Download Chapter 6 --Alternate Measures of Capital Investment Desirability

Chapter 6 --Alternate Measures of
Capital Investment Desirability

Goals for this chapter:
 Know
how to calculate the following measures of
investment desirability:
Net present value
 Profitability index
 Internal rate of return
 Payback period

 Strengths
Modified profitability index
Modified internal rate of return
Present value payback
and weaknesses of various methods
 Know the reasons for multiple measures and when each
would be appropriately used in reality
Calculating a Net Present Value
 Steps
to calculate the net present value:
Step 1 -- Lay out the years and cash flows
Step 2 -- Discount back to present with the
NPV function
Step 3 -- Net the result of step 2 with the
initial outlay
Calculating a Profitability Index
 Steps
to calculate the profitability index:
Step 1 -- Calculate the net present value
Step 2 -- Use the formula in the book to
calculate the PI
PI = 1 + NPV/ Initial outlay (always
positive)
What Does the Profitability Index
Measure?
The
wealth created per dollar of initial
outlay
The margin of safety or margin for error
When Would You Use the
Profitability Index?
 As
a very crude short cut when your firm is facing capital
rationing
 Capital rationing may exist when the firm is not large
enough or profitable enough to raise money in the capital
markets
 This is not uncommon for small, new or rapidly growing
businesses
 You must still watch for size differentials
 Might use this when you cannot see all your projects at one
time (which is often the case)
The Modified Profitability Index
 Steps
to calculate the Modified Profitability Index:
 Calculate the NPV
 Start at the rightmost negative number
 Discount the amount in step 2 back one year by dividing by the 1+
the interest rate
 Net step three with that year’s cash flow
 If negative, continue steps 3 and 4
 If positive, stop, this is a self financing project and MPI = PI
 When arriving at 0 you have the additional investment
 Add the additional investment to the initial outlay to get the initial
commitment
 Use the formula MPI = 1 + NPV / Initial commitment (always
positive)
Strengths of the Modified
Profitability Index
 Strengths
of the modified profitability index over the
profitability index
 It tells you the up front initial commitment needed
to finish the project
 You can use this to:
 Ask the regulators for rate hikes or commitments
 Raise the appropriate amount of money up front
rather than at many points in the future.
(negative signal and costly)
Calculating the Internal
Rate of Return
 Steps
to calculate the internal rate of return:
Lay out the years and cash flows
Discount back to present with
the IRR function on the calculator as
described in earlier chapters
Must use the goal seek tool (under the
tools menu) on the computer if you have
mid-year cash flows
Weaknesses of the
Internal Rate of Return
 Weaknesses
of the internal rate of return:
It assumes that new projects will come along
in future years that will pay at least the
internal rate of return (reinvestment rate
assumption
It ignores the size of the project
Calculating the Modified
Internal Rate of Return
 Steps
to calculate the modified internal rate of return:
Begin with year 1 and grow to the end of the project
by multiplying by 1 plus the discount rate raised to the
remaining years
Do this for all remaining cash flows
Sum the terminal values
Fill the intermediate years with zeros
Use the IRR function to solve for the modified IRR
Strengths of the Modified
Internal Rate of Return
 Strengths
 It
of the modified internal rate of return:
eliminates the reinvestment rate assumption
 There appears to be many cases where companies in
the US are generating more cash than worthwhile
projects. In this case, the MIRR may give a better
indication of the return from the project
 MIRR is a worst case scenario which assumes that
excess cash is used to retire debt and equity. By
definition this action earns the cost of money
Calculating a Payback Period
 Steps
to calculating the payback period:
Lay out your years and cash flow
Accumulate the cash flows
Identify where the accumulation goes from
negative to positive
Use the year on the left
Use the result in step 4 and add the amount
needed divided by the amount received
Strengths and Weaknesses of the
Payback Period Method
 Weaknesses
of the payback method:
It ignores the time value of money
It ignores all cash flows after the payback
period
It ignores risk
 Strengths of the payback method:
It is a measure of liquidity
It can be used as a short cut in industries
where the product life is very short
Calculating the Present Value Payback
Period
 Steps
to calculate the present value payback
 Lay out the years and cash flows
 Bring the cash flows back to present by dividing by (1 +
discount rate) raised to the number of years
 Accumulate the cash flows

the accumulation should equal the NPV in the last year
 Identify
where the accumulation goes from negative to
positive
 Use the year on the left
 Use the result in step 4 and add the amount needed divided
by the present value amount received
The Accounting Rate of Return
 Calculating
the accounting rate of return
There are many different ways to calculate
an accounting rate of return
All of these methods ignore the time value of
money
Reasons for Multiple Measures
Different
measures for different
circumstances
Multiple measure allow members of the
committee to use the measures with
which they are comfortable
Multiple measures may provide better
information