1 Estimated Cash Flows for Two Projects (S and L) Cost of Capital =.10 YearProject SProject L 0($1,000)($1,000)

2 Payback Period Project SProject L (1,000)Total(1,000)Total , , ,400 Payback for Project S = 2.33 years Payback for Project L = 3.33

Discounted Payback – Project S 500 x (1.10) ^-1 = x (1.10) ^-2 = x (1.10) ^-3 = x (1.10) ^-4 = Discounted Payback =

4 Net Present Value (NPV) NPV S = 500(1.1) (1.1) (1.1) (1.1) = = NPV L = 100(1.1) (1.1) (1.1) (1.1) = = Decision Rule 1) If NPV ≥ 0, Then Accept Project 2) If NPV < 0, Then Reject Project

5 Internal Rate of Return (IRR) K NPV S X 0 ? x 79/87 =.045 IRR S = =.145 KNPV L X 0 ? x 49/129 =.018 IRR L = =.118 Decision Rule 1) If IRR ≥ K, Then Accept Project 2) If IRR < K, Then Reject Project

6 Example of What IRR Represents Deposit 1000 into a Bank Account Paying 14.5% per year: Interest first year 1,145.00Amount in account at end of first year Withdraw 500 from account Amount remaining 93.53Interest second year Amount in account at end of second year Withdraw 400 from account Amount remaining 49.08Interest third year Amount in account at end of third year Withdraw 300 from account 87.61Amount remaining 12.39Interest fourth year Amount in account at end of fourth year Withdraw 100 from account 0.00Amount remaining

7 Profitability Index PI = PV Future Cash Flows/NICO PI S = 1079/1000 = PI L = 1049/1000 = Decision Rule 1) If PI ≥ 1, Then Accept Project 2) If PI < 1, Then Reject Project

Average Rate of Return You are reviewing a new project and have estimated the following cash flows: –Year 0:CF = -165,000 –Year 1:CF = 63,120; NI = 13,620 –Year 2:CF = 70,800; NI = 3,300 –Year 3:CF = 91,080; NI = 29,100 –Average Book Value = 72,000 8

Average Rate of Return Assume we require an average accounting return of 25% Average Net Income: –(13, , ,100) / 3 = 15,340 AAR = 15,340 / 72,000 =.213 = 21.3% Do we accept or reject the project? 9