,Why Net Present Value Leads to Better Investment Decisions than Other Criteria,Principles of Corporate Finance,Chapter 5,Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved,Topics Covered,NPV and its Competitors The Payback Period The Book Rate of Return Internal Rate of Return Capital Rationing,NPV and Cash Transfers,Every possible method for evaluating projects impacts the flow of cash about the company as follows.,Cash,Investment opportunity (real asset),Firm,Shareholder,Investment opportunities (financial assets),Invest,Alternative: pay dividend to shareholders,Shareholders invest for themselves,Payback,The payback period of a project is the number of years it takes before the cumulative forecasted cash flow equals the initial outlay. The payback rule says only accept projects that “payback” in the desired time frame. This method is very flawed, primarily because it ignores later year cash flows and the the present value of future cash flows.,Payback,ExampleExamine the three projects and note the mistake we would make if we insisted on only taking projects with a payback period of 2 years or less.,Payback,ExampleExamine the three projects and note the mistake we would make if we insisted on only taking projects with a payback period of 2 years or less.,Book Rate of Return,Book Rate of Return - Average income divided by average book value over project life. Also called accounting rate of return.Managers rarely use this measurement to make decisions. The components reflect tax and accounting figures, not market values or cash flows.,Internal Rate of Return,ExampleYou can purchase a machine tool for $4,000. The investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment?,Internal Rate of Return,ExampleYou can purchase a machine tool for $4,000. The investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment?,Internal Rate of Return,ExampleYou can purchase a machine tool for $4,000. The investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment?,Internal Rate of Return,IRR=28%,Internal Rate of Return,Pitfall 1 - Lending or Borrowing? With some cash flows (as noted below) the NPV of the project increases as the discount rate increases. This is contrary to the normal relationship between NPV and discount rates.,Internal Rate of Return,Pitfall 1 - Lending or Borrowing? With some cash flows (as noted below) the NPV of the project increases s the discount rate increases. This is contrary to the normal relationship between NPV and discount rates.,Discount Rate,NPV,Internal Rate of Return,Pitfall 2 - Multiple Rates of Return Certain cash flows can generate NPV=0 at two different discount rates. The following cash flow generates NPV=0 at both (-50%) and 15.2%.,Internal Rate of Return,Pitfall 2 - Multiple Rates of Return Certain cash flows can generate NPV=0 at two different discount rates. The following cash flow generates NPV=0 at both (-50%) and 15.2%.,1000,NPV,500,0,-500,-1000,Discount Rate,IRR=15.2%,IRR=-50%,Internal Rate of Return,Pitfall 3 - Mutually Exclusive Projects IRR sometimes ignores the magnitude of the project. The following two projects illustrate that problem.,Internal Rate of Return,Pitfall 3 - Mutually Exclusive Projects,Internal Rate of Return,Calculating the IRR can be a laborious task. Fortunately, financial calculators can perform this function easily. Note the previous example.,Internal Rate of Return,Calculating the IRR can be a laborious task. Fortunately, financial calculators can perform this function easily. Note the previous example.,HP-10B EL-733A BAII Plus -350,000 CFj -350,000 CFi CF 16,000 CFj 16,000 CFfi 2nd CLR Work 16,000 CFj 16,000 CFi -350,000 ENTER 466,000 CFj 466,000 CFi 16,000 ENTERIRR/YR IRR 16,000 ENTER466,000 ENTERIRR CPT,All produce IRR=12.96,Profitability Index,When resources are limited, the profitability index (PI) provides a tool for selecting among various project combinations and alternatives A set of limited resources and projects can yield various combinations. The highest weighted average PI can indicate which projects to select.,Profitability Index,Example We only have $300,000 to invest. Which do we select?Proj NPV Investment PI A 230,000 200,000 1.15 B 141,250 125,000 1.13 C 194,250 175,000 1.11 D 162,000 150,000 1.08,Profitability Index,Example - continued Proj NPV Investment PI A 230,000 200,000 1.15 B 141,250 125,000 1.13 C 194,250 175,000 1.11 D 162,000 150,000 1.08Select projects with highest Weighted Avg PI WAPI (BD) = 1.13(125) + 1.08(150) + 0.0 (25)(300) (300) (300)= 1.01,Profitability Index,Example - continued Proj NPV Investment PI A 230,000 200,000 1.15 B 141,250 125,000 1.13 C 194,250 175,000 1.11 D 162,000 150,000 1.08Select projects with highest Weighted Avg PIWAPI (BD) = 1.01WAPI (A) = 0.77WAPI (BC) = 1.12,