chapter6A

# chapter6A - Chapter 6 NPV versus its Competitors Example:...

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Chapter 6 NPV versus its Competitors

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Example: Net Present Value The Alpha Corporation is considering investing in a riskless project costing \$100. The project receives \$107 in one year and has no other cash flows. The discount rate is 6 percent. NPV of the project = The basic investment rule: Accept if the NPV is greater than zero Reject if the NPV is less than zero How do we interpret the NPV of \$.94?
Overview Key features of NPV rule: Competitors 1. Payback period rule and discounted payback rule 2. Average accounting return 3. The internal rate of return

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Payback period method Payback period = number of years before expected cash flows equal initial outlay Payback rule: Accept all projects with a payback period shorter than some cutoff Example: Project C 0 C 1 C 2 C 3 C4 Payback NPV at period r=.10 A -100 50 50 0 60 2 21.52 B -100 50 30 20 60 3 26.26 C -100 30 50 20 60,000 3 40,966.08
Problems: (1) ignores the time value of money within the payback period (2) totally ignores payments after the payback period (3) cutoff date is arbitrary Set it short tend to reject positive NPV projects Set it long tend to accepts negative NPV projects Firms often set cutoff date by guesswork based on a “typical” projects cash flow pattern

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A “slight” improvement – discounted payback How does this work? First discount all cash flows from a project Calculate payback period for discounted cash flows Accept project if discounted payback period < cutoff Why would firms ever use such silly rules? 1. Simple and easy to communicate 2. Easy to check ex post whether decision was correct 3. If firm is cash constrained, quick payback may allow reinvestment
Average Accounting Return Basic approach is to calculate: (avg. net income)/(avg. book value of investment)

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## This note was uploaded on 04/15/2008 for the course BUS 135 taught by Professor Na during the Winter '08 term at UC Riverside.

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chapter6A - Chapter 6 NPV versus its Competitors Example:...

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