Once a number of projects are identified as possiblities, their value must be calculated. The methods of doing so most often used include: calculating NET PRESENT VALUE, INTERNAL RATE OF RETURN, using the PAYBACK METHODor using the PROFITABILITY INDEX.
The first step in doing this is to calculate the cash flows for each project. There are three main categories of cash flows: initial investment, annual operating cash flows, which last for the life of the project, and termination cash flows.
INITIAL INVESTMENT=project cost-investment tax credits - sale of existing asset +/- tax effect of asset sale
ANNUAL OPERATING CASH FLOWS =earnings after tax + depreciation
TERMINATION CASH FLOWS= income from the sale +/- tax effect +/- recovery of net working capital
Once the cash flows are determined, a valuation method must be chosen.
II= initial investment
OFC= operating cash flows in year t
n= life span (in years) of the project
R(r)= project required rate of return
What this equation does is take future cash flows that the business is expected to produce with the project, and discount them to the present. Once this is done, NPV is found as the difference between the present value of the future cash flows and the cost of investment.
Suppose we are given the task of deciding whether or not a new special addition soccer ball should be made by Nike in honor of the 1999 Women's World Cup. The projected cash flows for the product are $2,000 for the first year, $4,000 for the next two years, and than $1,000 for the fourth year. It will cost $5,000 to start up this project and Nike requires a 10% return. After four years, Nike will stop producing the balls and no longer sell them because the 2003 World Cup will be underway.
NPV= -5,000+ 1,818.18+ 3,305.79+ 3,005.26+ 683.01
Although NPV is considered the most used valuation model. it is not the only model.
IRR is the required return that results in zero NPV when it is used as the discount rate.
There is no mathematical approach to finding IRR. The only way to find an IRR is by trial and error.
|1. Can estimate IRR without knowing an appropriate discount rate|
|1. May lead to incorrect decisions in comparasons of mutually exclusive investments or if there are unconventional cash flows|
***An investment should be further considered if the IRR exceeds the required return. It should be rejected otherwise.***
A project has an initial investment of $1,000. The first two years have given a cash flow of $400 each, the third year is $150 and the fourth $200. What is the pay back period for this investment? We are looking to find how long it takes this project to give a cash flow of $1000. After the first three years there is a total cash flow of $950. Therefore, we need to recover $50. If we divide the $50 we need by the $200 of cash flow from the fourth year, we get .25 years (or 3 months). Our payback period is 3.25 years.
|1. Adjusts for uncertaintly of later cash flows|
|2. Biased towards liquidity since it is biased towards short-term projects|
|1. Ignores the time value of money; does not discount cash flow|
|2. Must choose an arbitrary cutoff point|
|3. Ignores cash flows beyond the cutoff date.|
|4. Biased against long-term projects that take longer time periods to become lucrative|
This ratio =
Now that we know how to calculate each method, and the advantages and disadvantages of each, the relevant question seems to be, which is the best method to use?
It seems that most investors would argue that NPV is the most accurate measure of 1.telling whether the project is a good investment and 2. telling which investments are better than others.
1. NPV assumes that project cash flows are reinvested at the company's required rate of return; the IRR assumes that they are reinvested at the IRR. Since IRR is higher than the required rate of return, in order for the IRR to be accurate, the company would have to keep finding projects that would reinvest the cash flow at this higher rate. It would be difficult for a company to keep this up forever, thus NPV is more accurate.
2. NPV measures project value more directly than IRR. This is because NPV actually calculates the project's value. If there is more than one project lined up, the manager can simply add the values together to get a total.
3. Often times, during the life of a project, cash flows must be reinvested to cover depreciation. This will give a negative cash flow for that period, thus leading to more than one IRR. If there is more than one IRR, than calculating only 1 IRR for the project is not reliable. NPV must be used for this type of project.
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This website was created in May 1999 by Alison Hirsch '01, and is maintained by Professor Satya Gabriel, of the Economics Department at Mount Holyoke College font>