•Should ask•Impact on stock or firm value and not the amount of time to recover initial investment

8-31

Calculating Payback: 1•What is the payback period for the set of cash flows?•Should the project be accepted or rejected?•If the cutoff period is set at 2 years, should the project be accepted for rejected?•How is the cutoff period determined?

Calculating Payback: 22-33

Calculating Payback: 32-34

8-35Average Accounting Return•Many different definitions for average accounting return (AAR)•In this book: –Note: Average book value depends on how the asset is depreciated.•Requires specifying a target cutoff rate•Decision Rule: Accept the project if the AAR is greater than target rate.ValueBookAverageIncomeNet AverageAAR

8-36Computing AAR for the Project•Sample Project Data:–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•Required average accounting return = 25%•Average Net Income:($13,620 + 3,300 + 29,100) / 3 = $15,340•Average Accounting Return:$15,340 / 72,000 = .213 = 21.3%•Do we accept or reject the project?

8-37Initial Asset Cost Year 0: $500,000Initial Book Value: $500,000Ending Book Value: $0As long as we use straight-line depreciation and a zero salvage value, the average investment will always be one-half of the initial investment= $250k

8-38Decision Criteria Test - AAR•Does the AAR rule account for the time value of money?•Does the AAR rule account for the risk of the cash flows?•Does the AAR rule provide an indication about the increase in value?•Should we consider the AAR rule for our primary decision criteria?

8-39Advantages and Disadvantages of AAR•Advantages–Easy to calculate–Needed information usually available•Disadvantages–Not a true rate of return•Time value of money ignored•Near and future values same weight–Uses an arbitrary benchmark cutoff rate–Based on accounting net

Calculating AAR: 42-40

8-41Internal Rate of Return•Most important alternative to NPV•Widely used in practice •Intuitively appealing•Based entirely on the estimated cash flows •Independent of interest rates.–Single rate of return that summarizes the merits of a project.–The IRR depends only on the cash flows of a particular investment, not on other rates.

8-42IRR Definition and Decision Rule•Definition: –IRR = discount rate that makes the NPV = 0•The required rate that results in NPV = 0 when IRR is used as the discount rate.•Decision Rule: –Accept the project if the IRR is greater than the required return

8-43Net Present Value Sum of the PVs of all cash flows•If NPV is positive, accept the project•NPV > 0 means: •Project is expected to add value to the firm•Will increase the wealth of the owners•NPV = 0 means:•Project earns a return equal to the discount rate.•Indifferent to taking or not taking investment•Economically, a break-even proposition – return is equal to opportunity cost.ntttRCFCF101)(