Chapter 9, Net Present Value and Other Investment CriteriaOutlineCapital Budgeting - the process of planning and managing firm’s long-term investmentsI. Capital Budgeting Decision Rules1. Net Present Value2. Payback3. Discounted payback4. Internal rate of return (IRR)5. Profitability IndexWe will denote the discount rate as RII. Net Present Value (NPV)a measure of the difference between the market value of an investment and its costdetermine the NPV by discounting all of the futures cash flows and then subtracting the cost.NPV=∑ PV of CF-I00nn2211IR)(1CF...R)(1CFR)(1CFNPV1

Example 1: You are looking at a new project and you have estimated the following cash flows:Year 0:CF = -165,000Year 1:CF = 63,120Year 2:CF = 70,800Year 3:CF = 91,080Your required return for assets of this risk is 12%.What is the NPV of this project? Should we accept or reject the project?

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Using Calculator – uneven cash flowsDecision Criteria for NPVDoes the NPV rule account for the time value of money?Does the NPV rule account for the risk of the cash flows?Does the NPV rule provide an indication about the increase in value?Should we consider the NPV rule for our primary decision rule?AdvantagesDisadvantagesConsiders all of the cash flows in the computationUses the time value of moneyProvides the answer in dollar terms, which is easy to understandUsually provides a similar answer to the IRR computationRequires the use of the time value of money, thus a bit more difficult to computeProjects that differ by orders of magnitude in cost are not obvious in the NPV final figure3

III. Payback Rulepayback period - length of time until the accumulated cash flows equal or exceed the original investmentto compute:

Example 2: What is the payback period for the project? If we require a payback of 2 years, should we accept the project?4

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Decision Criteria for Payback