Chapter7b

Chapter7b - Chapter 7 (Contd) Investment Decision Rules...

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Chapter 7 (Cont’d) Investment Decision Rules
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4 Spring 2011 Outline Decision Rules Standalone Projects Mutually Exclusive Projects Projects w/ Resource Constraints NPV vs. IRR Pay Back Profitability Index Differences in Scales Timing of CF Differences in Lives Delayed Investments Multiple IRRs
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5 Spring 2011 Learning Objectives 1. Compare NPV and IRR when selecting mutually exclusive projects, and explain why NPV always gives the correct decision. 2. Compute the crossover point or incremental IRR for mutually exclusive projects with differences in scales and timing of cash flows. 3. Compute Equivalent Annual Annuity (Equivalent Annual Cost EAC) for mutually exclusive projects with different lives. 4. Compute profitability index and use it to select projects under resource constraints.
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6 Spring 2011 Mutually Exclusive Projects When you must choose only one project among several possible projects, the choice is mutually exclusive. Problem: Consider the following two mutually exclusive projects with same initial investment (projects of identical scale): Girlfriend’s Business 2-computer Internet Cafe Initial Investment $10,000 $10,000 Cash Flow Year 1-3 $6,000 $5,000 Cost of Capital 12% 12%
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7 Spring 2011 Projects of Identical Scale Solution: Girlfriend’s Business NPV = $4,411; IRR = 36.3% Internet Cafe NPV = $2,009; IRR = 23.4% Both the NPV rule and the IRR rule indicate the girlfriend’s business is the better alternative. -$10,000 $6,000 $6,000 $6,000 -$10,000 $5,000 $5,000 $5,000
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8 Spring 2011 NPV Profiles of Projects w/ Identical Scale
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9 Spring 2011 Projects with Differences in Scale What if there are 10 computers in the internet cafe? i.e., the internet café investment is 5 times larger? The NPV would be 5 times larger at $2009*5 = $10,046, but the IRR remains the same at 23.4%. The girlfriend’s business has an IRR of 36.3%, but its NPV is only $4,411. Our decision: Use NPV rule The 10-computer internet café makes more money. It has a higher NPV.
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10 Spring 2011 Return Vs Dollar Impact on Value The IRR is a measure of the average return , but NPV is a measure of the total dollar impact on value . When a project’s size is doubled, its NPV will double. This is not the case with IRR. the IRR rule cannot be used to compare projects of different scales. NPV rule is the best decision rule because it is consistent with the objective of wealth maximization.
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11 Spring 2011 NPV Profiles of Projects w/ Different Scale The NPV of the 10- computer internet cafe is larger than the NPV of the girlfriend’s business for cost of capital lower than 20%.
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12 Spring 2011 Crossover Point (Incremental IRR) Problem: How to Compute the crossover point?
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This note was uploaded on 07/30/2011 for the course FIN 111 taught by Professor Mark during the Spring '11 term at HKU.

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Chapter7b - Chapter 7 (Contd) Investment Decision Rules...

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