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The first step is to estimate the expected future cash
The second step is to estimate the required return for
projects of this risk level
The third step is to find the present value of the cash
flows and subtract the initial investments
NPV – Decision Rule
If NPV is POSITIVE, ACCEPT the project
A positive NPV means that the project is
expected to add value to the firm and will
therefore increase the wealth of the owners
Since our goal is to increase owner wealth,
NPV is a direct measure of how well this
project will meet our goal
Project Example Information Based on projected sales and costs, we expect that the cash flows over the five year life of the project will be RM2000 in the first two years, RM4000 in the next two years, and RM5000 in the last year. It will costs about RM10000 to begin the production. We use a 10 percent discount rate to evaluate new products. What should we do?
Computing NPV for the Project Using the formulas: Present Value: (RM 2000/1.1) + (RM 2000/1.1)2 + (RM 4000/1.1)3 + (RM 4000/1.1)4 + (RM 5000/1.1)5 =RM (1818+1653+3005+2732+3105) =RM 12313 NPV : RM (12313-10000)=RM 2313
The amount of time required for an investment
to generate cash flows sufficient to recover its
How long does it take to get the initial cost
back in a nominal sense.
Accept if the payback period is less than some preset
THE PAYBACK RULE
There are several disadvantages for the payback rule.
The time value of money is ignored.
The payback period is calculated by simply adding up the future cash flows.
Analyzing the Rule
No discounting involved.
Fails to consider any risk differences.
Coming up with the right cutoff period.
No objective basis for choosing a particular year.
No economic rationale for looking at payback.
No guide on how to pick the cutoff.
Using a number that is chosen without any rational reason.
Redeeming Qualities Of The Rule
The payback period rule is often used by large companies when making minor decision.
In addition to its simplicity, the payback rule has two other positive features.
First, because it is biased toward short-term project, it is biased towards liquidity.
Second, the cash flows that are expected to occur later in a project’s life are probably more uncertain.
THE PAYBACK RULE Advantages Disadvantages
Easy to understand.
Adjusts for uncertainty of later cash flows.
Biased towards liquidity.
Ignores the time value of money.
Requires a cutoff point without any reason.
Ignores cash flows beyond the cutoff date.
Biased against long-term projects, such as research and development, and new projects.
THE PAYBACK RULE
Payback period is a kind of “break-even” measure.
Because time value is ignored.
Payback period as the length of time it takes to break even in an accounting sense, but not in an economic sense.
Payback rule doesn’t ask the right question.
Nevertheless, companies use it as a screen for dealing with a large number of minor investment decision that they have to make because it is so simple.
THE DISCOUNTED PAYBACK
The length of time until the sum of discounted cash
flows is equal to the initial investment.
The discounted payback rule would be :-
Based on the discounted payback rule, an
investment is acceptable if its discounted payback
is less than some prespecified number of years.
Computing discounted payback for the project
Assume we will accept the project if it pays
back on a discounted basis in 2 years.
Compute the PV for each cash flow and
determine the payback period using discounted
YEAR 1 : 165,000 – 63,120/1.12^1= 108,643
YEAR 2 : 108,643 – 70,800/1.12^2 = 52,202
YEAR 3 : 52,202 – 91,080/1.12^3 = -12,627
PROJECT PAY BACK IN YEAR 3
ADVANTAGES AND DISADVANTAGES OF DISCOUNTED PAYBACK DISADVANTAGES *MAY REJECT POSITIVE NPV INVESTMENTS *REQUIRES AN ARBITRAY CUTOFF POINT *IGNORES CASH FLOWS BEYOND THE CUTOFF POINT *BAISED AGAINST LONG-TERM PROJECTS, SUCH AS R&D AND NEW PRODUCTS. ADVANTAGES *INCLUDES TIME VALUE OF MONEY *EASY TO UNDERSTAND *DOES NOT ACCEPT NEGATIVE ESTIMATED NPV INVESTMENTS WHEN ALL FUTURE CASH FLOWS ARE POSITIVE *BIASED TOWARDS LIQUIDITY