Mini Case:
12  1
Chapter 12
Capital Budgeting:
Decision Criteria
ANSWERS TO BEGINNINGOFCHAPTER QUESTIONS
121
The 7 criteria are discussed below.
All except the Accounting Rate of Return are
calculated and analyzed in the spreadsheet model for the chapter.
Payback.
Easy to calculate and understand, but doesn’t tell us if the project is
economically profitable because it doesn’t take account of either time value of money or
cash flows beyond the payback period.
Discounted payback.
Does take account of time value of money, and if the
discounted payback is positive, then the project is economically feasible—if it lasts just
over its payback period, then NPV will be positive.
It doesn’t take account of cash flows
beyond the payback period, hence could lead to mistakes when considering mutually
exclusive projects. Does provide a sense of liquidity and risk.
Accounting rate of return.
This method finds the average income over a project’s
life and then divides this income by the average investment over the project’s life.
This
method is flawed because it does not take account of the time value of money.
NPV
is the most logical method, and the one that is most consistent with value
maximization.
It has gained acceptance by businesses (finally), and is now used by most
large corporations.
IRR
is a “reasonable” method that produces correct accept/reject decisions for
independent projects.
It always leads to the same accept/reject decisions as NPV for
independent projects (except where multiple IRRs exist).
However, its rankings of
mutually exclusive projects can differ from NPV rankings if projects’ cash flow timing
patterns differ or if the projects differ in size.
In those cases, NPV is theoretically better.
IRR is widely used—about as widely used as NPV by large companies.
A few years
ago IRR was much more widely used, but NPV has caught up.
IRR does give people an idea of the margin of safety in a project, i.e., cash inflows
could fall quite a bit below forecast and a high IRR project will still be profitable.
MIRR
is not as widely used as IRR, but it is actually superior to the regular IRR
because it is generally more logical to assume reinvestment at the WACC (which the
MIRR generally does) than at the IRR (which the IRR does).
Also, the MIRR can be
calculated with whatever reinvestment rate is deemed most appropriate—we do not have
to use the WACC if there is reason to think that the actual reinvestment rate will be
different from the WACC.
In summary, the MIRR is superior to the regular IRR because
it gives better estimate of the rate of return an investment will actually earn over its
lifetime.
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There cannot be multiple MIRR’s, which is another advantage over the regular IRR.
Also, the MIRR and the NPV always agree on mutually exclusive projects (if the MIRR
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 Spring '08
 melissawilliams
 Net Present Value, Internal rate of return

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