# 06_Oheads - Lecture Notes 6 Alternative Investment Rules...

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1 Lecture Notes 6 Alternative Investment Rules Key features of net present value • A firm operating in the interests of its shareholders should ac- cept investment projects if and only if they have positive NPV . • The net present value criterion has three key features: i. NPV uses cash flows . – Other criteria often use accounting earnings. ii. NPV uses all the cash flows of a project. – Other criteria often ignore cash flows beyond some date iii. NPV discounts future cash flows. – Discounting represents an opportunity cost of funds. The payback period rule • The payback period is the number of years it takes before the sum of the undiscounted cash flows from the project is positive. • The payback period rule accepts all and only those projects that

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2 have a payback period less than or equal to a “cutoff” time. Example . Consider the projects in Table 1. Suppose the appropriate discount rate is 12%. The NPV are (1) (2) • Serious deficiencies of the payback period rule: i. By foregoing discounting, it ignores the timing of cash flows within the payback period and the opportunity cost of funds. ii. Cash flows beyond the “cutoff” time are ignored. iii. The rule favors projects with early positive cash flows. • There is no rational basis for focusing on the time it takes to “re- cover” the investment. By contrast, NPV focuses on excess re- turns , or the benefit relative to the next best alternative. Table 1: Cash flows on two projects Project C 0 C 1 C 2 C 3 Payback Period X -1,000 1,000 0 0 1 year Y -1,000 500 500 2,000 2 years NPV X () 1000 1000 1.12 ----------- + 107.14286 == NPV Y 1000 500 1.12 ---------- 500 1.12 2 ----------------- 2000 1.12 3 ++ + 1268.586
3 • Why is the payback period rule used? Possible explanations: i. The decisions are minor ones with short horizons. ii. A more formal procedure might cost more in administrative expenses than it saves in terms of making better decisions. iii. The quality of decision-making is relatively easy to evaluate. iv. A limit on the funds allowed to be allocated using a payback period rule forces crucial decisions to be made at a higher level. v. Early cash flows may be important if the firm is liquidity con- strained, but there are better ways of handling this. • In response to objection (i), the discounted payback period rule has been proposed. This rule has the defects: i. it ignores cash flows beyond the cutoff period, ii. the rule still favors projects with early positive cash flows, iii. once we have implemented discounting, we might as well use the conceptually correct NPV rule instead.

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## 06_Oheads - Lecture Notes 6 Alternative Investment Rules...

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