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Investment Decision Rules
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Decision Criteria
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NPV
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The Payback Rule
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Accounting Rate of Return
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IRR
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Mutually Exclusive Projects
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The case of multiple IRRs
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Good Decision Criteria
We need to ask ourselves the following
questions when evaluating decision criteria
Does the decision rule adjust for the time value
of money?
Does the decision rule adjust for risk?
Does the decision rule provide information on
whether we are creating value for the firm?
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We will look at these questions for each
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Suppose you are looking at a new project
and you have estimated the following cash
flows and Net Income:
Year 0:
CF = 165,000
Year 1:
CF = 63,120; NI = 13,620
Year 2:
70,800; NI = 3,300
Year 3:
91,080; NI = 29,100
Average Book Value = 72,000
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Your required return for assets of this risk is
12%.
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Net Present Value
The NPV of a project is the sum of discounted cash
flows, both inflows (revenue, income, etc.) and outflows
(investment costs).
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It answers the question: how much value is created from
undertaking a project?
The first step is to estimate the expected cash flows in each
period.
The second step is to estimate the required return for projects of
this risk level.
○
The discount rate, required rate of return or cost of capital.
The third step is to find the present value of the cash flows and
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If the NPV is positive, accept the project
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A positive NPV means that the project is expected to
add value to the firm and will therefore increase the
wealth of the owners.
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Since our goal is to increase owner wealth, NPV is a
direct measure of how well this project will meet our
goal.
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One advantage of NPV is that it is an additive
measure:
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Computing NPV for the
Turning back to our project, we discount
the cash flows at the required rate of return
and find:
NPV = – 165,000 + 63,120/(1.12) + 70,800/
(1.12)2 + 91,080/(1.12)3 = 12,627.42
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Do we accept or reject the project?
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Since the NPV > 0, accepting the project
would increase firm value by 12,627.42 and
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The NPV rule accounts for the time value
of money, by discounting.
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The NPV rule accounts for the risk of the
cash flows, by using an appropriate
discount rate.
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This note was uploaded on 04/04/2011 for the course MBA 648 taught by Professor Jake during the Spring '11 term at Pace.
 Spring '11
 Jake
 Accounting, Finance

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