Investment Decisions: NPV, IRR, and Discounted Cash Flow
Chapter 8: NPV and Other Investment Criteria
NPV = PV – Initial Investment
A positive NPV means that the project is expected to add value to the firm and, therefore, will increase the wealth of the owner. Accept a project if NPV > 0.
IRR: The project’s expected return. If the cost of capital (required return) equals the IRR (expected return), the NPV = 0. A project’s IRR is the discount rate that makes its NPV = 0. Accept the project if the IRR is greater than r (the project’s cost of capital). Pitfalls include:
- Lending or borrowing (investing (good) or financing (bad))?
- If cash flows change signs more than once, you will have multiple internal rates of return. If you have more than one IRR, which do you use?
NPV Profile: An NPV profile plots the project’s NPV as a function of the discount rate. It shows both the NPV and IRR of the project.
Types of Projects:
- Conventional Projects: The first cash flow is negative, and all the rest are positive.
- Two projects are independent if undertaking one does not affect the other.
- Two projects are mutually exclusive if undertaking one precludes taking the other.
Payback period: Time until cash flows recover the initial investment of the project. Downfalls include that it ignores the time value of money, requires an arbitrary cutoff point, ignores cash flows beyond the cutoff date, and is biased against long-term projects such as R&D and new products.
Decision Rule: Accept the project if the payback period is less than a preset amount of time.
Profitability Index: = NPV / Initial Investment. It is the ratio of net present value to initial investment. Accept the project if the profitability is greater than 0. Pitfalls include using the profitability index decision rule in situations without capital rationing, which leads to erroneous choices, and using the profitability index without capital rationing wrongly favors small projects over large projects.
If there is a conflict between NPV and another decision, always use NPV.
NPV only fails when capital rationing exists; use the profitability ratio.
Chapter 9: Using Discounted Cash Flow Analysis
Incremental Cash Flows: Incremental cash flow = cash flow with project – cash flow without project. Include all indirect effects (both positive and negative side effects). Ignore sunk costs. Include opportunity costs. Recognize the investment in working capital.
Separation of Investment and Financing Decisions: When the cash flows of an investment are analyzed, how the investment is financed or the financing costs are ignored. How the project is financed and financing costs are variables affecting the opportunity rate of return used to discount the cash flows. The value of the investment is considered by itself, independent of financing choice.
Operating Cash Flow (OCF): Incremental cash flows from operations may be calculated in 3 ways:
- OCF = revenues – cash expenses – taxes
- OCF = net income + depreciation
- OCF = (revenues – cash expenses) x (1 – tax rate) + (tax rate x depreciation)
Depreciation: The depreciation expense used for capital budgeting should be the depreciation schedule required by the IRS for tax purposes. Depreciation itself is a non-cash expense. Consequently, it is only relevant because it affects taxes. Depreciation tax shield = D (depreciation expense) * T (marginal tax rate).
Computing Depreciation:
- Straight-line Depreciation: D = (Initial Cost – Book Value) / number of years
- MARCS: Need to know which asset class is appropriate for tax purposes. Multiply the percentage given in the table by the initial cost. Depreciate to zero. The mid-year convention causes depreciation expense to be taken in one more year than specified by the property class.
Depreciation Tax Shield Comparison: The MARCS provides a faster depreciation rate and tax shield recovery compared to the straight-line depreciation rate, which provides for equal depreciation amounts over the useful life of the project. The MARCS depreciation tax shield affects cash flow and is relevant for capital budgeting analysis.
After-Tax Salvage: If the salvage value is different from the book value of the asset, then there is a tax effect. Book value = initial cost – accumulated depreciation. After-tax salvage = salvage – T (salvage – book value).