°






|
  
    



6
 


‡ Question: are we creating value for the firm?

± Do not forget about TVM and risk
‡ Net Present Value
‡ Other Investment Criteria
± The Internal Rate of Return
± The (Discounted) Payback Rule
± The Average Accounting Return
± The Profitability Index
‡ The Practice of Capital Budgeting


 
 |
  
    



6 °  

‡ The difference between the market value of a

project and its cost
‡ Discounted Cash Flow (DCF) Valuation:
± The first step is to estimate the expected future
cash flows
± The second step is to estimate the required return
for projects of this risk level
± The third step is to find the present value of the
cash flows and subtract the initial investment


 
 |
  
    



6 ° 




‡ O




 





‡ A positive NPV means that the project is
expected to add value to the firm and will
therefore increase the wealth of the owners
‡ Since our goal is to increase owner wealth,
NPV is a direct measure of how well this
project will meet our goal


 
 |
  
    



6 @

°
°


‡ You are looking at a new project and you have

estimated the following cash flows:
± Year 0:CF = -
,000
± Year
:CF = ,
0;
± Year :CF = 70,800;
± Year :CF = 6
,080;
‡ Your required return for assets of this risk is


‡ NPV = ,
0/(

) + 70,800/(

) +
6
,080/(

) ±
,000 =
,7 
‡ ½









 
 |
  
    



6 


@

  °

‡ Does the NPV rule account for the time value

of money?
‡ Does the NPV rule account for the risk of the
cash flows?
‡ Does the NPV rule provide an indication about
the increase in value?
‡ Should we consider the NPV rule for our
primary decision criteria?


 
 |
  
    



6 O   
 

‡ Definition: IRR is the return that makes the

NPV = 0
‡ Decision Rule: ˜






O







‡ This is the most important alternative to NPV
± Often used in practice
± Intuitively appealing
± Based entirely on the estimated cash flows and is
independent of interest rates found elsewhere
‡ Compute using trial and error process

 
 |
  
    



67 @
O
NPV Profile For The Project









IRR =






























u




















u




 

 
 |
  
    



68 °O

‡ NPV and IRR will generally give us the same

decision
‡ Exceptions
± Non-conventional cash flows ± cash flow signs
change more than once ± may be several IRRs
± Mutually exclusive projects
‡ Initial investments are substantially different
‡ Timing of cash flows is substantially different
‡ Whenever there is a conflict between NPV and
another decision rule, you should  use
NPV

 
 |
  
    



66




 @ 

‡ Suppose an investment will cost $60,000
initially and will generate the following cash
flows:
± Year
:
,000
± Year :
00,000
± Year : -
0,000
‡ The required return is
; IRR = 0
; 0 
‡ Should we accept or reject the project?
‡ You need to recognize that there are non-
conventional cash flows and look at the NPV
profile

 
 |
  
    



6
0 °°


IRR =
0

 and  















G 







G 






G 






G







G 






 


 
 |
  
    



6

O   !"#
°


‡ Mutually exclusive projects

± If you choose one, you can¶t choose the other
± Example: You can choose to attend graduate
school next year at either Harvard or Stanford, but
not both
‡ Intuitively you would use the following
decision rules:
± NPV ± choose the project with the higher NPV
± IRR ± choose the project with the higher IRR


 
 |
  
    



6

"# $
  !"#
°

Period Project A Project B
The required return
for both projects is
0 -00 -00
0

 
Which project
  00 should you accept
and why?
IRR
6  
7

NPV  0 0 7


 
 |
  
    



6
 °°










IRR for A =
6 



IRR for B = 
7





Crossover Point =

8

























G











G 



 


 
 |
  
    



6
 G

%° !& '°



‡ How long does it take to get the initial cost

back in a nominal sense?
‡ Computation
± Estimate the cash flows
± Subtract (present value of) the future cash flows
from the initial cost until the initial investment has
been recovered
‡ Decision Rule ± ˜













 



 
 |
  
    



6
 @

° !& '
 °


‡ Assume we will accept the project if it pays

back within two years
± Year
:
,000 ± ,
0 =
0
,880 still to
recover
± Year :
0
,880 ± 70,800 = 
,080 still to recover
± Year : 
,080 ± 6
,080 = -0,000 i
i 

  
‡ ½










 
 |
  
    



6
  

 

‡ There are many different definitions for

average accounting return
‡ We use:
± Average net income / average book value
‡ Need to have a target cutoff rate
‡ Decision Rule: ˜






˜˜






 



 
 |
  
    



6
7 @


 °


‡ Project:
± Year
:NI =
,0;
± Year :NI = ,00;
± Year :NI = 6,
00;
± average book value 7,000
± require an average accounting return of 
‡ Average Net Income:
± (
,0 + ,00 + 6,
00) /  =
,0
‡ AAR =
,0 / 7,000 = 
 = 

‡ ½









 
 |
  
    



6
8 °

 &

!O#

‡ Measures the benefit per unit cost, based on

the time value of money
‡ A profitability index of

implies that for
every $
of investment, we create an
additional $0
0 in value
‡ This measure can be very useful in situations
where we have limited capital


 
 |
  
    



6
6 ° 

‡ Advantages of NPV ‡ Disadvantages of NPV

± Accounts for time value
of money and risk
± Does not requires an
arbitrary cutoff point
± Balances long-term and
short-term goals
± Based on market values,
not accounting values
± May be difficult to
communicate
± May be difficult to
calculate
± Does not account for
liquidity needs


 
 |
  
    



6 0 @ 
 (
O° 


‡ We should consider several investment criteria

when making decisions
‡ NPV and IRR are the most commonly used
primary investment criteria
‡ Payback is a commonly used secondary
investment criteria


 
 |