448_06AltRules - Lecture Notes 6 Alternative Investment...

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47 Lecture Notes 6 Alternative Investment Rules Key features of net present value • We showed in lecture notes 3 that a firm operating in the interests of its shareholders should ac- cept investment projects if and only if they have positive net present value. • The net present value criterion has three key features: i. NPV uses cash flows. Other criteria often use earnings. Accounting earnings, however, are an artificial construct that need not bear a close relationship to the true economic benefits or costs of a project. Furthermore, accounting earnings can be altered by choosing different accounting rules. ii. NPV uses all the cash flows of a project. While a particular investment may affect earnings far into the future, other criteria often arbitrarily ignore cash flows beyond a particular date. iii. NPV discounts the cash flows properly. Discounting recognizes the opportunity cost of having funds invested in a particular project and unavailable for alternative investments. Approaches that ignore discounting do not take account of this important cost of investing. 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. A particular cutoff time, say two years, is then selected and the pay- back period rule accepts all and only those projects that have a payback period less than or equal to the cutoff. • The payback period rule has three serious deficiencies: i. The rule ignores the timing of cash flows within the payback period. Cash flows are simply summed regardless of the year in which they occur. By treating cash flows in different years with- in the period as equivalent the payback period rule effectively assumes a discount rate of zero – that is, it ignores the opportunity cost of investing. ii. The payback period rule ignores all cash flows beyond the cutoff time. This can lead to the
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48 rejection of very profitable projects with a long gestation period. iii. There is no rational basis for choosing the cutoff time. • Despite these critical flaws, the payback period rule continues to be used for some investment decisions. Fortunately for the shareholders, these are usually decisions that are of minor conse- quence for the profitability of the firm. Since so little is at stake with these decisions other factors may be more important. For example, a more formal procedure that required more elaborate jus- tification might cost more in administrative expenses than it saves in terms of making better in- vestment decisions. Furthermore, it is relatively easy to evaluate the quality of decision-making under a simple payback period rule. To see that subordinates are accurate in their understanding of the costs and benefits of a projects, supervisors merely need to check at the end of the cutoff time that the sum of the cash flows has indeed been positive. Finally, since the rule discriminates
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This note was uploaded on 12/20/2011 for the course ECON 448 taught by Professor Bejan during the Spring '06 term at Rice.

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448_06AltRules - Lecture Notes 6 Alternative Investment...

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