Chapter 8: Net Present Value

Advantages of Profitability Index (PI)

1. Closely related to NPV, generally leading to identical decisions 2. Easy to understand and communicate. 3. May be useful when available investment funds are limited.

Advantages of Average Accounting Return

1. Easy to calculate 2. Needed information will usually be available.

Disadvantages of Profitability Index (PI)

1. May lead to incorrect decisions in comparisons of mutually exclusive investments

Disadvantages of the Average Accounting Return

1. Not a true rate of return; time value of money is ignored 2. Uses an arbitrary benchmark cutoff rate. 3. Based on accounting net income and book values, not cash flows and market values.

Mutually exclusive investment decisions

A situation in which taking one investment prevents the taking of another Example, if we own one corner lot, we can build an apartment building or a gas station, but not both.

discounted cash flow valuation

A) Calculating the present value of a future cash flow to determine its value today B) The process of valuing and investment by discounting its future cash flows.

Internal Rate of Return (IRR) Rule

An investment is acceptable if the IRR exceeds the required return. It should be rejected otherwise.

Average Accounting Return (AAR)

An investment's average net income divided by its average book value

Reinvestment Approach

Compound all cash flows (positive and negative) except the first out to the end of the project's life and then calculate the IRR. In a sense, we are "reinvesting" the cash flows and not taking them out of the project until the very end. The rate used could be the required return on the project or it could be a separately specified "reinvestment rate"

Discounting Approach to MIRR

Idea is to discount all the negative cash flows back to the present at the required return and add them to the initial cost. Since only the initial cash flow is negative there will only be one IRR (MIRR). The discount rate used might be the required return or it might be some other externally supplied rate.

Modified internal rate of return (MIRR)

Idea is to modify the cash flows first and then calculate the IRR using modified cash flows.

What is the IRR on an investment?

It is the required return that results in a zero NPV when it is used as the discount rate.

payback rule

The amount of time required for an investment to generate cash flows sufficient to recover its initial cost.

Net Present Value (NPV)

The difference between an investment's market value and its cost

Internal Rate of Return (IRR)

The discount rate that makes the Net Present Value (NPV) of an investment zero.

Payback Period

The length of time required for an investment's cash flows to cover its cost. Based on the payback rule, an investment is acceptable if its calculated payback period is less than some prespecified number of years

Profitability Index (PI) or benefit cost ration

The present value of an investment's future cash flows divided by its initial cost. If a project has a positive NPV, then the present value of the future cash flows must be bigger than the initial investment. The PI would thus be bigger than 1.00 for a positive NPV investment and less than 1.00 for a negative NPV investment.

Advantages of IRR

1) Closely related to NPV, often leading to identical decisions 2) Easy to understand and communicate.

Payback period rule shortcomings

1) Doesn't take into account time value of money. (No discounting takes place) 2) Choosing the right cutoff period is arbitrary 3) Ignores cash flows beyond the cutoff date. 4) Biased against long-term projects, such as research and development, and new projects By ignoring time value, we can be led to take investments that are actually worth less than they cost and by ignoring cash flows beyond the cutoff, we may be led to reject profitable long-term investments. Using a payback period rule will bias towards shorter-term investments.

Payback Period Rule Advantages

1) Easy to understand (breakeven point) 2) Adjusts for uncertainty of later cash flows (by ignoring them) 3) Biased towards liquidity

What is important but difficult in figuring out NPV of an investment?

1) Future Cash flows 2) Appropriate Discount rate (the higher the discount rate, the harder it will be to make a profit)

Disadvantages of IRR

1) May result in multiple answers with nonconventional cash flows. 2) May lead to incorrect decisions in comparisons of mutually exclusive investments

Combination approach

Negative cash flows are discounted back to the present, and positive cash flows are compounded to the end of the project. In practice, different discount or compounding rates might be used.

Do IRR & NPV rules always lead to identical decisions?

Yes, IF 2 conditions are met: 1) Cash flows are conventional, meaning the first cash flow (initial investment) is negative and all the rest are positive. 2) Project must be independent, meaning the decision to accept or reject this project does not affect the decision to accept or reject any other.

average accounting return rule

a project is acceptable if its average accounting return exceeds a target average accounting return

net present value profile

graphical representation of the relationship between an investment's NPVs and various discount rates

multiple rates of return

the possibility that more than one discount rate will make the NPV of an investment zero Can be seen with unconventional cash flows. IRR can be confusing, but NPV rule will still work.