Question

Name three investment rules. Detail the mechanics for each of these rules and compare their advantages and disadvantages. Finally, tell us which rule you personally prefer and why.

Answer 1

The top 3 conventional rules of investing are:

1. Net Present Value (NPV)
2. Internal Rate of Return (IRR)
3. Payback Period

Discussing each:

1. Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period., Or simply put. compares the time vale of money invested in the project under study to investing in another asset/project.

Present Value (PV) is the value of a cost or benefit that has been computed in terms of the VALUE of cash today, after all costs in order to determine if the investment is a gain, break even, or loss. Ergo.

• NPV = PV of Benefits – PV of Costs

Example:

If one buys an apartment today for $816,000, we estimate that the cash flow from this investment property will be 280,000 per year, starting at the end of the first year and lasting for four years.

If it is ascertained that a 10% return on investment is obtainable each year in another property, therefore 10% will be the cost of capital.

Discounting the PV of cash flows for 4 years, the NPV = NPV = $887,560 – $816,000 = 71,560 = positive NPV

NPV brings to attention that investment decision must take into consideration the cost of capital, meaning what money could be earning in another investment if one were to decline the current investment opportunity being presented to you.

2. Internal rate of return (IRR) is the interest rate at which the net present value of all the cash flows (both positive and negative) from a project or investment equal zero.

The IRR is based on the concept that if the return on investment opportunity you are considering is greater than the return on other alternatives in the market with equivalent risk and maturity, you should undertake the investment.

The IRR of the above example above was 14% which meant you should undertake it since the cost of capital was only 10%.

That is if NPV>0, the IRR is greater than cost of capital. If NPV=0, the determine IRR.

Both methods have a disadvantage:

Disadvantages of the NPV/IRR

The biggest disadvantage to the calculation of NP/IRR is its (i) choosing or determining the right discount rate. (ii) insensitivity to the discount rate over time periods and

If NPV is considered a summation of multiple discounted cash flows—both positive and negative—converted into present value (PV) terms for the same point in time (usually when the cash flows begin).

As such, the discount rate used in the denominators of each present value (PV) calculation is critical in determining what the final NPV number will be. A small increase or decrease in the discount rate will have a considerable effect on the final output.

Example: Consider an investment that would cost $4,000 upfront today but is expected to pay $1,000 in annual profits for five years (for a total nominal amount of $5,000) beginning at the end of this year. Using a 5% discount rate in the NPV calculation, five $1,000 payments are equal to $4,329.48 in today's dollars. Subtracting the $4,000 initial payment gives an NPV of $329.28.

However, raising the discount rate from 5% to 10% results in a very different NPV. At a 10% discount rate, the investment's cash flows add up to a present value of $3,790.79. Subtracting the $4,000 initial cost from this amount gives an NPV of -$209.21. Simply by adjusting the rate, the investment had changed from one that creates value to one that loses value.

Because NPV calculations require the selection of a discount rate, they can be unreliable if the wrong rate is selected.

(ii) insensitivity to the discount rate over time periods and

An additional complexity is the possibility that the investment will not have the same level of risk throughout its entire time horizon – (meaning each period could have a different level of market risk)

How should an investor calculate NPV if the investment had a high risk of loss for the first year but a relatively low risk for the last four years?

The investor could apply different discount rates for each period, but this would make the model even more complex and require the pegging of five discount rates

For short term projects, the Alternative to the IRR is the Modified IRR, that estimates or approximate real opportunity costs of capital across the life of the investment.

Finally, another major disadvantage to using NPV as an investment criterion is that it wholly excludes the value of any (a) Intangible Assets, (b) Embedded Options that may exist within the investment/Firm.

Consider our five-year investment example again. Suppose the investment is in a Biotech company that is currently losing money but is expected to expand significantly within three years if they discover a cure for all types of cancer.

If an investor is confident that expansion will occur, they should incorporate the value of that (a) embedded IP (b) option into the total NPV of the investment. However, the standard NPV formula provides no way to include the value of real options.

3. The payback period (PB) refers to the amount of time it takes to recover the cost of an investment. Simply put, the payback period is the length of time an investment reaches a breakeven point.

One can also analyse an investment by how long it will take the annual cash flows to payback your initial principal.

If one investment will pay you $10,000/year and you have to invest $100,000 up front to earn these annual pay-outs, it will take 10 years to retrieve your $100,000 investment.

Drawback of the payback

Note that the payback method only considers the time required to return the original investment. It does not consider the time value of money as discussed in the NPV/IRR. Considering two projects and both have the same payback period of three years. However, Project A returns most investment in the first one and one-half years whereas Project B returns most of its cash flow return in years two and three.

Since both have the same payback period of three years, so which to choose?

One would Project A, because you would get most of your money back in the early years, as opposed to Project B, which has returns concentrated in the later years.

But suppose that Project A had zero cash flow beyond the third year, whereas the cash flow from Project B continued to generate $10,000 per year in years four, five, six and beyond. Now, which project would you choose?

Choice of Method:

Risk Profile of Investor:

What a poor investment to one is a high risk, high reward to another. It comes down to risk appetite of the investor.

Personal choice

None of the above methods are fool proof. However, my personal choice is to use Macaulay DURATION with a comparison to DISCOUNTED PAYBACK:

The payback period only looks at the flows within the payback period and ignores all later flows.

The duration considers all the flows and works out a weighted average over the period.

Pros and Cons of Discounted PB

Advantages–Includes both the NPV/IRR time value of money Does not accept negative estimated NPV investments, but fundamentally as an investor I should be Biased towards liquidity•

Disadvantages– May reject positive NPV investments–Requires an arbitrary cut off point–Ignores cash flows beyond the cut-off date–Biased against long-term projects, such as research and development, and new projects

Further, if investors are unable to decide the Cost of Capital for NPV/IRR, PAYBACK cash flows are easier to extrapolate on a per project basis-addressing liquidity risk as stated above

Prefer to use Discounted PB+Duration to projects are limited to single product or service and/or restricted and/or captive markets. These risks are termed FINITE risk because of more predictive cash flows