WHY MIGHT
GENERAL MOTORS
COMPLAIN
TO THE U.S. SECRETARY OF TREASURY ABOUT
WHY IS REDUCING
A FIRM'S
WHAT
DOES "ROI"
STAND FOR?
WHAT
IS THE FORMULA
WHAT
IS THE MOST EFFECTIVE WAY OF IMPROVING
WHY MIGHT
THE GOVERNMENTS
WHAT
SALES BY ONE DOLLAR?
IS MEANT
EURO
Chapter 8 Net resent Value and
Other Investment
Criteria
~ Understand:
The payback ule and its shortcomings
Accounting rates of return and their problems
The internal rate of return and its strengths
and weaknesses TLVZVZ : K
The net present va
Net Present Value
Sum of the PVs of all cash flows.
CALCULATOR
NPV =
L (1CFR)
+
n
G
t t-
CFo
EXCEL
t=1
8-13
Rationale for the NPV Method
NPV = PV inflows - Cost
NPV=O -+ Project's inflows are "exactly
sufficient to repay the invested capital
~JQ.Y,!de
c~C-:
~
c:~
Advantages
Disadvantages
_ Easy to calculate
- Not a true rate orretUrfI
_ Needed information
usually available
- Time value of money
ignored
~ ~(J
.~ cfw_.- - Uses an arbitrary
(\LQ fN. S\wl-cf'N"
benchmark cutoff rate
t:.- ('\ (\
t-
K' '\
Computing IRR For The Project
Without a financial calculator or Excel, this
becomes a trial-and-error process
Calculator
- Enter the cash flows as for NPV
- Press IRR and then CPT
-IRR
=
16.13% > 12%
required return
Do we accept or reject the project?
Summary of Decisions for the
Project
Summary
Net Present Value
Accept
Payback Period
?
Average Accounting Return
?
Internal Rate of Return
Accept
8-35
NPV
I
VS.
IRR
]
NPV and IRR will generally give the same
decision
Exceptions
- Non-conventional cash f
Reinvestment Rate Assumption
IRR assumes reinvestment at IRR
NPV assumes reinvestment at the firm's
weighted average cost of capital
(opportunity cost of capital)
- More realistic
- NPV method is best
NPV should be used to choose between
mutually exclu
Iconfli~ts Between NPV and IRRI
NPV directly measures the increase in
value to the firm
Whenever there is a conflict between
NPV and another decision rule,
a/ways use NPV
IRR is unreliable in the following situations:
- Non-conventional cash flows
- Mu
MIRR
First, find PV and TV
= RR = 20%)
(FR
1
20%
I
2
I
0
I
- 60.00
-69.444 '
I
-100.0
155.0
I
20%
I
186
186
-129.444
IPV
outflows
I
I
lTV inflows
8-53
Second: Find discount rate that
equates PV and TV
012
I
I
-129.444 .
MIRR = 19.87%
IPV outflows I
I
186.
Advantages and Disadvantages
of Profitability Index
Advantages
Disadvantages
- Closely related to
NPV, generally leading
to identical decisions
Considers all CFs
Considers TVM
- Easy to understand
and communicate
- May lead to incorrect
decisions in
c
NPV Summary
Net present value
=
- Difference between market value (PV of
inflows) and cost
-Accept if NPV >
a
- No serious flaws
- Preferred decision criterion
8-63
IRR Summary
Internal rate of return =
- Discount rate that makes NPV
-Accept if IRR > requ
1.) Comment on Kerr memo
(a)Firms may borrow from banks by using: a line of credit, a revolving credit agreement, or a term loan.
Banks use line of credit to provide short-term financing to firms whose needs are predictable and
recurring in nature. The ti