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Unformatted text preview: Click to edit Master subtitle style Lecture 03 Mark HumpheryJenner Lecture Outline Net Present Value The Payback Rule The Discounted Payback The Average Accounting Return The Internal Rate of Return The Profitability Index The Practice of Capital Budgeting 92 Key Concepts and Skills Be able to compute payback and discounted payback and understand their shortcomings Understand accounting rates of return and their shortcomings Be able to compute internal rates of return (standard and modified) and understand their strengths and weaknesses Be able to compute the net present value and understand why it is the best decision criterion 93 Good Decision Criteria We need to ask ourselves the following questions when evaluating capital budgeting decision rules: 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? 94 Net Present Value The difference between the market value of a project and its cost How much value is created from undertaking an investment? The first step is to estimate the expected future cash flows. The second step is to estimate the required return for projects of this risk level. The third step is to find the present value of the cash flows and subtract the initial investment. 95 Project Example Information You are reviewing a new project and have estimated the following cash flows: Year 0: CF = 165,000 Year 1: CF = 63,120; NI = 13,620 Year 2: CF = 70,800; NI = 3,300 Year 3: CF = 91,080; NI = 29,100 Average Book Value = 72,000 Your required return for assets of this risk level is 12%. 96 NPV – Decision Rule If the NPV is positive, accept the project A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners. Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal. 97 Computing NPV for the Project Using the formulas: NPV = 165,000 + 63,120/(1.12) + 70,800/ (1.12)2 + 91,080/(1.12)3 = 12,627.41 Using the calculator: CF0 = 165,000; C01 = 63,120; F01 = 1; C02 = 70,800; F02 = 1; C03 = 91,080; F03 = 1; NPV; I = 12; CPT NPV = 12,627.41 Do we accept or reject the project?...
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