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Outline
•
Net Present Value
•
The Payback Rule
•
The Discounted Payback
•
The Average Accounting Return
•
The Internal Rate of Return
•
The Profitability Index
Net Present Value
•
The difference between the market value of a project
and its cost
•
How
much
value
is
created
from
undertaking
an
investment?
–
The first step is to estimate the expected future cash flows.
–
The
second
step
is
to
estimate
the
required
return
for
projects of this risk level.
–
The third step is to find the present value of the cash flows
and subtract the initial investment.
Project Example Information
•
You are reviewing a new project and have estimated
the following cash flows:
–
Year 0: CF = 165,000
–
Year 1: CF = 63,120; NI = 13,620
–
Year 2: CF = 70,800; NI = 3,300
–
Year 3: CF = 91,080; NI = 29,100
–
Average Book Value = 72,000
•
Your
required
return
for
assets
of
this
risk
level
is
12%.
NPV – Decision Rule
•
If the NPV is positive, accept the project
•
A
positive
NPV
means
that
the
project
is
expected
to
add
value
to
the
firm
and
will
therefore increase the wealth of the owners.
•
Since
our
goal
is
to
increase
owner
wealth,
NPV
is
a
direct
measure
of
how
well
this
project will meet our goal.
Computing NPV for the Project
•
Using the formulas:
–
NPV = 165,000 + 63,120/(1.12) + 70,800/(1.12)
2
+
91,080/(1.12)
3
= 12,627.41
•
Using the calculator:
–
CF
0
= 165,000; C01 = 63,120; F01 = 1; C02 = 70,800; F02
= 1; C03 = 91,080; F03 = 1; NPV; I = 12; CPT NPV =
12,627.41
•
Do we accept or reject the project?
Payback Period
•
How
long
does
it
take
to
get
the
initial
cost
back in a nominal sense?
•
Computation
–
Estimate the cash flows
–
Subtract
the
future
cash
flows
from
the
initial
cost
until
the
initial
investment
has
been recovered
•
Decision Rule –
Accept if the payback period
is less than some preset limit
Computing Payback for the Project
•
Assume
we
will
accept
the
project
if
it
pays
back within two years.
–
Year 1: 165,000 – 63,120 = 101,880 still to
recover
–
Year 2: 101,880 – 70,800 = 31,080 still to
recover
–
Year 3: 31,080 – 91,080 = 60,000
project
pays back in year 3
•
Do we accept or reject the project?
Computing Payback for the Project
50
.
35
$
))
15
.
0
/
))
15
.
1
/
1
(
1
((
*
100
(
4250
)
(
81
.
11
$
)
15
.
1
/
200
(
)
15
.
1
/
100
(
250
)
(
4
2
=

+

=

=
+
+

=
long
NPV
short
NPV
Advantages and Disadvantages of
Payback
•
Advantages
–
Easy to understand
–
Adjusts for
uncertainty of later
cash flows
–
Biased toward
liquidity
•
Disadvantages
–
Ignores the time value
of money
–
Requires an arbitrary
cutoff point
–
Ignores cash flows
beyond the cutoff date
–
Biased against long
term projects, such as
research and
development, and new
projects
Discounted Payback Period
•
Compute the present value of each cash flow and then
determine
how
long
it
takes
to
pay
back
on
a
discounted basis
•
Compare to a specified required period
•
Decision Rule 
Accept the project if it pays back on
a discounted basis within the specified time
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