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13.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Project Evaluation:
Alternative Methods
Simple Method
Payback Period (PBP)
Discounted Cash Flow (DCF) Method
Internal Rate of Return (IRR)
Net Present Value (NPV)
Profitability Index (PI)
13.4
Refer to the additional PowerPoint slides and the Excel
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Proposed Project Data
–40 K 10 K 12 K 15 K 10 K 7K
Cumulative
Inflows PBP = a + ( b – c ) / d
= 3 + (40 – 37) / 10
= 3 + (3) / 10 = 3.3
Years
13.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Payback Solution (#3)
0 1 2 3 4 5
–40 K 10 K 12 K 15 K 10 K 7K
–40 K –30 K –18 K –3 K 7K 14 K
PBP = 3 + ( 3K ) / 10K =
Cumulative 3.3 Years
Cash Flows Note: Take absolute value of last
negative cumulative cash flow value.
13.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
PBP Acceptance Criterion
13.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Payback Period (PBP)
(Solution)
Payback period = Cash outflow/
Annual Cash inflow
$40,000 / 15,000 = 2.67
0.67 x 12 = 8.04
0.04 x 30 = 1.2
The (PBP) is 2 years and 8 month
13.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
PBP Strengths
and Weaknesses
Strengths: Weaknesses:
Easy to use and Does not account
understand for TVM
Can be used as a Does not consider
measure of cash flows
liquidity beyond the PBP
Easier to forecast Cutoff period is
ST than LT flows subjective
13.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Internal Rate of Return (IRR)
13.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
IRR Solution
$40,000 = $10,000(PVIF10%,1) +
$12,000(PVIF10%,2) +
$15,000(PVIF10%,3) + $10,000(PVIF10%,4)
+ $ 7,000(PVIF10%,5)
$40,000 = $10,000(0.909) +
$12,000(0.826) + $15,000(0.751) +
$10,000(0.683) + $ 7,000(0.621)
13.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
IRR Solution (Try 10% )
Year Net Cash PVIF 10% Present
Flows Value
1 10,000 0.909 9,090
2 12,000 0.826 9,912
3 15,000 0.751 11,265
4 10,000 0.683 6,830
5 7,000 0.621 4,347
Total 41,444
Present
Value
13.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
IRR Solution (Try 15%)
$40,000 = $10,000(PVIF15%,1) +
$12,000(PVIF15%,2) +
$15,000(PVIF15%,3) + $10,000(PVIF15%,4)
+ $ 7,000(PVIF15%,5)
$40,000 = $10,000(0.870) +
$12,000(0.756) + $15,000(0.658) +
$10,000(0.572) + $ 7,000(0.497)
13.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
IRR Solution (Try 15%)
Year Net Cash PVIF 15% Present
Flows Value
1 10,000 0.870 8,700
2 12,000 0.756 9,072
3 15,000 0.658 9,870
4 10,000 0.572 5,720
5 7,000 0.497 3,479
Total Present 36,841
Value
13.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
IRR Solution (Interpolate)
0.10$41,444
X $1,444
0.05 IRR $40,000 $4,603
0.15$36,841
=
X $1,444 0.05
$4,603
13.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
IRR Solution (Interpolate)
0.10$41,444
X $1,444
0.05 IRR $40,000 $4,603
0.15$36,841
=
X $1,444 0.05
$4,603
13.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
IRR Solution (Interpolate)
0.10$41,444
X $1,444
0.05 IRR $40,000 $4,603
0.15$36,841
X= X = 0.0157
($1,444)(0.05)
IRR = 0.10 + 0.0157 = 0.1157 or 11.57%
$4,603
13.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
IRR Acceptance Criterion
The management of Basket Wonders
has determined that the required rate
is 13% for projects of this type.
Should this project be accepted?
13.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
IRR Strengths
and Weaknesses
Strengths: Weaknesses:
Accounts for Assumes all cash
TVM flows reinvested
Considers all at the IRR
cash flows Difficulties with
Less project rankings and
subjectivity Multiple IRRs
13.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Net Present Value (NPV)
13.26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
NPV Solution
Basket Wonders has determined that the
appropriate discount rate (k) for this
project is 13%.
NPV = $10,000 +$12,000 +$15,000 +
(1.13)1 (1.13)2 (1.13)3
$10,000 $7,000
4 + 5 - $40,000
(1.13) (1.13)
13.27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
NPV Solution
NPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) +
$15,000(PVIF13%,3) + $10,000(PVIF13%,4) + $
7,000(PVIF13%,5) – $40,000
NPV = $10,000(0.885) + $12,000(0.783) +
$15,000(0.693) + $10,000(0.613) + $
7,000(0.543) – $40,000
NPV = $8,850 + $9,396 + $10,395 +
$6,130 + $3,801 – $40,000
= - $1,428
13.28 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
NPV Solution (Another
Method)
Year Cash Flows PVIF 13% Present
Value
1 10,000 0.885 8,850
2 12,000 0.783 9,396
3 15,000 0.693 10,396
4 10,000 0.613 6,130
5 7,000 0.543 3,801
Total PV 38,573
Cash outflow 40,000
Net PV (1,427)
13.29 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
NPV Acceptance Criterion
The management of Basket Wonders
has determined that the required
rate is 13% for projects of this type.
Should this project be accepted?
13.30 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
NPV Strengths
and Weaknesses
Strengths: Weaknesses:
Cash flows May not include
assumed to be managerial
reinvested at the options embedded
required rate. in the project. See
Chapter 14.
Accounts for TVM.
Considers all
cash flows.
13.31 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Profitability Index (PI)
13.33 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
PI Acceptance Criterion
PI = $38,573 / $40,000
= .9643 (Method #1, previous
slide)
13.34 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
PI Strengths
and Weaknesses
Strengths: Weaknesses:
Same as NPV Same as NPV
Allows Provides only
comparison of relative profitability
different scale Potential Ranking
projects Problems
13.35 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Evaluation Summary
13.36 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Independent Project
• For this project, assume that it is
independent of any other potential
projects that Basket Wonders may
undertake.
Independent – A project whose
acceptance (or rejection) does not
prevent the acceptance of other
projects under consideration.
13.38 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Other Project
Relationships
• Dependent – A project whose
acceptance depends on the
acceptance of one or more other
projects.
Mutually Exclusive – A project whose
acceptance precludes the acceptance
of one or more alternative projects.
13.39 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Potential Problems
Under Mutual Exclusivity
Ranking of project proposals may
create contradictory results.
A. Scale of Investment
B. Cash-flow Pattern
C. Project Life
13.40 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
A. Scale Differences
Compare a small (S) and a
large (L) project.
A. Scale Differences
Year CF - Small CF - Large
0 $ (100) $ (100,000)
1 $ - $ - Graph the NPV Profiles for 'Small' and 'Large'
2 $ 400 $ 156,250
projects
$350.00 $60,000.00
Discount rate: 10%
IRR: 100.00% 25.00%
$300.00
NPV: $ 230.58 $ 29,132.23 $50,000.00
PI: 3.31 1.29
$250.00
$40,000.00
BEST!!
Greatest NPV $200.00
$30,000.00
$150.00 NPV - Small
project at various
Project I discount rates.
400
NPV@10%
200
IRR
Project D
0
-200
0 5 10 15 20 25
Discount Rate (%)
13.46 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
600
Net Present Value ($)
Fisher’s Rate of Intersection
At k>10%, D is best!
0 5 10 15 20 25
Discount Rate ($)
13.47 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
C. Project Life Differences
Let us compare a long life (X) project
and a short life (Y) project.
13.56 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Choosing by IRRs for BW
Project ICO IRR NPV PI
C $ 5,000 37% $ 5,500 2.10 F
15,000 28 21,000 2.40 E 12,500
26 500 1.04 B 5,000 25
6,500 2.30
Projects C, F, and E have the
three largest IRRs.
The resulting increase in shareholder wealth
is $27,000 with a $32,500 outlay.
13.57 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Choosing by NPVs for BW
Project ICO IRR NPV PI
F $15,000 28% $21,000 2.40 G
17,500 19 7,500 1.43 B 5,000
25 6,500 2.30
Projects F and G have the two
largest NPVs.
The resulting increase in shareholder wealth
is $28,500 with a $32,500 outlay.
13.58 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Choosing by PIs for BW
Project ICO IRR NPV PI
F $15,000 28% $21,000 2.40 B
5,000 25 6,500 2.30 C 5,000
37 5,500 2.10 D 7,500 20
5,000 1.67 G 17,500 19 7,500
1.43
Projects F, B, C, and D have the four largest PIs.
The resulting increase in shareholder wealth is
$38,000 with a $32,500 outlay.
13.59 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Summary of Comparison
Method Projects Accepted Value Added
PI F, B, C, and D $38,000
NPV F and G $28,500
IRR C, F, and E $27,000