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: – CF0 = -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?
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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