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NPV
947 NPV Profiles
$160.00 IRR for A = 19.43% $140.00 IRR for B = 22.17% $120.00 Crossover Point = 11.8% $100.00
NPV $80.00 A
B $60.00
$40.00
$20.00
$0.00
($20.00) 0 0.05 0.1 0.15 0.2 0.25 0.3 ($40.00)
Discount Rate
948 Conflicts Between NPV and IRR
• NPV directly measures the increase in
value to the firm
• Whenever there is a conflict between NPV
and another decision rule, you should
always use NPV
• IRR is unreliable in the following situations
• Nonconventional cash flows
• Mutually exclusive projects 949 Decision Criteria Test  IRR
• Does the IRR rule account for the time value of money?
• The IRR rule accounts for time value because it is finding
the rate of return that equates all of the cash flows on a
time value basis.
• Does the IRR rule account for the risk of the cash flows?
• The IRR rule accounts for the risk of the cash flows
because you compare it to the required return, which is
determined by the risk of the project.
• Does the IRR rule provide an indication about the increase in
value?
• The IRR rule provides an indication of value because we
will always increase value if we can earn a return greater
than our required return. 950 Profitability Index 9.5
• Measures the benefit per unit cost, based
on the time value of money
• Profitability index =
Present value of future cash flows / cost • Recall that NPV = Present value of future
cash flows  cost
• If the profitability index is greater than 1,
then the NPV > 0 and the project should
be approved.
951 Profitability Index example
• With a discount rate of
12%, then the PV of
the future cash flows
is 177,627.
• Note that I computed
this in my calculator
by putting a zero at
the top of my cash
flow list before hitting
the NPV key. Time
0
1
2
3 Amount
165,000
63,120
70,800
91,080 • Profitability index
= 177,627 / 165,000
= 1.076
• Compare to NPV =
12,627 and IRR =
16.13%
952 Advantages and Disadvantages of
Profitability Index
• Advantages
• Closely related to NPV,
generally leading to
identical decisions
• Easy to understand
and communicate
• May be useful when
available investment
funds are limited • Disadvantages
• May lead to incorrect
decisions in
comparisons of
mutually exclusive
investments 953 The Practice of Capital Budgeting 9.6
• NPV and IRR are the most commonly used
primary investment criteria
• Payback is a commonly used secondary
investment criteria
• Capital budgeting techniques vary with industry.
• Firms that are better able to estimate cash flows
precisely are more likely to use NPV • These methods should be used with
considerable judgment and thought. There may
be more risk than we have considered or we may
want to pay additional attention to our cash flow
estimations.
954...
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This document was uploaded on 02/06/2014.
 Fall '14

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