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5 Investment Criteria

# 5 Investment Criteria - Click to edit Master subtitle style...

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Click to edit Master subtitle style Investment Decision Rules 11

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Learning Objectives Decision Criteria l NPV l The Payback Rule l Accounting Rate of Return l IRR l Mutually Exclusive Projects l The case of multiple IRRs 22
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? l We will look at these questions for each 33

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Project Example 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 l Your required return for assets of this risk is 12%. 44
Net Present Value The NPV of a project is the sum of discounted cash flows, both inflows (revenue, income, etc.) and outflows (investment costs). l 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 55

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NPV Decision Rule If the NPV is positive, accept the project f A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners. l Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal. l One advantage of NPV is that it is an additive measure: 66
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 l Do we accept or reject the project? l Since the NPV > 0, accepting the project would increase firm value by 12,627.42 and 77

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The NPV rule accounts for the time value of money, by discounting. l The NPV rule accounts for the risk of the cash flows, by using an appropriate discount rate. l
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5 Investment Criteria - Click to edit Master subtitle style...

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