NET PRESENT VALUE AND OTHER INVESTMENT RULES

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KEY CONCEPTS AND SKILLS

• Ability to compute and interpret an investment’s payback and discounted payback

• Competence in calculating and interpreting accounting rates of return

• Facility in computation and interpretation of the internal rate of return and profitability index • Fluency in describing the advantages and disadvantages of each valuation method specified above.

• Ability to compute and interpret the net present value and explain why it is the best decision criterion

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CHAPTER OUTLINE

7.1

7.2

7.3

7.4

7.5

7.6

7.7

7.8

Why Use Net Present Value?

The Payback Period Method

The Discounted Payback Period Method

The Average Accounting Return Method

The Internal Rate of Return

Problems with the IRR Approach

The Profitability Index

The Practice of Capital Budgeting

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7.1 NET PRESENT VALUE & ITS

RULES

• Net Present Value (NPV) =

Total PV of future project CF’s less the Initial Investment

• Estimating NPV:

1. Estimate future cash flows: how much? and when? 2. Estimate discount rate

3. Estimate initial costs

• Minimum Acceptance Criteria: Accept if NPV >

0

• Ranking Criteria: Choose the highest NPV

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NET PRESENT VALUE: EXAMPLE

• Suppose Big Deal Co. has an opportunity to make an investment of $100,000 that will return $33,000 in year 1,

$38,000 in year 2, $43,000 in year 3, $48,000 in year 4, and $53,000 in year 5. If the company’s required return is

12% should it make the investment?

Answe r: YES! The NPV is greater than $0.

Therefore, the investment does return at least the required rate of return. 7-5

WHY USE NET PRESENT VALUE?

• Accepting positive NPV projects benefits shareholders. NPV uses cash flows

NPV uses all relevant cash flows of the project

NPV discounts the cash flows properly

• Reinvestment assumption: the NPV rule assumes that all cash flows can be reinvested at the discount rate.

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CALCULATING NPV WITH

SPREADSHEETS

• Spreadsheets are an excellent way to compute

NPVs, especially when you have to compute the cash flows as well.

• Using the NPV function:

• The first component is the required return entered as a decimal. • The second component is the range of cash flows beginning with year 1.

• Add the initial investment after computing the NPV.

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7.2 THE PAYBACK PERIOD METHOD

• How long does it take the project to “pay back” its initial investment?

• Payback Period = number of years to recover initial costs

• Minimum Acceptance Criteria:

• Set by management; a predetermined time period

• Ranking Criteria:

• Set by management; often the shortest payback period is preferred

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THE PAYBACK PERIOD METHOD

• Disadvantages:

•

•

•

•

•

Ignores the time value of money

Ignores cash flows after the payback period

Biased against long-term projects

Requires an arbitrary acceptance criteria

A project accepted based on the payback criteria may not have a positive NPV

• Advantages:

• Easy to understand

• Biased toward liquidity

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EXAMPLE: PAYBACK METHOD

• Consider a project with an investment of $50,000 and cash inflows in years 1,2, & 3 of $30,000,

$20,000, $10,000

• The timeline above clearly illustrates that payback in this situation is 2 years. The first two years of return = $50,000 which exactly “ pays back” the initial investment

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7.3 THE DISCOUNTED PAYBACK PERIOD

• How long does it take the project to “pay back” its initial investment, taking the time value of money into account?

• Decision rule: Accept the project if it pays back on a discounted basis within the specified time.

• By the time you have discounted the cash flows, you might as well calculate the NPV.

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EXAMPLE: DISCOUNTED PAYBACK

PERIOD

• Suppose Big Deal Co. has an opportunity to make an investment of $100,000 that will return $33,000 in year 1,

$38,000 in year 2, $43,000 in year 3,