Learning Objectives • Principles Applied in This Chapter • An Overview of Capital Budgeting • Net Present Value • Other Investment Criteria • A Glance at Actual Capital-Budgeting Practices • Key Terms

  3. Learning Objectives • Understand how to identify the sources and types of profitable investment opportunities. • Evaluate investment opportunities using net present value and describe why net present value is the best measure to use.

  4. Learning Objectives (cont.) • Use the profitability index, internal rate of return, and payback criteria to evaluate investment opportunities. • Understand current business practice with respect to the use of capital-budgeting criteria.

  5. Principles Applied in This Chapter • Principle 1: Money Has a Time Value. • Principle 2: There is a Risk-Return Tradeoff. • Principle 3: Cash Flows Are the Source of Value. • Principle 5: Individuals Respond to Incentives.

  6. 11.1 An Overview of Capital Budgeting

  7. Disney’s Capital Budgeting Decision Disney’s decision to invest $17.5 million to build Disneyland park in California is an example of a major capital budgeting decision. How did this decision impact Disney?

  8. The Typical Capital-Budgeting Process • Phase I: The firm’s management identifies promising investment opportunities. • Phase II: The investment opportunity’s value- creating potential (for shareholders) is thoroughly evaluated.

  9. Types of Capital Investment Projects • Revenue enhancing Investments, • Cost-reduction investments, and • Mandatory investments that are a result of government mandates

  10. Types of Capital Investment Projects (cont.) To determine the desirability of investment proposals, we can use several analytical tools such as: Net Present Value (NPV), Equivalent Annual Cost (EAC), the Profitability Index (PI), the Internal Rate of Return (IRR), and the discounted payback period.

  11. 11.2 Net Present Value

  12. Net Present Value • The net present value (NPV) is the difference between the present value of cash inflows and the cash outflows. NPV estimates the amount of wealth that the project creates. • Decision Criteria: Investment projects should be accepted if the NPV of the project is positive and should be rejected if the NPV is negative.

  13. Calculating an Investment’s NPV

  14. Calculating the NPV CHECKPOINT 11.1: CHECK YOURSELF

  15. The Problem Saber Electronics provides specialty manufacturing services to defense contractors located in the Seattle, WA area. The initial outlay is $3 million and, management estimates that the firm might generate cash flows for years one through five equal to $500,000; $750,000; $1,500,000; $2,000,000; and $2,000,000. Saber uses a 20% discount rate for projects of this type. Is this a good investment opportunity?

  16. Step 1: Picture the Problem k=20% Years Cash flows -$3M +$0.5M +$0.75M +$1.5M $2M $2M (in $ millions) 0 1 2 3 4 5 Net Present Value =?

  17. Step 2: Decide on a Solution Strategy • We need to analyze if this is a good investment opportunity. We can do that by computing the Net Present Value (NPV), which requires computing the present value of all cash flows. • We can compute the NPV by using a mathematical formula, a financial calculator or a spreadsheet.

  18. Step 3: Solve Using a Mathematical Formula

  19. Step 3: Solve (cont.) • NPV = -$3m + $.5m/(1.2) + $.75m/(1.2)2 + $1.5m/(1.2)3 + $2m/(1.2)4 + $2m/(1.2)4 • NPV = -$3,000,000 + $416,666.67 + $520,833.30 + $868,055.60 + $964,506 + $803,755.10 • NPV = $573,817

  20. Step 3: Solve (cont.) Using an Excel Spreadsheet NPV = NPV (discount rate, CF1-5 ) + CF0 = NPV(.20, 500000, 750000, 1500000, 2000000,2000000) - 3000000 = $573,817

  21. Step 4: Analyze • The project requires an initial investment of $3,000,000 and generates futures cash flows that have a present value of $3,573,817. Consequently, the project cash flows are $573,817 more than the required investment. • Since the NPV is positive, the project is an acceptable project.

  22. Independent Versus Mutually Exclusive Investment Projects • An independent investment project is one that stands alone and can be undertaken without influencing the acceptance or rejection of any other project. • Accepting a mutually exclusive project prevents another project from being accepted.

  23. Evaluating an Independent Investment Opportunity It requires two steps to evaluate: • Calculate NPV; • Accept the project if NPV is positive and reject if it is negative.

  24. Evaluating Mutually Exclusive Investment Opportunities Following are two situations where firm is faced with mutually exclusive projects: • Substitutes – When a firm is analyzing alternative investments, and each performs the same function. • Firm Constraints – Firm faces constraints such as limited managerial time or limited financial capital that limit its ability to invest in all the positive NPV projects.

  25. Choosing Between Mutually Exclusive Investments • If mutually exclusive investments have equal lives, we will calculate the NPVs and choose the one with the higher NPV. • If mutually exclusive investments do not have equal lives, we must calculate the Equivalent Annual Cost (EAC), the cost per year. We will then select the one that has a lower EAC.

  26. Choosing Between Mutually Exclusive Investments (cont.) Computation of EAC

  27. Calculating the Equivalent Annual Cost CHECKPOINT 11.2: CHECK YOURSELF

  28. The Problem What is the EAC for a machine that costs $50,000, requires payment of $6,000 per year for maintenance and operation expense, and lasts for 6 years? You may assume that the discount rate is 9% and there will be no salvage value associated with the machine. In addition, you intend to replace this machine at the end of its life with an identical machine with identical costs.

  29. Step 1: Picture the Problem k=9% Years Cash flows -$50 -$6 -$6 -$6 -$6 -$6 -$6 (in $, thousands) 0 1 2 3 4 5 6 EAC =?

  30. Step 2: Decide on a Solution Strategy Here we need to calculate the EAC, which will tell us the annual cost for a machine that lasts 6 years. EAC can be computed using a mathematical formula or financial calculator.

  31. Step 3: Solve Using a Mathematical Formula It requires 2 steps: • Computation of NPV • Computation of EAC

  32. Step 3: Solve (cont.) NPV = -$50,000 + PV of $6,000 each year = -$50,000 + -$6,000 (PV of Annuity Factor) = -$50,000 + -$6,000 {[1-(1/(1.09)6] ÷ (.06)} = -$50,000 + -$6,000 {4.4859) = -$76,915

  33. Step 3: Solve (cont.) EAC = NPV ÷ Annuity Factor = -$76,915 ÷ 4.4859 = -$17,145.95

  34. Step 3: Solve (cont.) Using a Financial Calculator • Data and Key InputDisplay CF; -50000; ENTER CFO=-50000 ;-6000; ENTER CO1=-6000 ;6; ENTER FO1=6.00 NPV;8; ENTER i=8 CPT NPV=-77,372

  35. Step 3: Solve (cont.) Enter • N = 6 • 1/y = 9 • PV = -76915 • FV = 0 • PMT = -17,145.86 Thus EAC = $-17,145.86

  36. Step 4: Analyze EAC indicates the annual cost that is adjusted for time value of money. Here EAC is equal to $17,145.86.

  37. 11.3 Other Investment Criteria

  38. Profitability Index The profitability index (PI) is a cost-benefit ratio equal to the present value of an investment’s future cash flows divided by its initial cost.

  39. Profitability Index (cont.) Decision Criteria: • If PI is greater than one, the NPV will be positive and the investment should be accepted • When PI is less than one, which indicates a bad investment, NPV will be negative and the project should be rejected.

  40. Calculating the Profitability Index CHECKPOINT 11.3: CHECK YOURSELF

  41. The Problem PNG Pharmaceuticals is considering an investment in a new automated materials handling system that is expected to reduce its drug manufacturing costs by eliminating much of the waste currently involved in its specialty drug division. The new system will require an initial investment of $50,000 and is expected to provide cash savings over the next six-year period as shown on next slide.

  42. The Problem (cont.)

  43. Step 1: Picture the Problem k=10% Years Cash flows -$50 +$15 +$8 +$10 +$12 +$14 +$16 (in $, thousands) 0 1 2 3 4 5 6 PI =?

  44. Step 2: Decide on a Solution Strategy The PI for a project is equal to the present value of the project’s expected cash flows for years 1-6 divided by the initial outlay. PI = PV of expected cash flows ÷ -Initial outlay

  45. Step 3: Solve We can proceed in two steps: • Compute PV of expected cash flows by discounting the cash flows from Year 1 to Year 6 at 10%. PVt = CFt÷(1.09)t • Compute PI

  46. Step 3: Solve (cont.) Step 1: Computing PV of Cash Inflows

  47. Step 3: Solve (cont.) Step 2: Compute the PI PI = PV of expected CF1-6 ÷ Initial Outlay = $53,681.72 ÷ $50,000 = 1.073

  48. Step 4: Analyze • PNG Pharmaceuticals requires an initial investment of $50,000 and provides future cash flows that have a present value of $53,681.72. Thus, PI is equal to 1.073. • It is an acceptable project since PI is greater than one.

  49. Internal Rate of Return The internal rate of return (IRR) of an investment is analogous to the yield to maturity (YTM) on a bond defined in Chapter 9. Specifically, the IRR is the discount rate that results in a zero NPV for the project.

  50. Internal Rate of Return

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