Lecture 4
NPV & Other Techniques

Major Topics
•
The following topics will be discussed in this
lecture :
–
Concepts of Capital Budgeting.
–
Major investment criteria, including :
•
Net Present Value
•
Payback Rule
•
Average Accounting Return Rule
•
Internal Rate of Return
•
Profitability Index
–
Non-conventional Cash Flows & Mutually Exclusive
Projects
–
Modified Internal Rate of Return
2

Capital Budgeting
•
It is the process of decision making with respect
to investments in fixed assets.
•
It helps to consider whether we should accept or
reject a proposed project.
•
Projects may originate from :
–
Within the firm
–
Other sources
3

Capital Budgeting
•
Within the firm :
–
Research & Development (R&D)
Department of a firm will search for ways of
improving existing products or finding new
projects.
•
Other Sources :
–
Projects may come from the needs to tackle
competitions, from demand of suppliers, or
usually from the pressure from customers.
4

Capital Budgeting Decision Criteria
•
Capital budgeting focuses on free cash flows,
which are the benefits generated from accepting
a capital-budgeting proposal.
•
Based on these free cash flows, we have some
commonly used criteria for determining the
acceptability of investment proposals or projects.
–
Net Present Value (NPV)
–
Payback Rule
–
Average Accounting Return (AAR)
–
Profitability Index
–
Internal Rate of Return (IRR)
5

Capital Budgeting Decision Criteria
•
Before we discuss the details, please
note that when we are evaluating these
decision criteria, we need to consider a
number of factors :
–
Adjustments for Time Value of Money.
–
Adjustments for Risk.
–
Value Creation for the firm.
6

Background Information
•
Before illustrating different decision criteria,
here are the background information of a new
project.
•
Your required return for projects of similar risk
is 12% p.a.
7
Year
Cash Flow $
Net Income $
0
-165,000
1
63,120
13,620
2
70,800
3,300
3
91,080
29,100
Average Book Value = $72,000

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Net Present Value (NPV)
NPV = PV – Required Investment
NPV
C
C
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NPV
C
C
r
C
r
C
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=
+
+
+
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0
1
1
2
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1
1
1
(
)
(
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...
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