Chapter 6 --Alternate Measures of Capital Investment Desirability

1. 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 Modified profitability index • Internal rate of return Modified internal rate of return • Payback period Present value payback • Strengths and weaknesses of various methods • Know the reasons for multiple measures and when each would be appropriately used in reality

2. 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

3. 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)

4. What Does the Profitability Index Measure? • The wealth created per dollar of initial outlay • The margin of safety or margin for error

5. 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)

6. 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)

7. 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)

8. 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

9. 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

10. 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

11. Strengths of the Modified Internal Rate of Return • Strengths of the modified internal rate of return: • It 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

12. 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

13. 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

14. 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

15. 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

16. 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