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Ct
NPV = C 0 +
(1 + r ) t
C1 C2 Ct
NPV = C 0 + + + ...+
(1 + r ) 1
(1 + r ) 2
(1 + r ) t
7- 7
Terminology
C = Cash Flow
t = time period of the investment
r = “opportunity cost of capital”
Present Value 0 1 2 3
14,953
13,975
380,395
$409,323
7- 11
Payback Method
Payback Period - Time until cash flows recover the
initial investment of the project.
Payback Method
Example
The three project below are available. The company accepts all
projects with a 2 year or less payback period. Show how this
policy will impact our decision.
Cash Flows
Project C0 C1 C2 C3 Payback NPV@10%
A -2000 +1000 +1000 +10000 2 + 7,249
B -2000 +1000 +1000 0 2 - 264
C -2000 0 +2000 0 2 - 347
7- 15
Payback Method
ÂThe limitation of payback method:
Î Payback does not consider any cash flows that arrive after
the payback period
Î Payback gives equal weight to all cash flows arriving
before the cutoff period (an improved method is to
calculate the discounted payback period)
Î Usually the large construction projects inevitably have
long payback periods
* Therefore, payback method is most commonly used when
the capital investment is small when the merits of the
project is so obvious that formal analysis is unnecessary.
7- 16
C1 -investment
Rate of Return=
investment
IRR = 12.96%
7- 19
150
100 IRR=12.96%
NPV (,000s)
50
0
0 5 10 15 20 25 30 35
-50
-100
-150
-200
Discount rate (%)
7- 22
16 16 466
NPV = −350 + + + =0
(1 + IRR) (1 + IRR) (1 + IRR)
1 2 3
= 12.96%
400
NPV = −350 + =0
(1 + IRR )1
= 14.29%
7- 26
50
40 initial proposal
NPV $, 1,000s
30
IRR= 12.96%
20 IRR= 14.29%
10 another proposal
0
-10
IRR= 12.26%
-20
8 10 12 14 16
Discount rate, %
7- 28
C0 C1 C2 C3 C4 C5 IRR NPV
-22 15 15 15 15 -40 6.00% $0
28.00% $0
*When there are multiple changes in the sign of the cash flows, the IRR
rule does not work, but the NPV rule always does
7- 31
Example
Select one of the two following projects,
based on highest NPV.
System C0 C1 C2 C3 NPV
Faster − 800 350 350 350 + 118.5
Slower − 700 300 300 300 + 87.3
Investment Timing
Investment Timing
Example
You may purchase a computer anytime within the
next five years. While the computer will save your
company money, the cost of computers continues to
decline. If your cost of capital is 10% and given the
data listed below, when should you purchase the
computer?
7- 35
Investment Timing
Example
You may purchase a computer anytime within the next five years. While
the computer will save your company money, the cost of computers
continues to decline. If your cost of capital is 10% and given the data
listed below, when should you purchase the computer?
Capital Rationing
Capital Rationing - Limit set on the amount of
funds available for investment.
Profitability Index
Profitability Index – Ratio of present value to
initial investment (NPV per dollar spent)
Project C0 (Investment) C1 C2 NPV@10% Profitability Index
L -3 2.2 2.42 1 1/3 = .33
M -5 2.2 4.84 1 1/5 = .20
N -7 6.6 4.84 3 3/7 = .43
O -6 3.3 6.05 2 2/6 = .33
P -4 1.1 4.84 1 1/4 = .25
* N →O (=L) →P →M
* If there is no soft or hard capital rationing, more NPVs will
be preferred even when more dollars are spent
* This rule cannot rank mutually exclusive projects
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Summary
 A Comparison of Investment Decision Rules
(p.201 Table 7-3)
 A recent survey found that
Î 75% of firms either always or almost always use both NPV and
IRR to evaluate projects
Î Just over half of corporations will always or almost always
compute a project’s payback period
Î Profitability index is routinely computed by about 12 % of firms