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Outline Net Present Value The Payback Rule The Discounted Payback The Average Accounting Return The Internal Rate of Return The Profitability Index Net Present Value The difference between the market value of a project and its cost How much value is created from undertaking an investment? 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. Project Example Information You are reviewing a new project and have estimated the following cash flows: Year 0: CF = -165,000 Year 1: CF = 63,120; NI = 13,620 Year 2: CF = 70,800; NI = 3,300 Year 3: CF = 91,080; NI = 29,100 Average Book Value = 72,000 Your required return for assets of this risk level is 12%. NPV Decision Rule If the NPV is positive, accept the project 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. Computing NPV for the Project Using the formulas: NPV = -165,000 + 63,120/(1.12) + 70,800/(1.12) 2 + 91,080/(1.12) 3 = 12,627.41 Using the calculator: CF = -165,000; C01 = 63,120; F01 = 1; C02 = 70,800; F02 = 1; C03 = 91,080; F03 = 1; NPV; I = 12; CPT NPV = 12,627.41 Do we accept or reject the project? Payback Period How long does it take to get the initial cost back in a nominal sense? Computation Estimate the cash flows 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 Computing Payback for the Project Assume we will accept the project if it pays back within two years. Year 1: 165,000 63,120 = 101,880 still to recover Year 2: 101,880 70,800 = 31,080 still to recover Year 3: 31,080 91,080 = -60,000 project pays back in year 3 Do we accept or reject the project? Computing Payback for the Project 50 . 35 $ )) 15 . / )) 15 . 1 / 1 ( 1 (( * 100 ( 4250 ) ( 81 . 11 $ ) 15 . 1 / 200 ( ) 15 . 1 / 100 ( 250 ) ( 4 2 =- +- =- = + +- = long NPV short NPV Advantages and Disadvantages of Payback Advantages Easy to understand Adjusts for uncertainty of later cash flows Biased toward liquidity Disadvantages Ignores the time value of money Requires an arbitrary cutoff point Ignores cash flows beyond the cutoff date Biased against long- term projects, such as research and development, and new projects Discounted Payback Period Compute the present value of each cash flow and then determine how long it takes to pay back on a discounted basis Compare to a specified required period Decision Rule - Accept the project if it pays back on a discounted basis within the specified time Computing Discounted Payback for the ... View Full Document