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MITOCW | watch?v=sMKQywwkIjQThe following content is provided under a Creative Commons license. Your support will help MITOpenCourseWare continue to offer high quality educational resources for free. To make a donation, or to viewadditional materials from hundreds of MIT courses, visit MIT OpenCourseWare at ocw.mit.edu.ANDREW LO:In today's lecture, I want to continue where we were last time in talking about applications ofthe net present value rule to capital budgeting and project financing. As promised, today whatI'm going to do is to talk specifically about other alternatives to net present value that are notrecommended, but which you need to know about simply because they actually are used inpractice to some degree. And you have to be an intelligent consumer of all of these differentideas so that you can pick and choose.And actually, there are some instances where these other alternatives can shed some light onthe particular problem and challenges at hand. I'll try to describe those as we go over them.Before I do, a student came up and asked me about a concept called adjusted present value. Iwanted just to make a note of that because, so far, we've been talking about NPV. But in fact,both the textbook, as well as the best practices, would suggest that you use something calledadjusted present value. Which basically makes adjustments for things like taxes, projectinteractions, strategic alternatives, optionality, and so on. I want to recommend that you first ofall, keep in mind this notion of adjusted present value. That's what you'll be learning about in402, and in more advanced courses on capital budgeting and project financing.So for now, NPV is the right answer, but when you learn more about how to make thoseadjustments, you're going to want to use them, and then we call the particular criterion APVinstead of NPF. Just terminology that you should be aware of.All right, so what I want to do today, as I said, is to talk about three other approaches to capitalbudgeting that various professionals have used in the past, and which some are used to agreat extent even today. And they are payback period and the discounted version of thatcalled discounted payback. Second is the IRR, Internal Rate of Return, and the third is theprofitability index.Each of these have its own particular uses, and I'm going to try to describe them to you verybriefly. And then we're going to talk about different applications. The bottom line, just to besure that there's no misunderstanding, NPV is always the right thing to do. So that's whatwe're recommending for any capital budgeting application. However, you should stillunderstand what these three other alternatives are so that you can speak about them
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intelligently, talk about their advantages, and disadvantages.
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  • Spring '17
  • Jim Angel

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