9-0 Net Present Value and Other Investment Criteria Chapter 9 Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

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9-0 Net Present Value and Other Investment Criteria Chapter 9 Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Chapter Outline Net Present Value Payback Rule Discounted Payback Rule Internal Rate of Return (IRR) Profitability Index Capital Budgeting in Practice 1

Net Present Value The difference between the market value of a project and its cost NPV = - cost + PV of future cash flows Decision Rule: accept if NPV Advantages and disadvantages 2

Net Present Value Example Calculate the NPV given the following information: assume a rate of return= CF:-$100 $50 $40 $40 $15 3

Payback Rule Payback period: How long does it take to get the initial cost back? Decision Rule: accept if the payback period is a preset limit Advantages and disadvantages 4

Payback Rule Example Calculate the Payback Period given the following information: CF:-$100 $50 $40 $40 $15 Cum. CF: 5

Discounted Payback Rule Discounted payback period: Compute the present value of each cash flow and then determine how long it takes to pay back your cost. Decision Rule: accept if the discounted payback period is a preset limit Advantages and disadvantages 6

Discounted Payback Rule Example Calculate the Discounted Payback Period given the following information: (r=10%) CF: -$100 $50$40 $40 $15 DCF: Cum. DCF: 7

Internal Rate of Return (IRR) Definition: IRR is the return that makes the NPV = 0 Decision Rule: accept if the IRR the required return Advantages and disadvantages IRR cannot be used when:

IRR Example Calculate the IRR for the following CF: 0123 CF:-$100$50$70$40 9

IRR Example – 2 Mutually Exclusive Projects Calculate the IRR for the following two CFs. Which project should you choose? Project A: 012 CF: -$300$200$170 Project B: 012 CF: -$400$250$230 10

Profitability Index Measures the benefit per unit cost, based on the time value of money PI = PV of future CFs/cost Decision Rule: accept if PI Advantages and disadvantages 11

Profitability Index Example What is the Profitability Index for the following CF, assuming a 20% return? 0123 CF:-$100$50$70$40 12

Capital Budgeting In Practice Typically investment criteria are evaluated when making decisions. and are the most commonly used investment criteria. While is the most popular method, the is the best method. Different evaluation criteria are used across industries. 13