Using Net Present Value to Make Investment Decisions Student Presentations –Net Present Value –Internal Rate of Return Alternative Investment Decision Rules Additional Considerations

Capital Budgeting Methods CFO Survey by Graham and Harvey in 1999 – Which techniques do you always or almost always use? –IRR (76%) –NPV (75%) –Hurdle rate (57%) –Payback (57%) –Sensitivity analysis (52%) –Earnings multiple (39%) –Discounted payback period (29%) –Incorporate “real options” (27%) –Accounting rate of return (20%) –Value-at-Risk (14%) –Profitability index (12%) –Adjusted present value (11%)

What to Discount Only cash flow is relevant Estimate cash flows on an incremental basis –Average vs. incremental payoffs –Incidental effects –Include working capital requirements –Include opportunity costs –Forget sunk costs –Beware of allocated overhead costs Treat inflation consistently

IM&C’s Fertilizer Project

IM&C’s Fertilizer Project (2)

IM&C’s Fertilizer Project (3)

IM&C’s Fertilizer Project (4)

What Discount Rate Determining the cost of capital is critical Consider yield curve –Interest rates depend on timing of cash flows All investments do not have the same cost of capital

Next Class Risk and Return Student presentations –Capital Asset Pricing Model Guest speaker – Brian Callaci, Merrill Lynch Investment Banking Read Chapters 7 and 8 in the text