Beruflich Dokumente
Kultur Dokumente
Chapter 5
Net Present Value and Other
Investment Rules
Oct. 2012
Dr. Xiao Ming USTB
Chapter Outline
5.1 Why Use Net Present Value?
5.2 The Payback Period Method
5.3 The Discounted Payback Period Method
5.4 The Internal Rate of Return
5.5 Problems with the IRR Approach
5.6 The Profitability Index
5.7 The Practice of Capital Budgeting
Ranking Criteria:
Set by management
Advantages:
Easy to understand
Biased toward liquidity
Ranking Criteria:
Select alternative with the highest IRR
Reinvestment assumption:
All future cash flows are assumed to be reinvested at the IRR
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Advantages:
Easy to understand and communicate
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IRR: Example
Consider the following project:
0
-$200
$50
$100
$150
$50
$100
$150
NPV = 0 = 200 +
+
+
2
(1 + IRR) (1 + IRR) (1 + IRR) 3
Dr. Xiao Ming USTB
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$150.00
$100.00
NPV
0%
4%
8%
12%
16%
20%
24%
28%
32%
36%
40%
44%
$50.00
$0.00
-1%
($50.00)
IRR = 19.44%
9%
19%
29%
39%
($100.00)
Discount rate
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Multiple IRRs
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Multiple IRRs
There are two IRRs for this project:
$200
NPV
0
-$200
$800
3
- $800
$100.00
100% = IRR2
$50.00
$0.00
-50%
0%
50%
100%
($50.00)
($100.00)
150%
200%
Discount rate
0% = IRR1
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Modified IRR
Calculate the net present value of all cash outflows
using the borrowing rate.
Calculate the net future value of all cash inflows using
the investing rate.
Find the rate of return that equates these values.
Benefits: single answer and specific rates for borrowing
and reinvestment
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$1,000
$1,000
Project A
0
-$10,000
$1,000
$1,000
$12,000
Project B
0
-$10,000
20
Project A
$4,000.00
Project B
$3,000.00
NPV
$2,000.00
$1,000.00
$0.00
($1,000.00) 0%
10%
20%
30%
40%
($2,000.00)
($3,000.00)
($4,000.00)
($5,000.00)
12.94% = IRRB
16.04% = IRRA
Discount rate
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NPV
$3,000.00
$2,000.00
$1,000.00
$0.00
($1,000.00) 0%
10.55% = IRR
5%
10%
15%
20%
A-B
B-A
($2,000.00)
($3,000.00)
Discount rate
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Ranking Criteria:
Select alternative with highest PI
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Advantages:
May be useful when available investment funds are limited
Easy to understand and communicate
Correct decision when evaluating independent projects
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Project B
-$150.00
$240.80
$41.92
$90.80
0%, 100% 36.19%
1.2096
1.6053
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Project B
Time
CF
Cum.
CF
Cum. CF
-200
-200
-150
-150
200
50
-100
800
800
100
-800
150
150
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NPV for A
-87.52
0.00
59.26
59.48
42.19
20.85
0.00
-18.93
NPV for B
234.77
150.00
47.92
-8.60
-43.07
-65.64
-81.25
-92.52
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NPV
NPV Profiles
$400
$300
IRR 1(A)
IRR 2(A)
IRR (B)
$200
$100
$0
-15%
0%
15%
30%
45%
70%
($100)
($200)
Cross-over Rate
Discount rates
Project A
Project B
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Profitability Index
Benefit-cost ratio
Take investment if PI > 1
Cannot be used to rank mutually exclusive projects
May be used to rank projects in the presence of capital rationing
Dr. Xiao Ming USTB
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Quick Quiz
Consider an investment that costs $100,000 and has
a cash inflow of $25,000 every year for 5 years. The
required return is 9%, and payback cutoff is 4 years.
What is the payback period?
What is the discounted payback period?
What is the NPV?
What is the IRR?
Should we accept the project?
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