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1、Net Present Value and Other Investment Rules,Chapter 5,Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.,McGraw-Hill/Irwin,Key Concepts and Skills,Be able to compute payback and discounted payback and understand their shortcomings Be able to compute the internal rate of return a
2、nd profitability index, understanding the strengths and weaknesses of both approaches Be able to compute net present value and understand why it is the best decision criterion,Chapter Outline,5.1 Why Use Net Present Value? 5.2 The Payback Period Method 5.3 The Discounted Payback Period Method 5.4 Th
3、e Internal Rate of Return 5.5 Problems with the IRR Approach 5.6 The Profitability Index 5.7 The Practice of Capital Budgeting,5.1 Why Use Net Present Value?,Accepting positive NPV projects benefits shareholders. NPV uses cash flows NPV uses all the cash flows of the project NPV discounts the cash f
4、lows properly,The Net Present Value (NPV) Rule,Net Present Value (NPV) = Total PV of future CFs + 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: C
5、hoose the highest NPV,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 fl
6、ows beginning with year 1. Add the initial investment after computing the NPV.,5.2 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 Ranking Criter
7、ia: Set by management,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 Advantag
8、es: Easy to understand Biased toward liquidity,5.3 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
9、the time you have discounted the cash flows, you might as well calculate the NPV.,5.4 The Internal Rate of Return,IRR: the discount rate that sets NPV to zero Minimum Acceptance Criteria: Accept if the IRR exceeds the required return Ranking Criteria: Select alternative with the highest IRR Reinvest
10、ment assumption: All future cash flows are assumed to be reinvested at the IRR,Internal Rate of Return (IRR),Disadvantages: Does not distinguish between investing and borrowing IRR may not exist, or there may be multiple IRRs Problems with mutually exclusive investments Advantages: Easy to understan
11、d and communicate,IRR: Example,Consider the following project:,The internal rate of return for this project is 19.44%,NPV Payoff Profile,If we graph NPV versus the discount rate, we can see the IRR as the x-axis intercept.,Calculating IRR with Spreadsheets,You start with the same cash flows as you d
12、id for the NPV. You use the IRR function: You first enter your range of cash flows, beginning with the initial cash flow. You can enter a guess, but it is not necessary. The default format is a whole percent you will normally want to increase the decimal places to at least two.,5.5 Problems with IRR
13、,Multiple IRRs Are We Borrowing or Lending The Scale Problem The Timing Problem,Mutually Exclusive vs. Independent,Mutually Exclusive Projects: only ONE of several potential projects can be chosen, e.g., acquiring an accounting system. RANK all alternatives, and select the best one. Independent Proj
14、ects: accepting or rejecting one project does not affect the decision of the other projects. Must exceed a MINIMUM acceptance criteria,Multiple IRRs,There are two IRRs for this project:,Which one should we use?,Modified IRR,Calculate the net present value of all cash outflows using the borrowing rat
15、e. Calculate the net future value of all cash inflows using the investing rate. Find the rate of return that equates these values. Benefits: single answer and specific rates for borrowing and reinvestment,The Scale Problem,Would you rather make 100% or 50% on your investments? What if the 100% retur
16、n is on a $1 investment, while the 50% return is on a $1,000 investment?,The Timing Problem,The Timing Problem,Calculating the Crossover Rate,Compute the IRR for either project “A-B” or “B-A”,NPV versus IRR,NPV and IRR will generally give the same decision. Exceptions: Non-conventional cash flows cash flow signs change more than once Mutually exclusive projects Initial investments are substantially different Timing of cash flows is substantially different,5.6 The Profitability Index
