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Transcript of Capital Budgeting Tools
8/6/2019 Capital Budgeting Tools
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Net Present Value and Other Net Present Value and Other
Investment CriteriaInvestment Criteria
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Key Concepts and SkillsKey Concepts and Skills
Be able to compute payback and discountedBe able to compute payback and discountedpayback and understand their shortcomingspayback and understand their shortcomings
Understand accounting rates of return and their Understand accounting rates of return and their
shortcomingsshortcomings Be able to compute the internal rate of return andBe able to compute the internal rate of return and
understand its strengths and weaknessesunderstand its strengths and weaknesses
Be able to compute the net present value andBe able to compute the net present value and
understand why it is the best decision criterionunderstand why it is the best decision criterion
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Chapter OutlineChapter Outline
Net Present ValueNet Present Value
The Payback RuleThe Payback Rule
The Discounted PaybackThe Discounted Payback The Average Accounting ReturnThe Average Accounting Return
The Internal Rate of ReturnThe Internal Rate of Return
The Profitability IndexThe Profitability Index The Practice of Capital BudgetingThe Practice of Capital Budgeting
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Good Decision CriteriaGood Decision Criteria
We need to ask ourselves the followingWe need to ask ourselves the followingquestions when evaluating capitalquestions when evaluating capital
budgeting decision rulesbudgeting decision rules Does the decision rule adjust for the timeDoes the decision rule adjust for the time
value of money?value of money?
Does the decision rule adjust for risk?Does the decision rule adjust for risk?
Does the decision rule provide information onDoes the decision rule provide information onwhether we are creating value for the firm?whether we are creating value for the firm?
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Project Example InformationProject Example Information
You are looking at a new project and you haveYou are looking at a new project and you haveestimated the following cash flows:estimated the following cash flows:
Year 0:Year 0: CF =CF = --165,000165,000
Year 1:Year 1: CF = 63,120; NI = 13,620CF = 63,120; NI = 13,620
Year 2:Year 2: CF = 70,800; NI = 3,300CF = 70,800; NI = 3,300
Year 3:Year 3: CF = 91,080; NI = 29,100CF = 91,080; NI = 29,100
Average Book Value = 72,000 Average Book Value = 72,000
Your required return for assets of this risk isYour required return for assets of this risk is12%.12%.
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Net Present ValueNet Present Value
The difference between the market value of aThe difference between the market value of aproject and its costproject and its cost
How much value is created from undertaking anHow much value is created from undertaking an
investment?investment? The first step is to estimate the expected future cashThe first step is to estimate the expected future cash
flows.flows.
The second step is to estimate the required return for The second step is to estimate the required return for projects of this risk level.projects of this risk level.
The third step is to find the present value of the cashThe third step is to find the present value of the cashflows and subtract the initial investment.flows and subtract the initial investment.
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NPVNPV ± ± Decision RuleDecision Rule
If the NPV is positive, accept the project If the NPV is positive, accept the project
A positive NPV means that the project is A positive NPV means that the project isexpected to add value to the firm and willexpected to add value to the firm and will
therefore increase the wealth of the owners.therefore increase the wealth of the owners.
Since our goal is to increase owner wealth, NPVSince our goal is to increase owner wealth, NPVis a direct measure of how well this project willis a direct measure of how well this project will
meet our goal.meet our goal.
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Computing NPV for the ProjectComputing NPV for the Project
Using the formulas:Using the formulas:
NPV = 63,120/(1.12) + 70,800/(1.12)NPV = 63,120/(1.12) + 70,800/(1.12)22 ++91,080/(1.12)91,080/(1.12)33 ± ± 165,000 = 12,627.42165,000 = 12,627.42
Using the calculator:Using the calculator: CFCF00 == --165,000; C01 = 63,120; F01 = 1; C02 =165,000; C01 = 63,120; F01 = 1; C02 =
70,800; F02 = 1; C03 = 91,080; F03 = 1; NPV; I = 12;70,800; F02 = 1; C03 = 91,080; F03 = 1; NPV; I = 12;CPT NPV = 12,627.41CPT NPV = 12,627.41
Do we accept or reject the project? Do we accept or reject the project?
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Decision Criteria TestDecision Criteria Test -- NPVNPV
Does the NPV rule account for the time value of Does the NPV rule account for the time value of money?money?
Does the NPV rule account for the risk of theDoes the NPV rule account for the risk of the
cash flows?cash flows?
Does the NPV rule provide an indication aboutDoes the NPV rule provide an indication aboutthe increase in value?the increase in value?
Should we consider the NPV rule for our primaryShould we consider the NPV rule for our primarydecision rule?decision rule?
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Calculating NPVs with aCalculating NPVs with a
SpreadsheetSpreadsheet Spreadsheets are an excellent way to computeSpreadsheets are an excellent way to compute
NPVs, especially when you have to computeNPVs, especially when you have to computethe cash flows as well.the cash flows as well.
Using the NPV functionUsing the NPV function The first component is the required return enteredThe first component is the required return entered
as a decimalas a decimal
The second component is the range of cash flowsThe second component is the range of cash flows
beginning with year 1beginning with year 1 Subtract the initial investment after computing theSubtract the initial investment after computing the
NPVNPV
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Payback PeriodPayback Period
How long does it take to get the initial cost backHow long does it take to get the initial cost backin a nominal sense?in a nominal sense?
ComputationComputation
Estimate the cash flowsEstimate the cash flows
Subtract the future cash flows from the initial cost untilSubtract the future cash flows from the initial cost untilthe initial investment has been recoveredthe initial investment has been recovered
Decision RuleDecision Rule ± ± Accept if the payback period Accept if the payback period
is less than some preset limit is less than some preset limit
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Computing Payback for theComputing Payback for the
ProjectProject Assume we will accept the project if it pays back Assume we will accept the project if it pays back
within two years.within two years.
Year 1: 165,000Year 1: 165,000 ± ± 63,120 = 101,880 still to recover 63,120 = 101,880 still to recover
Year 2: 101,880Year 2: 101,880 ± ± 70,800 = 31,080 still to recover 70,800 = 31,080 still to recover
Year 3: 31,080Year 3: 31,080 ± ± 91,080 =91,080 = --60,00060,000 project pays back project pays back
in year 3in year 3
Do we accept or reject the project? Do we accept or reject the project?
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Decision Criteria TestDecision Criteria Test -- PaybackPayback
Does the payback rule account for the timeDoes the payback rule account for the timevalue of money?value of money?
Does the payback rule account for the risk of theDoes the payback rule account for the risk of the
cash flows?cash flows?
Does the payback rule provide an indicationDoes the payback rule provide an indicationabout the increase in value?about the increase in value?
Should we consider the payback rule for our Should we consider the payback rule for our primary decision rule?primary decision rule?
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Advantages and Disadvantages Advantages and Disadvantagesof Paybackof Payback
Advantages Advantages
Easy to understandEasy to understand
Adjusts for uncertainty Adjusts for uncertainty
of later cash flowsof later cash flows Biased toward liquidityBiased toward liquidity
DisadvantagesDisadvantages Ignores the time valueIgnores the time value
of moneyof money
Requires an arbitraryRequires an arbitrarycutoff pointcutoff point
Ignores cash flowsIgnores cash flowsbeyond the cutoff datebeyond the cutoff date
Biased against longBiased against long--term projects, such asterm projects, such asresearch andresearch anddevelopment, and newdevelopment, and newprojectsprojects
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Discounted Payback PeriodDiscounted Payback Period
Compute the present value of each cash flowCompute the present value of each cash flowand then determine how long it takes to payand then determine how long it takes to payback on a discounted basisback on a discounted basis
Compare to a specified required periodCompare to a specified required period
Decision RuleDecision Rule -- Accept the project if it pays Accept the project if it pays
back on a discounted basis within theback on a discounted basis within the
specified timespecified time
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Computing Discounted Payback for Computing Discounted Payback for the Projectthe Project
Assume we will accept the project if it pays back on a Assume we will accept the project if it pays back on adiscounted basis in 2 years.discounted basis in 2 years.
Compute the PV for each cash flow and determine theCompute the PV for each cash flow and determine thepayback period using discounted cash flowspayback period using discounted cash flows Year 1: 165,000Year 1: 165,000 ± ± 63,120/1.1263,120/1.1211 = 108,643= 108,643
Year 2: 108,643 Year 2: 108,643 ± ± 70,800/1.1270,800/1.1222 = 52,202= 52,202
Year 3: 52,202 Year 3: 52,202 ± ± 91,080/1.1291,080/1.1233 == --12,627 project pays back in12,627 project pays back inyear 3year 3
Do we accept or reject the project? Do we accept or reject the project?
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Decision Criteria TestDecision Criteria Test ± ± DiscountedDiscounted
PaybackPayback Does the discounted payback rule account for the timeDoes the discounted payback rule account for the time
value of money?value of money?
Does the discounted payback rule account for the riskDoes the discounted payback rule account for the risk
of the cash flows?of the cash flows?
Does the discounted payback rule provide an indicationDoes the discounted payback rule provide an indicationabout the increase in value?about the increase in value?
Should we consider the discounted payback rule for Should we consider the discounted payback rule for
our primary decision rule?our primary decision rule?
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Advantages and Disadvantages of Advantages and Disadvantages of Discounted PaybackDiscounted Payback
Advantages Advantages
Includes time value of Includes time value of moneymoney
Easy to understandEasy to understand Does not acceptDoes not accept
negative estimatednegative estimatedNPV investmentsNPV investments
when all future cashwhen all future cashflows are positiveflows are positive
Biased towardsBiased towardsliquidityliquidity
DisadvantagesDisadvantages
May reject positiveMay reject positiveNPV investmentsNPV investments
Requires an arbitraryRequires an arbitrarycutoff pointcutoff point
Ignores cash flowsIgnores cash flowsbeyond the cutoff pointbeyond the cutoff point
Biased against longBiased against long--term projects, such asterm projects, such asR&D and newR&D and newproductsproducts
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Average Accounting Return Average Accounting Return
There are many different definitions for averageThere are many different definitions for averageaccounting returnaccounting return
The one used in the book is:The one used in the book is:
Average net income / average book value Average net income / average book value
Note that the average book value depends on howNote that the average book value depends on howthe asset is depreciated.the asset is depreciated.
Need to have a target cutoff rateNeed to have a target cutoff rate
Decision Rule:Decision Rule: Accept the project if the AAR Accept the project if the AAR
is greater than a preset rate.is greater than a preset rate.
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Computing AAR for the ProjectComputing AAR for the Project
Assume we require an average accounting Assume we require an average accountingreturn of 25%return of 25%
Average Net Income: Average Net Income: (13,620 + 3,300 + 29,100) / 3 = 15,340(13,620 + 3,300 + 29,100) / 3 = 15,340
AAR = 15,340 / 72,000 = .213 = 21.3% AAR = 15,340 / 72,000 = .213 = 21.3%
Do we accept or reject the project?
Do we accept or reject the project?
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Decision Criteria TestDecision Criteria Test -- AAR AAR
Does the AAR rule account for the time value of Does the AAR rule account for the time value of money?money?
Does the AAR rule account for the risk of theDoes the AAR rule account for the risk of the
cash flows?cash flows?
Does the AAR rule provide an indication aboutDoes the AAR rule provide an indication aboutthe increase in value?the increase in value?
Should we consider the AAR rule for our primaryShould we consider the AAR rule for our primarydecision rule?decision rule?
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Advantages and Disadvantages Advantages and Disadvantages
of AARof AAR Advantages Advantages
Easy to calculateEasy to calculate
Needed informationNeeded information
will usually bewill usually beavailableavailable
DisadvantagesDisadvantages
Not a true rate of Not a true rate of return; time value of return; time value of
money is ignoredmoney is ignored Uses an arbitraryUses an arbitrary
benchmark cutoff ratebenchmark cutoff rate
Based on accountingBased on accounting
net income and booknet income and bookvalues, not cash flowsvalues, not cash flowsand market valuesand market values
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Internal Rate of ReturnInternal Rate of Return
This is the most important alternative toThis is the most important alternative toNPVNPV
It is often used in practice and is intuitivelyIt is often used in practice and is intuitivelyappealingappealing
It is based entirely on the estimated cashIt is based entirely on the estimated cashflows and is independent of interest ratesflows and is independent of interest ratesfound elsewherefound elsewhere
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IRRIRR ± ± Definition and DecisionDefinition and Decision
RuleRule Definition: IRR is the return that makes theDefinition: IRR is the return that makes the
NPV = 0NPV = 0
Decision Rule:Decision Rule: Accept the project if the I RR Accept the project if the I RR is greater than the required returnis greater than the required return
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Computing IRR for the ProjectComputing IRR for the Project
If you do not have a financial calculator , then thisIf you do not have a financial calculator , then thisbecomes a trial and error processbecomes a trial and error process
Calculator Calculator
Enter the cash flows as you did with NPVEnter the cash flows as you did with NPV
Press IRR and then CPTPress IRR and then CPT
IRR = 16.13% > 12% required returnIRR = 16.13% > 12% required return
Do we accept or reject the project?
Do we accept or reject the project?
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NPV Profile for the ProjectNPV Profile for the Project
-20,000
-10,000
0
10,000
20,000
30,000
40,000
50,000
60,000
70,000
0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22
Discount Rate
N P V
IRR = 16.13%
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Decision Criteria TestDecision Criteria Test -- IRRIRR
Does the IRR rule account for the time value of Does the IRR rule account for the time value of money?money?
Does the IRR rule account for the risk of theDoes the IRR rule account for the risk of the
cash flows?cash flows?
Does the IRR rule provide an indication aboutDoes the IRR rule provide an indication aboutthe increase in value?the increase in value?
Should we consider the IRR rule for our primaryShould we consider the IRR rule for our primarydecision criteria?decision criteria?
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Advantages of IRR Advantages of IRR
Knowing a return is intuitively appealingKnowing a return is intuitively appealing
It is a simple way to communicate the value of aIt is a simple way to communicate the value of aproject to someone who doesn¶t know all theproject to someone who doesn¶t know all the
estimation detailsestimation details
If the IRR is high enough, you may not need toIf the IRR is high enough, you may not need toestimate a required return, which is often aestimate a required return, which is often adifficult taskdifficult task
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Summary of Decisions for theSummary of Decisions for the
ProjectProjectSummarySummary
Net Present ValueNet Present Value Accept Accept
Payback PeriodPayback Period R eject R eject
Discounted Payback PeriodDiscounted Payback Period R eject R eject
Average Accounting Return Average Accounting Return R eject R eject
Internal Rate of ReturnInternal Rate of Return Accept Accept
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Calculating IRRs With ACalculating IRRs With A
SpreadsheetSpreadsheet You start with the cash flows the same as youYou start with the cash flows the same as you
did for the NPVdid for the NPV
You use the IRR functionYou use the IRR function
You first enter your range of cash flows, beginningYou first enter your range of cash flows, beginningwith the initial cash flowwith the initial cash flow
You can enter a guess, but it is not necessaryYou can enter a guess, but it is not necessary
The default format is a whole percentThe default format is a whole percent ± ± you willyou willnormally want to increase the decimal places to atnormally want to increase the decimal places to atleast twoleast two
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NPV vs. IRRNPV vs. IRR
NPV and IRR will generally give us theNPV and IRR will generally give us thesame decisionsame decision
ExceptionsExceptions NonNon--conventional cash flowsconventional cash flows ± ± cash flowcash flow
signs change more than oncesigns change more than once
Mutually exclusive projectsMutually exclusive projects
�� Initial investments are substantially differentInitial investments are substantially different
�� Timing of cash flows is substantially differentTiming of cash flows is substantially different
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IRR and NonIRR and Non--conventional Cashconventional Cash
FlowsFlows When the cash flows change sign more thanWhen the cash flows change sign more than
once, there is more than one IRRonce, there is more than one IRR
When you solve for IRR you are solving for theWhen you solve for IRR you are solving for theroot of an equation and when you cross the xroot of an equation and when you cross the x--axis more than once, there will be more thanaxis more than once, there will be more thanone return that solves the equationone return that solves the equation
If you have more than one IRR, which one doIf you have more than one IRR, which one doyou use to make your decision?you use to make your decision?
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Another Example Another Example ± ± NonNon--conventional Cash Flowsconventional Cash Flows
Suppose an investment will cost $90,000Suppose an investment will cost $90,000initially and will generate the following cashinitially and will generate the following cashflows:flows:
Year 1: 132,000Year 1: 132,000
Year 2: 100,000Year 2: 100,000
Year 3:Year 3: --150,000150,000
The required return is 15%.The required return is 15%. Should we accept or reject the project?Should we accept or reject the project?
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NPV ProfileNPV Profile
($10,000.00)
($8,000.00)
($6,000.00)
($4,000.00)
($2,000.00)
$0.00
$2,000.00
$4,000.00
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55
Discount Rate
N P V
IRR = 10.11% and 42.66%
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Summary of Decision RulesSummary of Decision Rules
The NPV is positive at a required return of The NPV is positive at a required return of 15%, so you should15%, so you should Accept Accept
If you use the financial calculator , youIf you use the financial calculator , youwould get an IRR of 10.11% which wouldwould get an IRR of 10.11% which wouldtell you totell you to R eject R eject
You need to recognize that there are nonYou need to recognize that there are non--conventional cash flows and look at theconventional cash flows and look at theNPV profileNPV profile
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IRR and Mutually ExclusiveIRR and Mutually Exclusive
ProjectsProjects Mutually exclusive projectsMutually exclusive projects
If you choose one, you can¶t choose the other If you choose one, you can¶t choose the other
Example: You can choose to attend graduate school at either Example: You can choose to attend graduate school at either
Harvard or Stanford, but not bothHarvard or Stanford, but not both Intuitively you would use the following decision rules:Intuitively you would use the following decision rules:
NPVNPV ± ± choose the project with the higher NPVchoose the project with the higher NPV
IRRIRR ± ± choose the project with the higher IRRchoose the project with the higher IRR
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Example With Mutually ExclusiveExample With Mutually ExclusiveProjectsProjects
PeriodPeriod ProjectProject A A
ProjectProjectBB
00 --500500 --400400
11 325325 325325
22 325325 200200
IRRIRR 19.43%19.43% 22.17%22.17%
NPVNPV 64.0564.05 60.7460.74
The r equir ed r eturn
for both projects is
10%.
Which project
should you acce pt
and why?
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NPV ProfilesNPV Profiles
($40.00)
($20.00)
$0.00
$20.00
$40.00
$60.00
$80.00
$100.00
$120.00
$140.00
$160.00
0 0.05 0.1 0.15 0.2 0.25 0.3
Discount Rate
N P V A
B
IRR for A = 19.43%
IRR for B = 22.17%
Crossover Point = 11.8%
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Conflicts Between NPV and IRRConflicts Between NPV and IRR
NPV directly measures the increase in value toNPV directly measures the increase in value tothe firmthe firm
Whenever there is a conflict between NPV andWhenever there is a conflict between NPV and
another decision rule, you shouldanother decision rule, you should alwaysalways useuseNPVNPV
IRR is unreliable in the following situationsIRR is unreliable in the following situations
NonNon--conventional cash flowsconventional cash flows
Mutually exclusive projectsMutually exclusive projects
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Profitability IndexProfitability Index
Measures the benefit per unit cost, basedMeasures the benefit per unit cost, basedon the time value of moneyon the time value of money
A profitability index of 1.1 implies that for A profitability index of 1.1 implies that for every $1 of investment, we create anevery $1 of investment, we create anadditional $0.10 in valueadditional $0.10 in value
This measure can be very useful inThis measure can be very useful insituations in which we have limited capitalsituations in which we have limited capital
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Advantages and Disadvantages Advantages and Disadvantagesof Profitability Indexof Profitability Index
Advantages Advantages
Closely related toClosely related toNPV, generallyNPV, generally
leading to identicalleading to identicaldecisionsdecisions
Easy to understandEasy to understandand communicateand communicate
May be useful whenMay be useful whenavailable investmentavailable investmentfunds are limitedfunds are limited
DisadvantagesDisadvantages
May lead to incorrectMay lead to incorrectdecisions indecisions in
comparisons of comparisons of mutually exclusivemutually exclusiveinvestmentsinvestments
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Capital Budgeting In PracticeCapital Budgeting In Practice
We should consider several investmentWe should consider several investmentcriteria when making decisionscriteria when making decisions
NPV and IRR are the most commonlyNPV and IRR are the most commonlyused primary investment criteriaused primary investment criteria
Payback is a commonly used secondaryPayback is a commonly used secondaryinvestment criteriainvestment criteria
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SummarySummary ± ± Discounted Cash FlowDiscounted Cash FlowCriteriaCriteria Net present valueNet present value
Difference between market value and costDifference between market value and cost Take the project if the NPV is positiveTake the project if the NPV is positive Has no serious problemsHas no serious problems Preferred decision criterionPreferred decision criterion
Internal rate of returnInternal rate of return
Discount rate that makes NPV = 0Discount rate that makes NPV = 0 Take the project if the IRR is greater than the required returnTake the project if the IRR is greater than the required return Same decision as NPV with conventional cash flowsSame decision as NPV with conventional cash flows IRR is unreliable with nonIRR is unreliable with non--conventional cash flows or mutuallyconventional cash flows or mutually
exclusive projectsexclusive projects
Profitability IndexProfitability Index
BenefitBenefit--cost ratiocost ratio Take investment if PI > 1Take investment if PI > 1
Cannot be used to rank mutually exclusive projectsCannot be used to rank mutually exclusive projects May be used to rank projects in the presence of capital rationingMay be used to rank projects in the presence of capital rationing
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SummarySummary ± ± Payback CriteriaPayback Criteria Payback periodPayback period
Length of time until initial investment is recoveredLength of time until initial investment is recovered
Take the project if it pays back within some specified periodTake the project if it pays back within some specified period
Doesn¶t account for time value of money and there is anDoesn¶t account for time value of money and there is an
arbitrary cutoff periodarbitrary cutoff period Discounted payback periodDiscounted payback period
Length of time until initial investment is recovered on aLength of time until initial investment is recovered on adiscounted basisdiscounted basis
Take the project if it pays back in some specified periodTake the project if it pays back in some specified period
There is an arbitrary cutoff periodThere is an arbitrary cutoff period
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SummarySummary ± ± Accounting Accounting
CriterionCriterion Average Accounting Return Average Accounting Return
Measure of accounting profit relative to bookMeasure of accounting profit relative to bookvaluevalue
Similar to return on assets measureSimilar to return on assets measure
Take the investment if the AAR exceeds someTake the investment if the AAR exceeds somespecified return levelspecified return level
Serious problems and should not be usedSerious problems and should not be used
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Quick QuizQuick Quiz Consider an investment that costs $100,000 and has aConsider an investment that costs $100,000 and has a
cash inflow of $25,000 every year for 5 years. Thecash inflow of $25,000 every year for 5 years. Therequired return is 9% and required payback is 4 years.required return is 9% and required payback is 4 years.
What is the payback period?What is the payback period?
What is the discounted payback period?What is the discounted payback period?
What is the NPV?What is the NPV?
What is the IRR?What is the IRR?
Should we accept the project?Should we accept the project?
What decision rule should be the primary decisionWhat decision rule should be the primary decision
method?method? When is the IRR rule unreliable?When is the IRR rule unreliable?
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End of Chapter End of Chapter
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Comprehensive ProblemComprehensive Problem
An investment project has the following cash An investment project has the following cashflows: CF0 =flows: CF0 = --1,000,000; C01 1,000,000; C01 ± ± C08 = 200,000C08 = 200,000eacheach
If the required rate of return is1
2%,
whatIf the required rate of return is1
2%,
whatdecision should be made using NPV?decision should be made using NPV?
How would the IRR decision rule be used for How would the IRR decision rule be used for this project, and what decision would bethis project, and what decision would be
reached?reached? How are the above two decisions related?How are the above two decisions related?