Chapter 8 - NPV and Other Investment Criteria

Learning objectives:
1) calculate NPV of an investment
2) calculate IRR of a project adn know what to look out for when using the Internal rate or return rule.
3) explain why the payback rule doesn't always make shareholders better off.
4) use the net present value rule to analyze three common problems that involve competing projects
a) when to postpone an investment expenditure
b) how to choose between projects with unequal lives
c) when to replace equipment
5) Calculate the profitability index and use it to choose between projects when funds are limited.

The investment decision aka "Capital budgeting" is

Any expenditure made in the hope of generating more cash later is called a capital investment project, regardless of whether the cash outlay goes to tangible or intangible assets.

Every shareholder wants to make money, therefore they want the firm to invest in every project that is worth more than it costs.

The difference between a project's value and its cost is termed the Net Present Value.(NPV)

Companies should invest in projects with positive NPV.

When companies have to make choices, they should pick the projects that have the highest NPV per dollar invested (the Profitability index)

8.1 Net Present Value

Def - Opportunity cost of capital - expected rate of return given up by investing ina  project.

Def - Net Present Value: Present Value (PV) of cash flows minus investment.
The net present value rule states that managers increase shareholder's wealth by accepting all projects that are worth more than they cost. Therefore, they should accept all projects with a positive NPV.

Basic Financial Principle: a risky dollar is worth less than a safe one.

NPV = C0 + C1/(1+r) + C2/(1+r)^2 + ... CH/(1+r)^H

Calculation NPV 
1) forecast future cash flows- this is hard to do. NPV analysis is only as good as it's forecasts.

2) estimate opportunity cost of capital


Def - mutually exclusive projects: two or more projects that cannot be pursued simultaneously. When you need to choose amont mutually exclusive projects, the decision rule is simpe: Calculate the NPV of each alternative, and choose the highest positive NPV project

8.2 Payback and IRR
Def - payback period: time until cash flows recover the initial investment in teh project.

Payback is a simple mechanism for assessing profitability. Often looks at short term and small capital investments. Manager asks "What is the payback period?" "When will this be profitable?".

Def IRR - Internal Rate of Return. Discount rate at which project NPV = 0. See Figure 8-2.

Instead of doing NPV calc, companies often prefer to ask whether the project's return is higher or lower than the opportunity cost of capital (return on other investments at same risk level in the market).

TWO RULES FOR DECIDING WHETHER TO INVEST
1) The NPV Rule: Invest in any project that has a positive NPV when its cash flows are discounted at the opportunity cost of capital
2) Rate of Return Rule: Invest in any project offering a rate of return that is higher than the opportunity cost of capital.

More decision making criteria
Investment timing - should you buy a computer now or wait and think again next year?
The decision rule for investment timing is to choose the investment date that results in the highest net present value today. (see pg 241)

Long vs Short lived equipment - should the company save money today by installing cheaper machinery that will not last as long? Select the machine with the lowest equivalent annual annuity.

Def - equivalent annual annuity: the cash flow per period with the same present value as the cost of buying and operating a machine.

Equivalent Annual Annuity = Present value of costs/Annuity Factor

Replacing an old machine - When should existing machinery be replaced?

8.4 Capital Rationing

Def Capital Rationing - limit set on the amount of funds available for investment

Soft Rationing - limits set by management, not investors

Hard Rationing - the firm can't raise the money it needs.

Def profitability index - ratio of net present value to initial index.

If you have 5 investments all with positive NPV but limited funds, you need to select the projects that give the highest nPV per dollar of investment.

Table 8-3 has a good overview of investment decision rules