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Net Present Value and Other Investment Criteria
Net Present Value and Other Investment Criteria
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McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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Chapter Outline
• The Practice of Capital Budgeting
• The Payback Rule
• The Average Accounting Return
• Net Present Value
• The Internal Rate of Return
• The Profitability Index
• Conflicts between NPV & IRR
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Capital Budgeting
• Investment in long-term assets
• We should consider several investment
criteria when making decisions:
– Payback period
– Average Accounting Return
– Net Present Value
– Internal Rate of return
– Profitability Index
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1. Payback Period
• How long does it take to get the initial cost
back in a nominal sense? (how long it
takes to recover the cost of investment?)
• Computation - Subtract the future cash
flows from the initial cost until the initial
investment has been recovered
• Decision Rule – Accept if the payback
period is less than some preset limit
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Example
• Assume we will accept the project if it pays back
within two years.
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Example
• Assume we require an average accounting
return of 25%
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NPV formula
n
NPV
CF t
t
t 0 (1 r )
NPV CF0
CF1 CF2 ..... CFn
1 2 n
(1 r) (1 r ) (1 r )
NPV = - (Cost of Investment) + PV(Cash flows)
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Example
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IRR formula
CF 1
CF 2
.....
CF n
CF0 1 2 n
(1 IRR ) (1 IRR) (1 IRR )
• Financial Calculator
• Constant Cash Flows – table
• Trial and Error
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Example
CF1 CF2 CFn
CF0 1
2
..... n
(1 IRR ) (1 IRR ) (1 IRR )
63120 70800 91080
165,000 1
2
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(1 IRR ) (1 IRR ) (1 IRR )
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20,000
10,000
0
-10,000 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22
-20,000
Discount Rate
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Advantages of IRR
• Knowing a return is intuitively appealing
• It is a simple way to communicate the value of a
project to someone who doesn’t know all the
estimation details
• If the IRR is high enough, you may not need to
estimate a required return, which is often a
difficult task
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Profitability Index
• Profitability Index=PV(future cash flow)/Initial Cost
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Summary
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Which project should
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NPV
IRR
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NPV Profiles
$60.00
B
$40.00
$20.00
$0.00
($20.00) 0 0.05 0.1 0.15 0.2 0.25 0.3
($40.00)
Discount Rate
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Quick Quiz
• Consider an investment that costs $100,000 and
has a cash inflow of $25,000 every year for 5
years. The required return is 9%.
– What is the payback period?
– What is the NPV?
– What is the IRR?
– Should we accept the project?
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Tutorial
• Problem 4, 7 and 15 from page 258
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