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McGraw-Hill/Irwin

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

5-2

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

5-3

shareholders.

NPV

NPV uses all the cash flows of the project

NPV discounts the cash flows properly

5-4

Total PV of future CFs + Initial Investment

Estimating NPV:

1. Estimate future cash flows: how much? and when?

2. Estimate discount rate

3. Estimate initial costs

Ranking Criteria: Choose the highest NPV

5-5

Spreadsheets are an excellent way to compute

NPVs, especially when you have to compute the

cash flows as well.

Using the NPV function:

a decimal.

The second component is the range of cash flows

beginning with year 1.

Add the initial investment after computing the NPV.

5-6

How long does it take the project to pay back

its initial investment?

Payback Period = number of years to recover

initial costs

Minimum Acceptance Criteria:

Set by management

Ranking Criteria:

Set by management

5-7

Disadvantages:

Ignores the time value of money

Ignores cash flows after the payback period

Biased against long-term projects

Requires an arbitrary acceptance criteria

A project accepted based on the payback

criteria may not have a positive NPV

Advantages:

Easy to understand

Biased toward liquidity

5-8

How long does it take the project to pay

back its initial investment, taking the time

value of money into account?

Decision rule: Accept the project if it pays

back on a discounted basis within the specified

time.

By the time you have discounted the cash

flows, you might as well calculate the NPV.

5-9

IRR: the discount rate that sets NPV

Minimum Acceptance Criteria:

Ranking

Criteria:

Reinvestment

to zero

assumption:

reinvested at the IRR

5-10

Disadvantages:

borrowing

IRR may not exist, or there may be multiple IRRs

Problems with mutually exclusive investments

Advantages:

5-11

IRR: Example

Consider the following project:

0

-$200

$50

$100

$150

$50

$100

$150

NPV 0 200

2

3

(1 IRR) (1 IRR) (1 IRR)

5-12

If we graph NPV versus the discount rate, we can see the IRR

as the x-axis intercept.

IRR = 19.44%

5-13

You start with the same cash flows as you did for

the NPV.

You use the IRR function:

with the initial cash flow.

You can enter a guess, but it is not necessary.

The default format is a whole percent you will

normally want to increase the decimal places to at

least two.

5-14

Multiple IRRs

5-15

potential projects can be chosen, e.g., acquiring an

accounting system.

project does not affect the decision of the other

projects.

5-16

Multiple IRRs

There are two IRRs for this project:

0

$200

$800

1

$200

we use?

3

$8

00

100% = IRR2

0% = IRR1

5-17

Modified IRR

outflows using the borrowing rate.

Calculate the net future value of all cash

inflows using the investing rate.

Find the rate of return that equates these

values.

Benefits: single answer and specific rates for

borrowing and reinvestment

5-18

Would you rather make 100% or 50% on your

investments?

What if the 100% return is on a $1

investment, while the 50% return is on a

$1,000 investment?

5-19

$10,000

$1,000

$1,000

Project A

0

Project B

$10,000

$1,000

$12,000

0

$10,00

0

$1,000

2

5-20

12.94% = IRRB

16.04% = IRRA

5-21

Compute the IRR for either project A-B or B-A

10.55% = IRR

5-22

NPV and IRR will generally give the same

decision.

Exceptions:

change more than once

Mutually exclusive projects

Initial

Timing of cash flows is substantially different

5-23

Total PV of Future Cash Flows

PI

Initial Investent

Accept if PI > 1

Ranking Criteria:

5-24

Disadvantages:

Advantages:

are limited

Easy to understand and communicate

Correct decision when evaluating independent

projects

5-25

Varies by industry:

rate of return.

corporations is either IRR or NPV.

5-26

Compute the IRR, NPV, PI, and payback period for

the following two projects. Assume the required

return is 10%.

Year

Project A

Project B

0

-$200-$150

1

$200$50

2

$800$100

3

-$800$150

5-27

Project A

-$200.00

Project B

-$150.00

PV0 of CF1-3

$241.92

$240.80

NPV =

IRR =

PI =

$41.92

0%, 100%

1.2096

$90.80

36.19%

1.6053

CF0

5-28

Payback Period:

Project A

Project B

Time

CF

Cum. CF

0

-200-200 -150-150

1

2000

50-100

2

800800

1000

3

-8000

150150

CF

Cum. CF

Payback period for project A = 1 or 3 years?

5-29

Discount rate

-10%

0%

20%

40%

60%

80%

100%

120%

NPV for A

-87.52

0.00

59.26

59.48

42.19

20.85

0.00

-18.93

NPV for B

234.77

150.00

47.92

-8.60

-43.07

-65.64

-81.25

-92.52

5-30

NPV

NPV Profiles

$400

$300

IRR 1(A)

IRR (B)

IRR 2(A)

$200

$100

$0

-15%

0%

15%

30%

45%

70%

($100)

($200)

Cross-over Rate

Discount rates

Project A

Project B

5-31

Accept the project if the NPV is positive

Has no serious problems

Preferred decision criterion

Discount rate that makes NPV = 0

Take the project if the IRR is greater than the required return

Same decision as NPV with conventional cash flows

IRR is unreliable with non-conventional cash flows or mutually exclusive projects

Profitability Index

Benefit-cost ratio

Take investment if PI > 1

Cannot be used to rank mutually exclusive projects

May be used to rank projects in the presence of capital rationing

5-32

Payback period

Take the project if it pays back in some specified period

Does not account for time value of money, and there is an

arbitrary cutoff period

discounted basis

Take the project if it pays back in some specified period

There is an arbitrary cutoff period

5-33

Quick Quiz

cash inflow of $25,000 every year for 5 years. The

required return is 9%, and payback cutoff is 4 years.

What is the payback period?

What is the discounted payback period?

What is the NPV?

What is the IRR?

Should we accept the project?

When is the IRR rule unreliable?

5-34

Review

four years. The project initially costs $10,600 to get started.

In year five, the project will be closed and as a result should

produce a cash inflow of $8,500. What is the net present

value of this project if the required rate of return is

13.75%?

A. -$5,474.76

B. -$1,011.40

C. -$935.56

D. $1,011.40

E. $5,474.76

5-35

the following cash flows. Will your choice between the two

projects differ if the required rate of return is 8% rather than

11%? If so, what should you do?

A. yes; Select A at 8% and B at 11%.

B. yes; Select B at 8% and A at 11%.

C. yes; Select A at 8% and select neither at 11%.

D. no; Regardless of the required rate, project A always has

the higher NPV.

E. no; Regardless of the required rate, project B always has

the higher NPV.

5-36

project be accepted if it has been assigned a required return of

9.5%? Why or why not?

A. yes; because the IRR exceeds the required return by about

0.39%.

B. yes; because the IRR is less than the required return by about

3.9%.

C. yes; because the IRR is positive.

D. no; because the IRR exceeds the required return by about

3.9%.

E. no; because the IRR is 9.89%.

5-37

a project with the following cash flows be accepted

if the discount rate is 8%? Why or why not?

A. yes; because the PI is 1.008.

B. yes; because the PI is .992.

C. yes; because the PI is .999.

D. no; because the PI is 1.008.

E. no; because the PI is .992.

5-38

estimates that the cost of inventory will be $4,200. The

remodeling and shelving costs are estimated at $1,500. Toy sales

are expected to produce net cash inflows of $1,200, $1,500,

$1,600, and $1,750 over the next four years, respectively.

Should Jack add toys to his store if he assigns a three-year

payback period to this project?

A. yes; because the payback period is 2.94 years.

B. yes; because the payback period is 2.02 years.

C. yes; because the payback period is 3.80 years.

D. no; because the payback period is 2.02 years.

E. no; because the payback period is 3.80 years.

5-39

cash inflows of $900 a year for 4 years. The project

has a 9% required rate of return and an initial cost of

$2,800. What is the discounted payback period?

A. 3.11 years

B. 3.18 years

C. 3.82 years

D. 4.18 years

E. never

5-40

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