Finance: Chapter 9: Net Present Value and Other Investment Criteria

Payback Period The amount of time required for an investment to generate cash flows sufficient to recover its initial cost
Discounted Payback The length of time required for an investment’s discounted cash flows to equal its initial cost
Average Accounting Return (AAR) An investments average net income divided by its average book value
Net Present Value (NPV) The difference between an investment’s market value and its cost. It is a measure of how much value is created or added today by undertaking an investment.
If the payback period is less than some present limit When do you accept the payback period?
Payback Rule An investment is acceptable if its calculated payback period is less than some prespecified number of years
Advantages of Payback – easy to understand and compute – adjusts for uncertainty of later cash flows – biased toward liquidity
Disadvantages of Payback – ignores the time value of money – required an arbitrary cutoff point- ignores cash flows beyond the cutoff date- biased against long-term projects, such as research and development, and new projects
Advantages of NPV – considers all of the cash flows in the computation- uses the time value of money- provides the answer in dollar terms, which is easy to understand
Disadvantages of NPV – requires the use of time value and money, thus a bit more difficult to compute- projects that differ by order of magnitude in cost are not obvious in the NPV final figure
Disadvantages of Payback – requires an arbitrary cutoff point – ignores cash flows beyond the cutoff point – biased against long-term projects, such as research and development and new products – may reject positive NPV investments
Average Account Return Rule Accept if the average accounting return exceeds a target average accounting return
accept the project if NPV is positive When do you accept a projected based on NPV?
Positive NPV The project is expected to add value to the firm and will therefore increase the wealth of the owners.
Internal Rate of Return (IRR) the discount rate that makes the NPV of an investment zero. It is the most important alternative to NPV. It is based entirely on the estimated cash flows and is independent of interest rates found elsewhere.
IRR Rule Accept if the IRR exceeds the required return. It should be rejected otherwise.
Advantages of IRR – considers the cash flows in the computation- uses the time value of money- if it is high enough, you may not need to estimate a required return- usually provides a similar answer to the NPV computation
Disadvantages of IRR – uses the firm’s required rate of return for comparison – usually high numbers can often occur when a significant amount of the project’s cash flows occur early in the life of the project
Profitability Index (PI) The present value of an investment’s future cash flows divided by its initial cost. Also called the benefit-cost ratio. It is usual in situations where you have multiple projects of hugely different costs and/or limited capitl. PV of future cash flows/initial investment
PR decision rule Accept if PI is greater than 1.
Modified Internal Rate of Return (MIRR) The possibility that more than one discount rate will make the NPV of an investment zero. The reinvestment rate for the cash flows is determined by the evaluator. It can produce a single number with specific rates for borrowing and reinvestment.
Net Present Value Profile A graphical representation of the relationship between an investment’s NPVs and various discount rates.
Mutually Exclusive Projects If you chose one, you can’t choose another.
When NPV and IRR indicate different rankings for mutually exclusive projects – initial investments are substantially different- timing of cash flows is substantially different
Mutually exclusive projects and nonconvential cash flows When will NPV an IRR give us different decisions?
NPV and IRR most commonly used in primary investment criteria and payback in secondary investment criteria NPV Which criteria are mostly used in practice and which one should you always use if there is a conflict between another decision rule?

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