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Ch7slides - Chapter 7 NPV and other investment rules While...

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Ch, 7- Chapter 7. NPV and other investment rules While we believe that the NPV approach is the best in evaluating capital budgeting projects, there are other approaches as well. This chapter studies alternative investment rules that compete with the NPV in practice. We first consider the NPV as the benchmark Then we consider four alternatives: Payback period Accounting rate of return Internal rate of return Profitability index 1
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Ch, 7- The Net Present Value (NPV) Rule Net Present Value (NPV) = Total PV of future CF’s – Initial Investment To get NPV we need to: 1. Estimate future cash flows: how much? and when? 2. Estimate discount rate 3. Estimate initial costs Minimum Acceptance Criteria: Accept if NPV > 0 Ranking Criteria: Choose the highest NPV 2
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Ch, 7- The NPV Rule : Example Assume you have the following information on Project X: Initial outlay -$1,100 Required return = 10% Annual cash revenues and expenses are as follows: Year Revenue Expenses 1 $1,000 $500 2 2,000 1,300 3 2,200 2,700 4 2,600 1,400 3
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Ch, 7- NPV = -C 0 + PV 0 (Future CFs) = -C 0 + C 1 /(1+r) + C 2 /(1+r) 2 + C 3 /(1+r) 3 + C 4 /(1+r) 4 = -1,100 + 500/1.1 + 700/1.1 2 + (-500)/1.1 3 + 1,200/1.1 4 = $377.02 > 0 The NPV Rule : Example (continued) 4 Based on the NPV rule, one should accept this project There are other rules to help decide whether a given project should be accepted or not
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Ch, 7- The Payback Period Rule How long does it take the project to “pay back” its initial investment? Payback Period = number of years to recover initial costs Minimum Acceptance Criteria: set by management Ranking Criteria: set by management may depend on amount invested. E.g., Big money projects is expected to pay back earlier than small projects 5
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Ch, 7- The Payback Period Rule (continued) Disadvantages: Ignores the time value of money Ignores cash flows after the payback period Biased against long-term projects Requires an arbitrary acceptance criteria A project accepted based on the payback criteria may not have a positive NPV Advantages: Easy to understand Biased toward liquidity 6
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Ch, 7- The Discounted Payback Period Rule How long does it take the project to “pay back” its initial investment taking the time value of money into account? Decision rule: Accept the project if it pays back on a discounted basis within the specified time. Disadvantages • By the time you have discounted the cash flows, you might as well calculate the NPV. • Suffers from the same disadvantages as the payback period rule except for the first one. 7
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Ch, 7- Assume you have the following info on Project X: Initial outlay -$1,000 Required return = 10% Annual that cash flows and their PVs are as follows: Year Cash flow PV of Cash flow 1 $ 200 $ 182 2 400 331 3 700 526 4 300 205 The Discounted Payback Period Rule: Example 8
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Ch, 7- Year Accumulated discounted CF 1 $ 182 2 513 3 1,039 4 1,244 The Discounted Payback Period Rule: Example (continued) Using the linear interpolation the discounted payback period is 2.93 When the discount rate is 0, it reduces to the regular payback period rule 9
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Ch, 7- The Average Accounting Return Rule Another attractive but fatally flawed approach.
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