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Chapter 5
“
Net Present
Value & Other
Investment
Rules
”
Prepared by
:
Razan Nayef
Jehan Adnan
Dalia Awwad
*

Key Concepts and Skills
▶
Be able to compute payback and discounted payback and
understand their shortcomings
▶
Be able to compute the internal rate of return and profitability
index, understanding the strengths and weaknesses of both
approaches
▶
Be able to compute net present value and understand why it is
the best decision criterion
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Chapter Outline
5.1
Why Use Net Present Value
?
5.2
The Payback Period Method
5.3
The Discounted Payback Period Method
5.4
The Internal Rate of Return
5.5
Problems with the IRR Approach
5.6
The Profitability Index
5.7
The Practice of Capital Budgeting

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5.1
Using The Net Present
Value [NPV
[
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5.1
why do we use the NPV
?
•
NPV : is calculating the difference between the sum of the
present values of the project’s future cash flows and the
initial cost of project .
•
Estimating NPV:
1. Estimate future cash flows: how much? and when?
2. Estimate discount rate
3. Estimate initial costs
•
(NPV) = Total PV of future CF’s + Initial Investment
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The basic investment rule can be generalized thus :
1. accept a project if the NPV is greater then zero
NPV> ZERO
ACCEPT
2. Reject a project if the NPV is less than zero
NPV< ZERO
REJECT
3. Accept less
than risky if the NPV is equal zero
NPV = ZERO
accept less
than risky
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5.1
The Net Present Value (NPV) Rule
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Example 5.1:
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ANSWER
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=-100.000+(20.000/1+0.1)+(40.000/1.1
2
)+
(60.000/1.1
3
)+(30.000/1.1
4
)+(10.000/1.1
5
)
=23,018
$
✓
ACCEPT

5.1
EXAMPLE
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X
REJECT

❖
Discussion
✓
What if both projects were
positive
?
✓
We choose the
higher
amount!
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5.1
Advantages of NPV
:
▶
Accepting
positive
NPV projects benefits
stockholders.
✓
NPV uses cash flows
✓
NPV uses all the cash flows of the project
✓
NPV discounts the cash flows properly
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Advantages of NPV
1)
NPV uses cash flow :
Cash flows from a project can be used for
other corporate purposes (such as
dividend payments or payments of
corporate interest)
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Advantages of NPV
2)
NPV uses all the cash flows of the
projects
Other approaches ignore cash flows
beyond a particular date.
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Advantages of NPV
3)
NPV discounts the cash flows
properly
Other approaches may ignore the time
value of money when handling cash flows.
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5.2 The Payback Period
Method

5.2
The Payback Period Method
:
•
The Payback Period Method :
The payback period; is the number of years required to
recover the original investment in a project.
1. How long does it take the project to “pay back “ its initial
investment ?
2. Payback period =number of yours to recover initial costs
3. minimum acceptance criteria ; set by management;
4. ranking criteria ; set by management.
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Example
A project requires a cash investment of $200,000 and it
generates cash as follows
:
Year 1: $20,000
Year 2: $60,000
Year 3: $80,000
Year 4: $100,000
Year 5: $70,000
The payback period is 3.4 years
($20,000 + $60,000 + $80,000
= $160,000 in the first three years + $40,000 of the $100,000
occurring in Year 4
).