Background
You recently bought a home with a structure distant from the main house. This area was used as an art studio by the previous owner. It has plumbing and electricity and is near the back of the property, where it is possible to construct a second entrance and set up sheltered parking. You are considering renovating this to use as a rental property.
The structure is large enough for four rental units. You have already established agreements to lease these units; however, revenue will be irregular because you live in a resort area where residence is not continuous. Crime and vandalism (and thus risk of loss and repair) are low, and you believe this is a low- to medium-risk investment compared to the standard range of assets you could otherwise invest in.
It will take you two years to complete the necessary renovations. In speaking with others with small investments in real estate similar to this one, you have learned that a typical rate of return on property rentals is 11 percent. You think of this as a “required rate of return” on the project. You will feel comfortable making this investment if the payback and discounted payback period for this project are 3 and 3.5 years, respectively.
Your partner is not certain this is a wise investment and has asked you to develop a financial rationale for taking this risk. You plan to use investment decision rules to create a compelling case that this is an attractive and viable opportunity. Expected cash flows are as follows:
Time 0 1 2 3 4 5
Cash Flow ($175,000) ($65,800) $94,000 $41,000 $122,000 $81,200
Initial Post
Please address the two questions below in your initial post. This discussion forum has been designated as “post first,” which means that you will need to complete your initial post before you can view the posts of your classmates.
Convince your partner of the possibilities in your own backyard by applying three decision rules, including Net Present Value (NPV) analysis, the Payback Rule, Average Accounting Return (AAR), Internal Rate of Return (IRR), or the Profitability Index (PI) to evaluate the attractiveness of this project.
Identify an analogous investment paying a similar rate of return, and compare the two options.
In this discussion, it’s crucial to incorporate the FORMULAS, RESULTS, and final recommendations.
*****Disscussion Notes*****
Net Present Value (NPV)
The net present value criterion is generally understood to be the preferred manner of evaluating the attractiveness of proposed investments. This type of analysis involves summing a series of discounted incremental cash flows back to the present, using present value analysis. The difference between an investment’s market value and its cost is its net present value (NPV).
Given that the manager’s goal is to create value for shareholders, the capital budgeting process can be understood as a process of securing investments with positive net present values. NPV is zero when the sum of the discounted cash flows equals the value of the initial investment and grows as the sum of discounted cash flows exceeds the value of the investment.
The profitability index (PI), or benefit–cost ratio, is a tool that builds upon this analysis. This index is defined as the present value of the future cash flows divided by the initial investment. If a project has a positive NPV, the present value of the future cash flows is expected to exceed the initial investment. Thus the percentage by which the profitability index exceeds 1 indicates the percentage return on the firm’s investment.
Internal Rate of Return (IRR)
The primary alternative to NPV as a means of assessing the acceptability of investment projects is the internal rate of return (IRR). Under an IRR rule, an investment is acceptable if its IRR exceeds a required rate of return, which is the discount rate that makes the NPV equal to zero. Thus, a project is considered to be beneficial to the firm if it yields a return that exceeds this value.
Comparing the IRR to the NPV rule, we find that these lead to identical decisions where a project’s cash flows are conventional and independent of the cash flows of alternative investments. Cash flows are conventional if the first in a series of cash flows (the initial investment) is negative, while all others are positive.
Modified Internal Rate of Return (MIRR)
On the other hand, cash flows are independent when projects are not mutually exclusive. If cash flows are not conventional, a manager may find that a project is associated with multiple rates of return, in which case a modified internal rate of return (MIRR) methodology may be applied that will eliminate the problem of multiple rates of return.
Project Cash Flows
In evaluating a project, a manager must include the total resource costs of a project, which are likely to include an investment in net working capital in addition to long-term assets. These facts account for a negative outflow at the project’s inception. However, as a project winds down, inventories can be sold, receivables can be collected, and working capital is returned to the firm.
By applying these rules, a manager can appropriately compare a project’s resulting DCF against those of alternative, equally risky investments that the firm has available to it. The manager is then able to decide among investments using objective criteria based on sound financial logic. A number of related techniques may, in fact, be used to assess a project. In this module, you are introduced to a range of techniques that are used in practice for the purpose of evaluating proposed investments.
The Payback Rule
Firms typically use multiple criteria for evaluating an investment proposal, and additional tools are useful in limited applications or areas of analysis. The first is the payback rule, which is the time it takes to recover an initial investment. The ordinary payback is the time it takes to break even in an accounting sense. In this case, managers do not focus on the impact of an investment on the value of the firm’s stock, which may lead the firm to decline profitable opportunities that require longer-term commitments of resources.
Based on the payback rule, an investment is acceptable if its calculated payback period is less than some preselected years. This criterion can also be applied once incremental revenues have been appropriately discounted through present value analysis. Based on the discounted payback rule, an investment would be acceptable if it yields a discounted payback period of less than some prescribed number of years. If a project pays back on a discounted basis, it must have a positive NPV by definition. On the other hand, the profitability index can be used to rank projects that are not
