Ch 5.pptx - Chapter 5:Prepared by Razan Nayef Jehan Adnan...

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1 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 2 *
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
4 5.1 Using The Net Present Value [NPV [ *
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 5 *
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 6 5.1 The Net Present Value (NPV) Rule *
Example 5.1: 7 *
ANSWER * 8 =-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 * 9 X REJECT
Discussion What if both projects were positive ? We choose the higher amount! * 10
11 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 *
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) 12
Advantages of NPV 2) NPV uses all the cash flows of the projects Other approaches ignore cash flows beyond a particular date. 13
Advantages of NPV 3) NPV discounts the cash flows properly Other approaches may ignore the time value of money when handling cash flows. 14
15 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. 16
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 ).

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