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Chapter Outline
CHAPTER
6
Some Alternative
Investment Rules
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6.1 Why Use Net Present Value?
6.2 The Payback Period Rule
6.3 The Discounted Payback Period Rule
6.4 The Average Accounting Return
6.5 The Internal Rate of Return
6.6 Problems with the IRR Approach
6.7 The Profitability Index
6.8 The Practice of Capital Budgeting
6.9 Summary and Conclusions
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6.1 Why Use Net Present Value?
The Net Present Value (NPV) Rule
Net Present Value (NPV) =
Total PV of future CF’s + Initial Investment
Accepting positive NPV projects benefits
shareholders.
9 NPV uses cash flows
9 NPV uses all the cash flows of the project
9 NPV discounts the cash flows properly
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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Good Attributes of the NPV Rule
1. Uses cash flows
2. Uses ALL cash flows of the project
3. Discounts ALL cash flows properly
Reinvestment assumption: the NPV rule assumes
that all cash flows can be reinvested at the
discount rate.
6.2 The Payback Period Rule
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
Ranking Criteria:
set by management
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The Payback Period Rule (continued)
6.5 The Internal Rate of Return (IRR) Rule
Disadvantages:
IRR: the discount that sets NPV to zero
Minimum Acceptance Criteria:
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
Accept if the IRR exceeds the required return.
Ranking Criteria:
Select alternative with the highest IRR
Reinvestment assumption:
All future cash flows assumed reinvested at the IRR.
Disadvantages:
Does not distinguish between investing and borrowing.
IRR may not exist or there may be multiple IRR
Problems with mutually exclusive investments
Advantages:
Advantages:
Easy to understand
Biased toward liquidity
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Easy to understand and communicate
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Multiple IRRs
6.6 Problems with the IRR Approach
There are two IRRs for this project:
$200
Multiple IRRs.
Are We Borrowing or Lending?
The Scale Problem
The Timing Problem
NPV
0
-$200
$800
1
2
Which one
should we use?
3
- $800
$100.00
100% = IRR2
$50.00
$0.00
-50%
0%
($50.00)
50%
100%
150%
0% = IRR1
200%
Discount rate
($100.00)
($150.00)
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The Scale Problem
Would you rather make 100% or 50% on your
investments?
What if the 100% return is on a $1 investment
while the 50% return is on a $1,000 investment?
The Timing Problem
$10,000
$1,000
$1,000
Project A
0
1
-$10,000
2
$1,000
3
$1,000
$12,000
Project B
0
1
2
3
-$10,000
The preferred project in this case depends on the discount rate, not
the IRR.
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Mutually Exclusive vs.
Independent Project
The Timing Problem
$5,000.00
Mutually Exclusive Projects: only ONE of several
potential projects can be chosen, e.g. acquiring an
accounting system.
$4,000.00
Project A
$3,000.00
Project B
10.55% = crossover rate
NPV
$2,000.00
$1,000.00
RANK all alternatives and select the best one.
$0.00
($1,000.00) 0%
10%
20%
30%
40%
Independent Projects: accepting or rejecting one project
does not affect the decision of the other projects.
($2,000.00)
($3,000.00)
($4,000.00)
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12.94% = IRRB
16.04% = IRRA
Discount rate
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Must exceed a MINIMUM acceptance criteria.
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6.7 The Profitability Index (PI) Rule
6.8 The Practice of Capital Budgeting
Total PV of Future Cash Flows
PI =
Initial Investent
Varies by industry:
Some firms use payback, others use accounting rate
of return.
Minimum Acceptance Criteria:
Accept if PI > 1
Ranking Criteria:
The most frequently used technique for large
corporations is IRR or NPV.
Select alternative with highest PI
Disadvantages:
Problems with mutually exclusive investments
Advantages:
May be useful when available investment funds are limited
Easy to understand and communicate
Correct decision when evaluating independent projects
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Example of Investment Rules
Compute the IRR, NPV, PI, and payback period for the
following two projects. Assume the required return is
10%.
Year
0
1
2
3
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Project A
-$200
$200
$800
-$800
Project B
-$150
$50
$100
$150
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Example of Investment Rules
CF0
PV0 of CF1-3
NPV =
IRR =
PI =
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Project A
-$200.00
$241.92
Project B
-$150.00
$240.80
$41.92
0%, 100%
1.2096
$90.80
36.19%
1.6053
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Relationship Between NPV and IRR
Example of Investment Rules
Payback Period:
Project A
Project B
Time
CF
Cum. CF
CF Cum. CF
0
-200
-200
-150
-150
1
200
0
50
-100
2
800
800
100
0
3
-800
0
150
150
Payback period for project B = 2 years.
Payback period for project A = 1 or 3 years?
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Discount rate NPV for A
-10%
-87.52
0%
0.00
20%
59.26
40%
59.48
60%
42.19
80%
20.85
100%
0.00
120%
-18.93
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NPV for B
234.77
150.00
47.92
-8.60
-43.07
-65.64
-81.25
-92.52
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NPV
NPV Profiles
6.9 Summary and Conclusions
$400
$300
IRR 1(A)
IRR (B)
This chapter evaluates the most popular
alternatives to NPV:
IRR 2(A)
$200
$100
$0
-15%
0%
15%
30%
45%
70%
100% 130% 160% 190%
($100)
($200)
Cross-over Rate
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Discount rates
Project A
Project B
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Payback period
Accounting rate of return
Internal rate of return
Profitability index
When it is all said and done, they are not the
NPV rule; for those of us in finance, it makes
them decidedly second-rate.
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