Mod 12 - DCF - Decision Criteria

7/21/2019 Mod 12 - DCF - Decision Criteria

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Michael R. RobertsWilliam H. Lawrence Professor of FinanceThe Wharton School, University of Pennsylvania

Discounted Cash Flow

Decision Criteria

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Last TimeDiscounted Cash Flow (DCF)• Forecasting free cash ows



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This TimeDiscounted Cash Flow (DCF)• Decision Criteria

Decision Criteria

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What do we do with cash ows?

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1. Compute the NPV (assumediscount rate of 12%)

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1. Compute the NPV

NPV =! $376.8

1 + 0.12( )0 +

! $133.6

1 + 0.12( )1 +

$111.6

1 + 0.12( )2 +

$505.7

1 + 0.12( )3 +

$542.1

1 + 0.12( )4 +

$725.5

1 + 0.12( )5

= $708.42

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1. Compute the NPV

Firm value (i.e., debt plus equity) increases by

$708.42 million, in expectation, if the project isundertaken ! undertake the project

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Lesson : The NPV Rule says accept allprojects with positive NPV, reject allprojects with negative NPV

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2. Compute internal rate of return

The internal rate of return (IRR) of a project is the

one discount rate such that the net present valueof the project’s free cash ows equals zero.

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NPV =! $376.8

1 + IRR ( )0 +! $133.6

1 + IRR ( )1 +

$111.6

1 + IRR ( )2 +

$505.7

1 + IRR ( )3 +$542.1

1 + IRR ( )4 +$725.5

1 + IRR ( )5

" IRR =

43.7%

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NPV =! $376.8

1 + IRR ( )0 +! $133.6

1 + IRR ( )1 +

$111.6

1 + IRR ( )2 +

$505.7

1 + IRR ( )3 +$542.1

1 + IRR ( )4 +$725.5

1 + IRR ( )5

" IRR = 43.7%

Typically need to solve numerically (e.g., IRR function inExcel), or trial and error.

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The promised return on investing in the project is43.7% > 12% ( hurdle rate ) ! undertake theproject

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Lesson : The IRR Rule says accept allprojects whose IRR > R , reject allprojects whose IRR < R

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Lesson : The IRR Rule is informativebut has several shortcomings that weexplore in Topic 4 (Return on

Investment)

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NPV vs. IRR

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3. Compute payback period

The payback period , pp , of a project is theduration until the the cumulative free cash owsturn positive.

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It takes 3 years to recover your investment. Good?Bad? Compare to some threshold payback period,pp *


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Lesson : The Payback Period Rulesays accept all projects with pp < pp* ,reject all projects whose pp > pp*

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Lesson : The Payback Period Rule hasseveral shortcomings…

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Lesson : The Payback Period Rule hasseveral shortcomings

#1: Ignores time value of money andrisk of cash ows

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3a. Compute discounted payback period

The discounted payback period , dpp , of a projectis the duration until the the cumulative discounted free cash ows turn positive.

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3a. Compute discounted payback period

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Lesson : The Discounted PaybackPeriod Rule has several shortcomings

#1: Ignores cash ows after cutoffleading to myopic decision making

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#2: Does not tell us value implicationsof our decision

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#3: Does not help in choosing amongprojects with similar payback periods

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Summary

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Lessons

• Several decision criteria – NPV unambiguously the best but – Others are informative. Understand their

shortcomings and use judiciously

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Coming up next• Discounted Cash Flow (DCF)

– Sensitivity analysis

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Mod 12 - DCF - Decision Criteria

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