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Ch. 8: Net Present Value and Other Investment Criteria
The Payback Rule The Average Accounting Return The Internal Rate of Return The Profitability Index
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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?
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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)
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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.
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Comparing NPVs
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2. The Payback Rule Payback is the length of time to recover the original investment The Payback Rule Advantages: Disadvantages:
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3. The Average Accounting Return
AAR = Ave. Net Income/Ave. Book Value The Average Accounting Return Rule Advantages: Disadvantages:
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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:
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5. The Profitability Index
PI = PV of future cash flows/initial cost The Profitability Index Rule Advantages: Disadvantages:
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Recommended Practice Self-Test Problems 8.1 - 8.3 on pp. 229-30
Questions 2, 9, 11 on pp Problems on pp : 3, 5, 9, 11, 13, 15, (answers are on p. 548)
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