1. CHAPTER 9 Net Present Value and Other Investment Criteria

2.  The difference between the market value of a project and its cost  Estimating NPV: (DCF)  The first step is to estimate the expected future cash flows.  The second step is to estimate the required return for projects of this risk level.  The third step is to find the present value of the cash flows and subtract the initial investment. Net Present Value

3.  If the NPV is positive, accept the project  A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners.  Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal. NPV – Decision Rule

4.  The amount of time required for an investment to generate cash flows sufficient to recover its initial cost.  An investment is accepted if its calculated period is less than some prespecified number of years Payback Period

5. EDCBAYear -50$-200$ -100 $0 100 40 301 -50,000,00010020 402 -20010 503 200130604 Example

6.  Does the payback rule account for the time value of money?  Does the payback rule account for the risk of the cash flows?  Does the payback rule provide an indication about the increase in value?  Should we consider the payback rule for our primary decision rule? Analyzing the rule

7. shortLongYear -250$ 0 100 1 2001002 0 3 0 4 Example

8.  Advantages  Easy to understand  Adjusts for uncertainty of later cash flows  Biased toward liquidity Advantages and Disadvantages of Payback Disadvantages  Ignores the time value of money  Requires an arbitrary cutoff point  Ignores cash flows beyond the cutoff date  Biased against long- term projects, such as research and development, and new projects

9.  The length of time required for an investment’s discounted cash flows to equal its initial cost.  An investment is acceptable if its discounted payback is less than some prespecified number of years Discounted Payback Period

10. Accumulated cash flowCash flow discountedundiscounteddiscountedundiscountedyear 8910089$100$1 168200791002 238300701003 300400621004 355500551005 Example

11.  Does the discounted payback rule account for the time value of money?  Does the discounted payback rule account for the risk of the cash flows?  Does the discounted payback rule provide an indication about the increase in value?  Should we consider the discounted payback rule for our primary decision rule? Decision Criteria Test – Discounted Payback

12.  Advantages  Includes time value of money  Easy to understand  Does not accept negative estimated NPV investments when all future cash flows are positive  Biased towards liquidity Advantages and Disadvantages of Discounted Payback Disadvantages  May reject positive NPV investments  Requires an arbitrary cutoff point  Ignores cash flows beyond the cutoff point  Biased against long- term projects, such as R&D and new products

13. Cash flowyear -34,000$0 16,0001 18,0002 15,0003 Ex 8 Page 293 Suppose the firm uses the NPV decision rule. At a required return of 11 percent, should the firm accept the project? What of the required return was 30 percent?

14. Cash flowyear -19,500$0 9,8001 10,3002 8,6003 Ex 11 Page 294 What is the NPV at a discount rate of zero percent?

15.  What is the payback period for the following set of cash flows? Ex 1 Page 292 Cash flowyear -6,400$0 1,6001 1,9002 2,3003 1,4004

16.  An investment project provides cash inflows of 765$ per year for eight years. What is the project payback period if the initial cost is 2,400$? Ex 2 Page 293

17.  An investment project has annual cash inflows of 4,200$, 5,300$, 6,100$ and 7,400$, and a discount rate of 14 percent. What is the discounted payback period for these cash flows if the initial cost is 13,000? Ex 4 Page 293

18.  An investment’s average net income divided by its average book value  A project is acceptable if its average accounting return exceeds a target average accounting return Average Accounting Return

19.  Suppose we are deciding whether to open a store in anew shopping mall. The required investment in improvements is 500,000$. The store would have a five-year life. The required investment would be 100 percent depreciated. The tax rate is 25 percent. Net income for the five years as follow: Example NIyear 100,0001 150,0002 50,0003 04 -50,0005

20.  Does the AAR rule account for the time value of money?  Does the AAR rule account for the risk of the cash flows?  Does the AAR rule provide an indication about the increase in value?  Should we consider the AAR rule for our primary decision rule? Decision Criteria Test - AAR

21.  Advantages  Easy to calculate  Needed information will usually be available Advantages and Disadvantages of AAR Disadvantages  Not a true rate of return; time value of money is ignored  Based on accounting net income and book values, not cash flows and market values

22.  The discounted rate that makes the NPV of an investment zero  This is the most important alternative to NPV  An investment is acceptable if the IRR exceeds the required return Internal Rate of Return

23.  Does the IRR rule account for the time value of money?  Does the IRR rule account for the risk of the cash flows?  Does the IRR rule provide an indication about the increase in value?  Should we consider the IRR rule for our primary decision criteria? Decision Criteria Test - IRR

24.  Advantageous o Closely related to NPV leading to identical decisions o Easy to understand and communicate Advantages and Disadvantages of IRR

25.  NPV directly measures the increase in value to the firm  Whenever there is a conflict between NPV and another decision rule, you should always use NPV Conflicts Between NPV and IRR

26.  A firm evaluates all of its projects by applying the IRR. If the required return is 16 percent, should the firm accept the following project? Ex 7 Page 293 CFyear $-34,0000 16,0001 18,0002 15,0003

27.  A project that provides annual cash flows of 28,500$ for nine years costs 138,000$ today. Is this a good project if the required rate of return is 20 percent? At what discount rate would you be indifferent between accepting the project and rejecting it? Ex 9 Page 293

28.  The present value of an investment’s future value cash flows divided by its initial cost.  This measure can be very useful in situations in which we have limited capital Profitability Index

29.  Advantages  Closely related to NPV, generally leading to identical decisions  Easy to understand and communicate  May be useful when available investment funds are limited Advantages of Profitability Index

30.  What is the profitability index for the following set of cash flows if the relevant discount rate is 22 percent? Ex 15 Page 294 CFyear -14,000$0 7,3001 6,9002 5,7003

31.  We should consider several investment criteria when making decisions  NPV and IRR are the most commonly used primary investment criteria  Payback is a commonly used secondary investment criteria Capital Budgeting In Practice

32.  An investment project has the following cash flows: CF0 = -1,000,000; C01 – C08 = 200,000 each  If the required rate of return is 12%, what decision should be made using NPV?  How would the IRR decision rule be used for this project, and what decision would be reached? Comprehensive Problem