# Chapter 6 - Chapter 6 NPV versus its Competitors Overview...

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Chapter 6 NPV versus its Competitors

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Overview Key features of NPV rule: Recognizes the time value of money Recognizes the risk of the project Calculations only affected by cash flows and risk Additive: NPV(A + B) = NPV(A) + NPV(B) Competitors 1. Payback period rule and discounted payback rule 2. Average accounting return 3. The internal rate of return
Payback Rule Payback period = number of years before expected cash flows equal initial outlay Payback rule: Accept all projects with a payback period shorter than some cutoff Example: Project C0 C1 C2 C3 Payback NPV at period r=.10 A -2,000 +500 +500 +5,000 3 2,624 B -2,000 +500 +1,800 0 2 -58 C -2,000 +1,800 +500 0 2 +58 If cutoff is 2 years, rule says reject project A and accept projects B and C Very different conclusion from NPV rule

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What’s going on? Payback sets r=0 for cash flows before the cutoff period ends, r= for cash flows afterwards Problems: (1) ignores the time value of money within the payback period (2) totally ignores the long-run payouts from a project (i.e. after period) (3) cutoff date is arbitrary Set it short  tend to reject positive NPV projects Set it long  tend to accepts negative NPV projects Firms often set cutoff date by guesswork based on a “typical” projects cash flow pattern
A “slight” improvement – discounted payback How does this work? First discount all cash flows from a project Calculate payback period for discounted cash flows Accept project if discounted payback period < cutoff r0 for cash flows before the cutoff period ends (good) r= for cash flows afterwards (bad) Why would firms ever use such silly rules? 1. Simple and easy to communicate 2. Easy to check ex post whether decision was correct 3. If firm is cash constrained, quick payback may allow reinvestment

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Average Accounting Return Basic approach is to calculate: (avg. net income)/(avg. book value of investment) Compare this to book return for firm’s other assets or industry averages Example: Consider project that costs \$9,000 and generates income for 3 years Year 0 Year 1 Year 2 Year 3
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Chapter 6 - Chapter 6 NPV versus its Competitors Overview...

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