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Net Present Value and Other

Investment Rules

Session 10
Evaluation Criteria
1. Discounted Cash Flow (DCF)
Criteria
Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index (PI)
2. Non-discounted Cash Flow Criteria
Payback Period (PB)
Discounted payback period (DPB)
Accounting Rate of Return (ARR)
Net Present Value Method
The formula for the net present value can
be written as follows:

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(

+
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=
n
1 t
0
t
t
0
n
n
3
3
2
2 1
C
) k 1 (
C
NPV
C
) k 1 (
C
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) k 1 (
C
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C
NPV
Why Use Net Present Value?
Accepting positive NPV projects
benefits shareholders.
NPV uses cash flows
NPV uses all the cash flows of the project
NPV discounts the cash flows properly
Reinvestment assumption: the NPV
rule assumes that all cash flows can
be reinvested at the discount rate.
The Net Present Value (NPV)
Rule
Net Present Value (NPV) =
Total PV of future CFs - Initial Investment
Estimating NPV:
1. Estimate future cash flows: how much? and when?
2. Estimate discount rate
3. Estimate initial costs
Minimum Acceptance Criteria: Accept if NPV
> 0
Ranking Criteria: Choose the highest NPV
Calculating Net Present Value
Assume that Project X costs Rs 2,500 now and is
expected to generate year-end cash inflows of Rs 900,
Rs 800, Rs 700, Rs 600 and Rs 500 in years 1 through
5. The opportunity cost of the capital may be assumed
to be 10 per cent.
Calculating NPV with
Spreadsheets

The Payback Period Method
How long does it take the project to
pay back its initial investment?
Payback Period = number of years to
recover initial costs
Minimum Acceptance Criteria:
Set by management
Ranking Criteria:
Set by management
Example
Assume that a project requires an
outlay of Rs 50,000 and yields annual
cash inflow of Rs 12,500 for 7 years.
The payback period for the project is:
years 4
12,000 Rs
50,000 Rs
PB = =
Acceptance Rule
The project would be accepted if its
payback period is less than the
maximum or standard payback
period set by management.
As a ranking method, it gives highest
ranking to the project, which has the
shortest payback period and lowest
ranking to the project with highest
payback period.
The Payback Period Method
Disadvantages:
Ignores the time value of money
Ignores cash flows after the payback period
Biased against long-term projects
Requires an arbitrary acceptance criteria
A project accepted based on the payback
criteria may not have a positive NPV
Advantages:
Easy to understand
Biased toward liquidity
The Discounted Payback
Period
How long does it take the project to
pay back its initial investment, taking
the time value of money into account?
Decision rule: Accept the project if it
pays back on a discounted basis
within the specified time.
By the time you have discounted the
cash flows, you might as well calculate
the NPV.

Average Accounting Return
Another attractive, but fatally flawed,
approach
Ranking Criteria and Minimum
Acceptance Criteria set by management
Investment of Value Book Average
Income Net Average
AAR =
Example
See page 209.
Average Accounting Return
Disadvantages:
Ignores the time value of money
Uses an arbitrary benchmark cutoff rate
Based on book values, not cash flows and
market values
Advantages:
The accounting information is usually
available
Easy to calculate

The Internal Rate of Return
IRR: the discount rate that sets NPV to
zero
Minimum Acceptance Criteria:
Accept if the IRR exceeds the required
return
Ranking Criteria:
Select alternative with the highest IRR
Reinvestment assumption:
All future cash flows assumed reinvested at
the IRR
INTERNAL RATE OF RETURN METHOD
The internal rate of return (IRR) is the
rate that equates the investment
outlay with the present value of cash
inflow received after one period. This
also implies that the rate of return is
the discount rate which makes NPV =
0.
CALCULATION OF IRR
Uneven Cash Flows: Calculating IRR
by Trial and Error
CALCULATION OF IRR
Level Cash Flows
Let us assume that an investment would cost Rs
20,000 and provide annual cash inflow of Rs
5,430 for 6 years
The IRR of the investment can be found out as
follows

NPV Rs 20,000 + Rs 5,430(PVAF ) = 0
Rs 20,000 Rs 5,430(PVAF )
PVAF
Rs 20,000
Rs 5,430
6,
6,
6,
=
=
= =
r
r
r
3683 .
IRR: Example
Consider the following project:
0 1 2 3
$50 $100 $150
-$200
The internal rate of return for this project is 19.44%
3 2
) 1 (
150 $
) 1 (
100 $
) 1 (
50 $
200 0
IRR IRR IRR
NPV
+
+
+
+
+
+ = =
NPV Payoff Profile
0% $100.00
4% $73.88
8% $51.11
12% $31.13
16% $13.52
20% ($2.08)
24% ($15.97)
28% ($28.38)
32% ($39.51)
36% ($49.54)
40% ($58.60)
44% ($66.82)
If we graph NPV versus the discount rate, we can see the IRR
as the x-axis intercept.
IRR = 19.44%
($80.00)
($60.00)
($40.00)
($20.00)
$0.00
$20.00
$40.00
$60.00
$80.00
$100.00
$120.00
-1% 9% 19% 29% 39%
Discount rate
N
P
V
Calculating IRR with
Spreadsheets
You start with the cash flows the same
as you did for the NPV.
You use the IRR function:
You first enter your range of cash flows,
beginning with the initial cash flow.
Internal Rate of Return (IRR)
Disadvantages:
Does not distinguish between investing
and borrowing
IRR may not exist, or there may be
multiple IRRs
Problems with mutually exclusive
investments

Advantages:
Easy to understand and communicate

Acceptance Rule
Accept the project when IRR > cost of
capital

Reject the project when IRR < cost of
capital

May accept the project when IRR = cost of
capital

The Profitability Index (PI)
Minimum Acceptance Criteria:
Accept if PI > 1

Ranking Criteria:
Select alternative with highest PI
Investent Initial
Flows Cash Future of PV Total
PI =
The Profitability Index
Disadvantages:
Problems with mutually exclusive
investments
Advantages:
May be useful when available investment
funds are limited
Easy to understand and communicate
Correct decision when evaluating
independent projects

Lets solve
Q8 and 9 on pg 233
The Practice of Capital Budgeting
Varies by industry:
Some firms use payback, others use
accounting rate of return.
The most frequently used technique for
large corporations is IRR or NPV.
thankyou