Chap007(WW-FIN357)NT - Chapter 7 NPV and Other Investment...

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Unformatted text preview: Chapter 7 NPV and Other Investment Rules 7-2 Chapter Outline 7.0 The Capital Budgeting Process 7.1 Net Present Value 7.2 The Payback Period 7.3 The Discounted Payback Period 7.4 The Average Accounting Return 7.5 The Internal Rate of Return 7.6 Problems with the IRR Approach 7.7 The Profitability Index 7.8 The Practice of Capital Budgeting 7.9 Spread Sheet Calculations 7-3 Key Concepts and Skills Compute payback and discounted payback and understand their shortcomings Understand accounting rates of return and their shortcomings Compute the IRR and profitability index, understanding the strengths and weaknesses of both approaches Compute the NPV and understand why it is the best decision criterion 7-4 7.0 The Capital Budgeting Process 1. Estimate the projects relevant cash flows 2. Determine the timing of the cash flows 3. Determine the appropriate discount rate 4. Determine the feasibility of the project using an appropriate evaluation technique 7-5 Project Evaluation Techniques Net present value (NPV) Payback period (PP) Discounted payback period (DPP) Average accounting return (AAR) Internal rate of return (IRR) Modified internal rate of return (MIRR) Profitability index (PI) 7-6 Basic Capital Budgeting Data Expected Net Cash Flow Year Project L Project S ($100) ($100) 1 10 70 2 60 50 3 80 20 7-7 7.1 Net Present Value Net Present Value (NPV) = Total PV of future CFs + Initial Investment ( 29 ( 29 1 1 1 n n t t t t t t CF CF NPV CF r r = = = + = + + Estimating NPV: 1. Estimate future cash flows: Amount? Timing? 2. Estimate discount rate (Risk?) 3. Estimate initial costs 7-8 Project L NPV 10 80 60 1 2 3 10% Project L:-100.00 9.09 49.59 60.11 18.79 = NPV L 7-9 Project S NPV 70 20 50 1 2 3 10% Project S:-100.00 63.64 41.32 15.03 19.98 = NPV S 7-10 NPV Calculation Project L Project S CF2 CF1 CF3 CF0 60 10 10-100 80 I/Y NPV $18.79-100 CF0 CF1 CF2 CF3 I/Y NPV 70 50 20 10 $19.98 7-11 Net Present Value Acceptance criteria Relationship between NPV and discount rate Relationship between NPV and stock price Reinvestment assumption Advantages/Disadvantages of NPV? 7-12 7.2 Payback Period How long does it take to recover the projects initial investment? Payback Period = number of years to recover initial costs (CF ) 7-13 Payback for Project L Project L Cash Flows Year Annual Cumulative ($100) ($100) 1 10 (90) 2 60 (30) 3 80 50 Payback L = 2 + 30/80 = 2.375 years 7-14 Payback for Project S Project S Cash Flows Year Annual Cumulative ($100) ($100) 1 70 (30) 2 50 20 3 20 40 Payback S = 1 + 30/50 = 1.6 years 7-15 Payback Period Minimum Acceptance Criteria Ranking Criteria Advantages/Disadvantages of payback? 7-16 7.3 Discounted Payback Period7....
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This note was uploaded on 10/16/2011 for the course FIN 357 taught by Professor Hadaway during the Spring '06 term at University of Texas at Austin.

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Chap007(WW-FIN357)NT - Chapter 7 NPV and Other Investment...

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