Ch. 8: Net Present Value and Other Investment Criteria The Payback Rule The Average Accounting Return The Internal Rate of Return The Profitability Index

Decision Rules for Capital Budgeting NPV is the correct rule Other rules are commonly used, are simpler, but can give wrong answers Each rule has advantages & disadvantages Evaluation of decision rules: Does the rule adjust for time value of money? Does the rule adjust for risk? Is the rule based on creating value for the firm?

1. Net Present Value Each cash flow is net (inflow - outflow) Ch. 9 & 12: WACC “The difference between an investment’s market value and its cost” (p. 209) The Net Present Value Rule HP 10B calculation Excel’s NPV glitch (p. 211)

Example a) Suppose WACC = 15%, initial CF = -$70,000, and cash flows after 1-5 years are $10,000, $30,000, $30,000, $30,000 and $10,000. b) Re-calculate for WACC = 18%. HP-10B: clear all; set P/YR=1, I/YR=15; enter -$70,000 and press CFj; enter remain- ing data, pressing CFj for each, and press NPV to get net present value of this project = If I/YR=18, NPV = Excel, etc.: be sure CF0 is not discounted.

Comparing NPVs

2. The Payback Rule Payback is the length of time to recover the original investment The Payback Rule Advantages: Disadvantages:

3. The Average Accounting Return AAR = Ave. Net Income/Ave. Book Value The Average Accounting Return Rule Advantages: Disadvantages:

4. Internal Rate of Return IRR is the discount rate that forces the NPV of a project to equal zero The IRR Rule: NPV Profile HP-10B calculation Advantages: Disadvantages:

5. The Profitability Index PI = PV of future cash flows/initial cost The Profitability Index Rule Advantages: Disadvantages:

Recommended Practice Self-Test Problems 8.1 - 8.3 on pp. 229-30 Questions 2, 9, 11 on pp. 230-2 Problems on pp. 232-4: 3, 5, 9, 11, 13, 15, (answers are on p. 548)