principles of
corporate
finance
Chapter 3
Lecturer
Sihem Smida
Making investment
decisions
1- 2
Chapter Objectives
Discuss the various investment evaluation
techniques, including their advantages and
disadvantages.
Apply these techniques to the evaluation of
projects.
Interpret the results of the application of these
techniques in accordance with their respective
decision rules.
Understand the importance of net present
value.
7-2
1- 3
Payback Period
 The amount of time required for an investment to generate cash flows to
recover its initial cost.
 Estimate the cash flows.
 Accumulate the future cash flows until they equal the initial investment.
 The length of time for this to happen is the payback period.
 An investment is acceptable if its calculated payback is less than some
prescribed number of years.
7-3
1- 4
Payback Period Illustrated
Initial investment = –$1000
Year
1
2
3
Year
1
2
3
Cash flow
$200
400
600
Accumulated
Cash flow
$200
600
1200
Payback period = 2 2/3 years
7-4
1- 5
Advantages of Payback Period
Easy to understand.
Adjusts for uncertainty of later cash flows.
Biased towards liquidity.
7-5
1- 6
Disadvantages of Payback Period
Time value of money and risk ignored.
Arbitrary determination of acceptable
payback period.
Ignores cash flows beyond the cut-off date.
Biased against long-term and new projects.
7-6
1- 7
Discounted Payback Period
The length of time required for an investment’s
discounted cash flows to equal its initial cost.
Takes into account the time value of money.
More difficult to calculate.
An investment is acceptable if its discounted
payback is less than some prescribed number of
years.
7-7
1- 8
Example—Discounted Payback
Year
1
Initial investment = —$1000
R = 10%
PV of
Cash flow
Cash flow
$200
$182
2
400
331
3
700
526
4
300
205
7-8
1- 9
Example—Discounted Payback (continued)
Year
1
2
3
4
Accumulated
discounted cash flow
$182
513
1039
1244
Discounted payback period is just under three
years
7-9
1- 10
Ordinary and Discounted Payback
Initial investment = –$300
R = 12.5%
Cash Flow
Accumulated Cash Flow
Year
Undiscounted
Discounted
Undiscounted
Discounted
1
2
3
4
5
$ 100
100
100
100
100
$ 89
79
70
62
55
$ 100
200
300
400
500
$89
168
238
300
355
• Ordinary payback?
• Discounted payback?
7-10
Advantages and Disadvantages of Discounted
Payback
 Advantages
 Disadvantages
- Includes time value of money
- Easy to understand
- Does not accept negative
estimated NPV investments
-
May reject positive NPV
investments
Arbitrary determination of
acceptable payback period
Ignores cash flows beyond the
cutoff date
7-11
1- 11
1- 12
Accounting Rate of Return (ARR)
Measure of an investment’s profitability.
average net profit
ARR 
average book value
A project is accepted if ARR > target
average accounting return.
7-12
1- 13
Example—ARR
Year
1
2
3
$440
$240
$160
Expenses
220
120
80
Gross profit
220
120
80
Depreciation
80
80
80
140
40
0
35
10
0
$105
$30
$0
Sales
Taxable income
Taxes (25%)
Net profit
Assume initial investment = $240
7-13
1- 14
Example—ARR (continued)
$105  $30  $0
Average net profit 
3
 $45
Initial investment  Salvage value
2
$240  $0

2
 $120
Average book value 
7-14
1- 15
Example—ARR (continued)
Average net profit
Average book value
$45

$120
 37.5%
ARR 
7-15
1- 16
Disadvantages of ARR
The measure is not a ‘true’ reflection of
return.
Time value is ignored.
Arbitrary determination of target average
return.
Uses profit and book value instead of cash
flow and market value.
7-16
1- 17
Advantages of ARR
Easy to calculate and understand.
Accounting information almost always
available.
7-17