This document outlines capital budgeting techniques for evaluating investment projects. It discusses payback period, discounted payback, net present value (NPV), and profitability index. Payback period calculates how long it takes to recover the initial cost but does not consider the time value of money. Discounted payback discounts future cash flows but still uses a cutoff date. NPV discounts all cash flows to determine if the present value of cash inflows exceeds the initial cash outflow. If NPV is positive, the project increases firm value. The document provides examples of calculating these techniques and compares their advantages and disadvantages. Spreadsheets are noted as useful for computing NPVs of multiple projects.
This document outlines various capital budgeting techniques including net present value (NPV), internal rate of return (IRR), payback period, and profitability index. It provides examples of calculating each for a sample project and discusses the advantages and disadvantages of each method. The key points are that NPV and IRR are generally the best primary criteria but can disagree for projects with non-conventional cash flows, and payback is useful secondary criteria but ignores the time value of money. Profitability index measures benefit per unit cost but may lead to incorrect decisions when comparing projects.
This chapter discusses various capital budgeting techniques for evaluating investment projects, including net present value (NPV), internal rate of return (IRR), payback period, accounting rate of return, and profitability index. NPV is identified as the best technique as it accounts for the time value of money and indicates whether a project will increase firm value. IRR can also be useful but may conflict with NPV in cases with non-conventional cash flows or mutually exclusive projects. Payback period and accounting rate of return are simpler but ignore the time value of money. Managers should consider multiple criteria when evaluating capital budgeting decisions in practice.
The document discusses various methods for analyzing the financial feasibility of a project, including net present value (NPV), payback period, discounted payback period, average accounting return, and internal rate of return (IRR). It then provides an example calculation of each method for a sample project with an initial investment of $165,000 and cash flows over 3 years. Based on the calculations, the project would be accepted based on the NPV and IRR methods but rejected according to the payback period, discounted payback period, and average accounting return methods.
This document discusses capital budgeting and investment decision making. It defines capital budgeting as the analysis of potential additions to fixed assets that are important long-term decisions for a firm's future. There are three types of capital budgeting projects: independent projects whose cash flows are unrelated; mutually exclusive projects where accepting one precludes the other; and contingent projects where one is dependent on another. The document outlines capital budgeting processes and techniques for evaluating projects, including net present value, internal rate of return, profitability index, payback period, and accounting rate of return. It provides an example project and calculations for each technique to determine whether to accept or reject the project.
The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project.
Slide 1
8-1
Capital Budgeting
• Analysis of potential projects
• Long-term decisions
• Large expenditures
• Difficult/impossible to reverse
• Determines firm’s strategic direction
When a company is deciding whether to invest in a new project, large sums of money can be at stake. For
example, the Artic LNG project would build a pipeline from Alaska’s North Slope to allow natural gas to
be sent from the area. The cost of the pipeline and plant to clean the gas of impurities was expected to be
$45 to $65 billion. Decisions such as these long-term investments, with price tags in the billions, are
obviously major undertakings, and the risks and rewards must be carefully weighed. We called this the
capital budgeting decision. This module introduces you to the practice of capital budgeting. We will
consider a variety of techniques financial analysts and corporate executives routinely use for the capital
budgeting decisions.
1. Net Present Value (NPV)
2. Payback Period
3. Average Accounting Rate (AAR)
4. Internal Rate of Return (IRR) or Modified Internal Rate of Return (MIRR)
5. Profitability Index (PI)
Slide 2
8-2
• All cash flows considered?
• TVM considered?
• Risk-adjusted?
• Ability to rank projects?
• Indicates added value to the firm?
Good Decision Criteria
All things here are related to maximize the stock price. We need to ask ourselves the following
questions when evaluating capital budgeting decision rules:
Does the decision rule adjust for the time value of money?
Does the decision rule adjust for risk?
Does the decision rule provide information on whether we are creating value for the firm?
Slide 3
8-3
Net Present Value
• The difference between the market value of a
project and its cost
• How much value is created from undertaking
an investment?
Step 1: Estimate the expected future cash flows.
Step 2: Estimate the required return for projects of
this risk level.
Step 3: Find the present value of the cash flows and
subtract the initial investment to arrive at the Net
Present Value.
Net present value—the difference between the market value of an investment and its cost.
The NPV measures the increase in firm value, which is also the increase in the value of what the
shareholders own. Thus, making decisions with the NPV rule facilitates the achievement of our
goal – making decisions that will maximize shareholder wealth.
Slide 4
8-4
Net Present Value
Sum of the PVs of all cash flows
Initial cost often is CF0 and is an outflow.
NPV =∑
n
t = 0
CFt
(1 + R)t
NPV =∑
n
t = 1
CFt
(1 + R)t
- CF0
NOTE: t=0
Up to now, we’ve avoided cash flows at time t = 0, the summation begins with cash flow zero—
not one.
The PV of future cash flows is not NPV; rather, NPV is the amount remaining after offsetting the
PV of future cash flows with the initial cost. Thus, the NPV amount determines the incremental
value created by unde.
This document discusses various investment criteria for capital budgeting decisions, with a focus on net present value (NPV). It defines NPV as the difference between the present value of a project's future cash flows and the initial investment cost. The document provides examples of calculating NPV for projects and discusses how NPV accounts for the time value of money and risk. It also discusses other criteria like payback period, accounting rate of return, and internal rate of return. It notes that the internal rate of return is the discount rate that makes the NPV equal to zero. The document compares the advantages and disadvantages of each method and emphasizes that NPV is generally the best criteria to use for capital budgeting decisions.
This document discusses various capital budgeting techniques including:
- NPV, payback period, IRR, profitability index, and linear programming. It provides examples of how to calculate and properly apply each technique. It also discusses potential pitfalls of some techniques like multiple IRRs. Capital rationing constraints can require using the profitability index approach. A post audit reviews actual vs predicted results to improve future forecasts and operations.
This document outlines various capital budgeting techniques including net present value (NPV), internal rate of return (IRR), payback period, and profitability index. It provides examples of calculating each for a sample project and discusses the advantages and disadvantages of each method. The key points are that NPV and IRR are generally the best primary criteria but can disagree for projects with non-conventional cash flows, and payback is useful secondary criteria but ignores the time value of money. Profitability index measures benefit per unit cost but may lead to incorrect decisions when comparing projects.
This chapter discusses various capital budgeting techniques for evaluating investment projects, including net present value (NPV), internal rate of return (IRR), payback period, accounting rate of return, and profitability index. NPV is identified as the best technique as it accounts for the time value of money and indicates whether a project will increase firm value. IRR can also be useful but may conflict with NPV in cases with non-conventional cash flows or mutually exclusive projects. Payback period and accounting rate of return are simpler but ignore the time value of money. Managers should consider multiple criteria when evaluating capital budgeting decisions in practice.
The document discusses various methods for analyzing the financial feasibility of a project, including net present value (NPV), payback period, discounted payback period, average accounting return, and internal rate of return (IRR). It then provides an example calculation of each method for a sample project with an initial investment of $165,000 and cash flows over 3 years. Based on the calculations, the project would be accepted based on the NPV and IRR methods but rejected according to the payback period, discounted payback period, and average accounting return methods.
This document discusses capital budgeting and investment decision making. It defines capital budgeting as the analysis of potential additions to fixed assets that are important long-term decisions for a firm's future. There are three types of capital budgeting projects: independent projects whose cash flows are unrelated; mutually exclusive projects where accepting one precludes the other; and contingent projects where one is dependent on another. The document outlines capital budgeting processes and techniques for evaluating projects, including net present value, internal rate of return, profitability index, payback period, and accounting rate of return. It provides an example project and calculations for each technique to determine whether to accept or reject the project.
The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project.
Slide 1
8-1
Capital Budgeting
• Analysis of potential projects
• Long-term decisions
• Large expenditures
• Difficult/impossible to reverse
• Determines firm’s strategic direction
When a company is deciding whether to invest in a new project, large sums of money can be at stake. For
example, the Artic LNG project would build a pipeline from Alaska’s North Slope to allow natural gas to
be sent from the area. The cost of the pipeline and plant to clean the gas of impurities was expected to be
$45 to $65 billion. Decisions such as these long-term investments, with price tags in the billions, are
obviously major undertakings, and the risks and rewards must be carefully weighed. We called this the
capital budgeting decision. This module introduces you to the practice of capital budgeting. We will
consider a variety of techniques financial analysts and corporate executives routinely use for the capital
budgeting decisions.
1. Net Present Value (NPV)
2. Payback Period
3. Average Accounting Rate (AAR)
4. Internal Rate of Return (IRR) or Modified Internal Rate of Return (MIRR)
5. Profitability Index (PI)
Slide 2
8-2
• All cash flows considered?
• TVM considered?
• Risk-adjusted?
• Ability to rank projects?
• Indicates added value to the firm?
Good Decision Criteria
All things here are related to maximize the stock price. We need to ask ourselves the following
questions when evaluating capital budgeting decision rules:
Does the decision rule adjust for the time value of money?
Does the decision rule adjust for risk?
Does the decision rule provide information on whether we are creating value for the firm?
Slide 3
8-3
Net Present Value
• The difference between the market value of a
project and its cost
• How much value is created from undertaking
an investment?
Step 1: Estimate the expected future cash flows.
Step 2: Estimate the required return for projects of
this risk level.
Step 3: Find the present value of the cash flows and
subtract the initial investment to arrive at the Net
Present Value.
Net present value—the difference between the market value of an investment and its cost.
The NPV measures the increase in firm value, which is also the increase in the value of what the
shareholders own. Thus, making decisions with the NPV rule facilitates the achievement of our
goal – making decisions that will maximize shareholder wealth.
Slide 4
8-4
Net Present Value
Sum of the PVs of all cash flows
Initial cost often is CF0 and is an outflow.
NPV =∑
n
t = 0
CFt
(1 + R)t
NPV =∑
n
t = 1
CFt
(1 + R)t
- CF0
NOTE: t=0
Up to now, we’ve avoided cash flows at time t = 0, the summation begins with cash flow zero—
not one.
The PV of future cash flows is not NPV; rather, NPV is the amount remaining after offsetting the
PV of future cash flows with the initial cost. Thus, the NPV amount determines the incremental
value created by unde.
This document discusses various investment criteria for capital budgeting decisions, with a focus on net present value (NPV). It defines NPV as the difference between the present value of a project's future cash flows and the initial investment cost. The document provides examples of calculating NPV for projects and discusses how NPV accounts for the time value of money and risk. It also discusses other criteria like payback period, accounting rate of return, and internal rate of return. It notes that the internal rate of return is the discount rate that makes the NPV equal to zero. The document compares the advantages and disadvantages of each method and emphasizes that NPV is generally the best criteria to use for capital budgeting decisions.
This document discusses various capital budgeting techniques including:
- NPV, payback period, IRR, profitability index, and linear programming. It provides examples of how to calculate and properly apply each technique. It also discusses potential pitfalls of some techniques like multiple IRRs. Capital rationing constraints can require using the profitability index approach. A post audit reviews actual vs predicted results to improve future forecasts and operations.
This document provides an overview and study guide for Chapter 9 of the textbook "Principles of Managerial Finance" which covers capital budgeting techniques. It discusses net present value (NPV), internal rate of return (IRR), payback period, and risk-adjusted discount rates. It provides examples and solutions to problems involving calculating NPV, IRR, and payback period for capital budgeting projects. Answers to review questions on these techniques are also included to help students learn the concepts.
This document provides an overview and instructor resources for a chapter on capital budgeting techniques from the textbook "Principles of Managerial Finance" by Lawrence J. Gitman. The chapter covers net present value, internal rate of return, payback period, and risk-adjusted discount rates. It includes sample problems, spreadsheet templates, and a study guide for classroom use. The document lists learning goals, solutions to review questions, and solutions to sample problems calculating various capital budgeting metrics for multiple projects.
ROSS FNCE CHAPTER 9, NPV AND OTHER INVESTMENTSDhruvangJoshi1
This document provides an overview of key concepts and methods for evaluating investment projects, including net present value (NPV), internal rate of return (IRR), payback period, and accounting rate of return. It gives examples of calculating these measures for a sample project and discusses their strengths and weaknesses as decision criteria. NPV is presented as the best method since it considers the time value of money and indicates whether a project will increase firm value. Other methods like payback period and accounting rate of return are easier to calculate but have shortcomings.
The document discusses various capital budgeting decision criteria for evaluating investment projects, including net present value (NPV), internal rate of return (IRR), payback period, discounted payback period, average accounting return, and profitability index. It provides the definitions, calculations, and advantages/disadvantages of each method. The key points are that NPV is the preferred decision rule as it accounts for time value of money and risk, while IRR can be unreliable for projects with non-conventional cash flows or when comparing mutually exclusive projects.
This document discusses various capital budgeting techniques for evaluating investment projects, including net present value (NPV), payback period, accounting rate of return, internal rate of return, and profitability index. It provides examples calculating each metric for a sample project with cash flows over three years. According to the NPV and IRR calculations, the project should be accepted as the NPV is positive and the IRR exceeds the required return rate. However, the payback period and accounting rate of return calculations would reject the project. The document also discusses the advantages and disadvantages of each method and situations where NPV and IRR may disagree, such as for projects with non-conventional cash flows or mutually exclusive projects.
The document discusses various investment criteria for capital budgeting decisions, with a focus on net present value (NPV). It defines NPV as the difference between the present value of a project's expected future cash flows and the initial investment cost. The document also discusses other criteria like payback period, accounting rate of return, and internal rate of return. It provides examples to demonstrate how to calculate NPV and compares it to other criteria. It emphasizes that NPV is preferable because it considers the time value of money and risk, and indicates whether a project will increase firm value.
Faculty of Law and Management FUNDAMENTALS OF FINANCE .docxmydrynan
Faculty of Law and Management
FUNDAMENTALS OF FINANCE
Lecture 5: Investment Evaluation Techniques
Presented by:
Dr Balasingham Balachandran
Professor of Finance
Department of Finance, La Trobe Business School
Investment Evaluation Techniques
2 These slides have been drafted by the La Trobe University School of Economics & Finance based on Berk (2011).
Topic Overview
Introduction to capital budgeting and investment
evaluation
Net Present Value (NPV)
Internal Rate of Return (IRR)
Payback Period (PP)
Accounting Rate of Return (ARR)
Choosing between projects when resources are
limited
These slides have been drafted by the Department of Finance, La Trobe Business School based on Berk (2014).
Investment Evaluation Techniques
Learning Objectives
Understand alternative decision rules and their
drawbacks
Choose between mutually exclusive investments
Rank projects when a company’s resources are
limited so that it cannot take all positive- NPV
projects
3
Investment Evaluation Techniques
4
The investment decision entails deciding which projects or investments
should be undertaken
Companies need to use investment evaluation techniques to determine
the value of the projects available to them
The final decision as to which projects a company should undertake is
known as ‘capital budgeting’
In this topic we will apply a number of techniques to the valuation of
individual projects
Investment evaluation and capital budgeting
Investment Evaluation Techniques
5
When a corporation allocates funds to long-term investment
projects, the outlay is made in the expectation of generating
future cash flows
In making the decision to invest in a project, the key
consideration is whether or not the proposal provides an
adequate return to investors
The process used to select projects to invest – capital budgeting
– is essentially a process to decide on the optimum use of scarce
resources
Investment evaluation and capital budgeting
Investment Evaluation Techniques
6
There are three fundamental stages in making capital budgeting
decisions:
Stage 1 is the forecasting of costs and benefits associated with a project – the most
important being the financial ones
Stage 2 involves the application of an investment evaluation technique to decide
whether a project is acceptable, or optimal amongst alternative projects
Stage 3 is the ultimate decision to accept or reject a project
The capital budgeting process
Investment Evaluation Techniques
7
In this lecture we will discuss the four best-known
investment evaluation techniques
Two of these are based on the discounted cash flow
(DCF) model:
Net present value (NPV)
Internal rate of return (IRR)
The other two are accounting-based techniques:
Payback
(Average) accounting rate of return (ARR)
Investment evaluation techniques
Investment ...
This document discusses various investment criteria used to evaluate capital budgeting projects. It covers net present value, benefit-cost ratio, internal rate of return, payback period, and accounting rate of return. Formulas are provided for calculating each method along with their pros and cons. The key steps in investment evaluation are estimating costs and benefits, assessing risk, calculating the cost of capital, and using these criteria to determine if a project is worthwhile.
This document discusses various capital budgeting techniques used to evaluate investment projects. It begins by explaining the importance of capital budgeting in long-term investment decisions and financial goals of maximizing firm value. Next, it outlines both non-discounted cash flow methods like average rate of return (ARR) and payback period (PBP), as well as discounted cash flow methods including net present value (NPV), internal rate of return (IRR), modified IRR, and profitability index (PI). For each technique, it provides the calculation method, advantages, and disadvantages. It emphasizes that NPV is the preferred approach as it considers the time value of money and is consistent with wealth maximization.
This document discusses various capital budgeting techniques for evaluating long-term investment projects, including payback period, net present value (NPV), internal rate of return (IRR), and profitability index. It covers how to calculate and apply these methods to determine whether to accept or reject stand-alone and mutually exclusive projects. It also addresses challenges like unequal project lives and capital rationing.
This document discusses the fundamentals of capital budgeting. It begins by explaining that capital budgeting decisions are the most important investment decisions firms make as they determine long-term assets. It then reviews several capital budgeting techniques: net present value (NPV), payback period, accounting rate of return (ARR), and internal rate of return (IRR). It discusses how to calculate each and their strengths/weaknesses as decision tools. The document emphasizes that NPV is the best technique and explains conditions where IRR may differ from NPV. It concludes by discussing capital budgeting in practice.
The document discusses various capital budgeting techniques used to analyze long-term investment projects. It describes methods like net present value (NPV), internal rate of return (IRR), payback period, and accounting rate of return. These techniques discount future cash flows to evaluate projects based on factors like profitability, risk, and investment recovery time. The document provides examples of applying these methods to hypothetical projects and comparing the results.
Capital expenditures (CAPEX) are funds used by a company to acquire or upgrade physical assets like equipment, property, or buildings to generate future benefits. CAPEX is evaluated using capital budgeting techniques like net present value (NPV) analysis, which discounts future cash flows to determine if a project's value exceeds its cost. The capital expenditure process involves generating investment proposals, evaluating proposals using methods like NPV, approving projects, and conducting post-completion audits to review project performance.
The document discusses present worth analysis and evaluating mutually exclusive project alternatives. It provides examples of calculating net present worth (NPW) to evaluate single projects and compare alternatives. The key points are:
1. Present worth analysis uses discounted cash flow techniques to calculate the net present value (NPW) of projects by discounting cash inflows and outflows.
2. Projects with a positive NPW that exceeds the minimum acceptable rate of return should be accepted.
3. Mutually exclusive alternatives must be compared over an equal time period using NPW.
4. The analysis period may differ from project lifetimes, requiring adjustments like estimating salvage value.
The document discusses various capital budgeting techniques for evaluating investment projects, including net present value (NPV), internal rate of return (IRR), payback period, and profitability index. It notes that NPV is the preferred method as it uses cash flows, discounts all cash flows properly, and considers the time value of money. Other methods like payback period, accounting rate of return, and IRR can produce incorrect results in some cases due to issues like ignoring the timing of cash flows.
- Project appraisal is the process of assessing proposals for resources before committing funds. It helps ensure projects benefit all community members and provide documentation for financial and audit requirements.
- Key issues in appraising projects include need, objectives, consultation, inputs/outputs, value for money, risks, sustainability, and more. Methods of appraisal include economic, technical, organizational, managerial, operational, and financial assessments.
- Capital budgeting determines the profitability of capital investments using methods like net present value (NPV), internal rate of return (IRR), profitability index (PI), and payback period to evaluate cash flows over time. Economic analysis assesses proposals based on their effects on the economy by adjusting
This document provides an overview of capital budgeting techniques for evaluating investment projects, including net present value (NPV), internal rate of return (IRR), payback period, and profitability index. It discusses the strengths and weaknesses of each method. The key points are:
- NPV discounts future cash flows to determine if a project's value exceeds its cost, and is the preferred decision criteria. IRR and payback period can give incorrect answers in some situations.
- IRR is the discount rate that yields an NPV of zero, but it has limitations like multiple rates of return or being unreliable for mutually exclusive projects.
- Payback period ignores the time value of money and cash flows after
The document discusses various capital budgeting techniques for evaluating investment projects. It outlines steps for estimating cash flows, including determining net cash outflows, annual cash flows, and final year cash flows. It then explains several evaluation techniques like average rate of return, payback period, discounted payback period, net present value, internal rate of return, and profitability index. The techniques consider factors like time value of money, risk, and whether the technique is consistent with maximizing shareholder wealth. NPV is highlighted as the preferred technique, though others provide supplementary insights into risk, costs, and returns.
This document provides an overview and study guide for Chapter 9 of the textbook "Principles of Managerial Finance" which covers capital budgeting techniques. It discusses net present value (NPV), internal rate of return (IRR), payback period, and risk-adjusted discount rates. It provides examples and solutions to problems involving calculating NPV, IRR, and payback period for capital budgeting projects. Answers to review questions on these techniques are also included to help students learn the concepts.
This document provides an overview and instructor resources for a chapter on capital budgeting techniques from the textbook "Principles of Managerial Finance" by Lawrence J. Gitman. The chapter covers net present value, internal rate of return, payback period, and risk-adjusted discount rates. It includes sample problems, spreadsheet templates, and a study guide for classroom use. The document lists learning goals, solutions to review questions, and solutions to sample problems calculating various capital budgeting metrics for multiple projects.
ROSS FNCE CHAPTER 9, NPV AND OTHER INVESTMENTSDhruvangJoshi1
This document provides an overview of key concepts and methods for evaluating investment projects, including net present value (NPV), internal rate of return (IRR), payback period, and accounting rate of return. It gives examples of calculating these measures for a sample project and discusses their strengths and weaknesses as decision criteria. NPV is presented as the best method since it considers the time value of money and indicates whether a project will increase firm value. Other methods like payback period and accounting rate of return are easier to calculate but have shortcomings.
The document discusses various capital budgeting decision criteria for evaluating investment projects, including net present value (NPV), internal rate of return (IRR), payback period, discounted payback period, average accounting return, and profitability index. It provides the definitions, calculations, and advantages/disadvantages of each method. The key points are that NPV is the preferred decision rule as it accounts for time value of money and risk, while IRR can be unreliable for projects with non-conventional cash flows or when comparing mutually exclusive projects.
This document discusses various capital budgeting techniques for evaluating investment projects, including net present value (NPV), payback period, accounting rate of return, internal rate of return, and profitability index. It provides examples calculating each metric for a sample project with cash flows over three years. According to the NPV and IRR calculations, the project should be accepted as the NPV is positive and the IRR exceeds the required return rate. However, the payback period and accounting rate of return calculations would reject the project. The document also discusses the advantages and disadvantages of each method and situations where NPV and IRR may disagree, such as for projects with non-conventional cash flows or mutually exclusive projects.
The document discusses various investment criteria for capital budgeting decisions, with a focus on net present value (NPV). It defines NPV as the difference between the present value of a project's expected future cash flows and the initial investment cost. The document also discusses other criteria like payback period, accounting rate of return, and internal rate of return. It provides examples to demonstrate how to calculate NPV and compares it to other criteria. It emphasizes that NPV is preferable because it considers the time value of money and risk, and indicates whether a project will increase firm value.
Faculty of Law and Management FUNDAMENTALS OF FINANCE .docxmydrynan
Faculty of Law and Management
FUNDAMENTALS OF FINANCE
Lecture 5: Investment Evaluation Techniques
Presented by:
Dr Balasingham Balachandran
Professor of Finance
Department of Finance, La Trobe Business School
Investment Evaluation Techniques
2 These slides have been drafted by the La Trobe University School of Economics & Finance based on Berk (2011).
Topic Overview
Introduction to capital budgeting and investment
evaluation
Net Present Value (NPV)
Internal Rate of Return (IRR)
Payback Period (PP)
Accounting Rate of Return (ARR)
Choosing between projects when resources are
limited
These slides have been drafted by the Department of Finance, La Trobe Business School based on Berk (2014).
Investment Evaluation Techniques
Learning Objectives
Understand alternative decision rules and their
drawbacks
Choose between mutually exclusive investments
Rank projects when a company’s resources are
limited so that it cannot take all positive- NPV
projects
3
Investment Evaluation Techniques
4
The investment decision entails deciding which projects or investments
should be undertaken
Companies need to use investment evaluation techniques to determine
the value of the projects available to them
The final decision as to which projects a company should undertake is
known as ‘capital budgeting’
In this topic we will apply a number of techniques to the valuation of
individual projects
Investment evaluation and capital budgeting
Investment Evaluation Techniques
5
When a corporation allocates funds to long-term investment
projects, the outlay is made in the expectation of generating
future cash flows
In making the decision to invest in a project, the key
consideration is whether or not the proposal provides an
adequate return to investors
The process used to select projects to invest – capital budgeting
– is essentially a process to decide on the optimum use of scarce
resources
Investment evaluation and capital budgeting
Investment Evaluation Techniques
6
There are three fundamental stages in making capital budgeting
decisions:
Stage 1 is the forecasting of costs and benefits associated with a project – the most
important being the financial ones
Stage 2 involves the application of an investment evaluation technique to decide
whether a project is acceptable, or optimal amongst alternative projects
Stage 3 is the ultimate decision to accept or reject a project
The capital budgeting process
Investment Evaluation Techniques
7
In this lecture we will discuss the four best-known
investment evaluation techniques
Two of these are based on the discounted cash flow
(DCF) model:
Net present value (NPV)
Internal rate of return (IRR)
The other two are accounting-based techniques:
Payback
(Average) accounting rate of return (ARR)
Investment evaluation techniques
Investment ...
This document discusses various investment criteria used to evaluate capital budgeting projects. It covers net present value, benefit-cost ratio, internal rate of return, payback period, and accounting rate of return. Formulas are provided for calculating each method along with their pros and cons. The key steps in investment evaluation are estimating costs and benefits, assessing risk, calculating the cost of capital, and using these criteria to determine if a project is worthwhile.
This document discusses various capital budgeting techniques used to evaluate investment projects. It begins by explaining the importance of capital budgeting in long-term investment decisions and financial goals of maximizing firm value. Next, it outlines both non-discounted cash flow methods like average rate of return (ARR) and payback period (PBP), as well as discounted cash flow methods including net present value (NPV), internal rate of return (IRR), modified IRR, and profitability index (PI). For each technique, it provides the calculation method, advantages, and disadvantages. It emphasizes that NPV is the preferred approach as it considers the time value of money and is consistent with wealth maximization.
This document discusses various capital budgeting techniques for evaluating long-term investment projects, including payback period, net present value (NPV), internal rate of return (IRR), and profitability index. It covers how to calculate and apply these methods to determine whether to accept or reject stand-alone and mutually exclusive projects. It also addresses challenges like unequal project lives and capital rationing.
This document discusses the fundamentals of capital budgeting. It begins by explaining that capital budgeting decisions are the most important investment decisions firms make as they determine long-term assets. It then reviews several capital budgeting techniques: net present value (NPV), payback period, accounting rate of return (ARR), and internal rate of return (IRR). It discusses how to calculate each and their strengths/weaknesses as decision tools. The document emphasizes that NPV is the best technique and explains conditions where IRR may differ from NPV. It concludes by discussing capital budgeting in practice.
The document discusses various capital budgeting techniques used to analyze long-term investment projects. It describes methods like net present value (NPV), internal rate of return (IRR), payback period, and accounting rate of return. These techniques discount future cash flows to evaluate projects based on factors like profitability, risk, and investment recovery time. The document provides examples of applying these methods to hypothetical projects and comparing the results.
Capital expenditures (CAPEX) are funds used by a company to acquire or upgrade physical assets like equipment, property, or buildings to generate future benefits. CAPEX is evaluated using capital budgeting techniques like net present value (NPV) analysis, which discounts future cash flows to determine if a project's value exceeds its cost. The capital expenditure process involves generating investment proposals, evaluating proposals using methods like NPV, approving projects, and conducting post-completion audits to review project performance.
The document discusses present worth analysis and evaluating mutually exclusive project alternatives. It provides examples of calculating net present worth (NPW) to evaluate single projects and compare alternatives. The key points are:
1. Present worth analysis uses discounted cash flow techniques to calculate the net present value (NPW) of projects by discounting cash inflows and outflows.
2. Projects with a positive NPW that exceeds the minimum acceptable rate of return should be accepted.
3. Mutually exclusive alternatives must be compared over an equal time period using NPW.
4. The analysis period may differ from project lifetimes, requiring adjustments like estimating salvage value.
The document discusses various capital budgeting techniques for evaluating investment projects, including net present value (NPV), internal rate of return (IRR), payback period, and profitability index. It notes that NPV is the preferred method as it uses cash flows, discounts all cash flows properly, and considers the time value of money. Other methods like payback period, accounting rate of return, and IRR can produce incorrect results in some cases due to issues like ignoring the timing of cash flows.
- Project appraisal is the process of assessing proposals for resources before committing funds. It helps ensure projects benefit all community members and provide documentation for financial and audit requirements.
- Key issues in appraising projects include need, objectives, consultation, inputs/outputs, value for money, risks, sustainability, and more. Methods of appraisal include economic, technical, organizational, managerial, operational, and financial assessments.
- Capital budgeting determines the profitability of capital investments using methods like net present value (NPV), internal rate of return (IRR), profitability index (PI), and payback period to evaluate cash flows over time. Economic analysis assesses proposals based on their effects on the economy by adjusting
This document provides an overview of capital budgeting techniques for evaluating investment projects, including net present value (NPV), internal rate of return (IRR), payback period, and profitability index. It discusses the strengths and weaknesses of each method. The key points are:
- NPV discounts future cash flows to determine if a project's value exceeds its cost, and is the preferred decision criteria. IRR and payback period can give incorrect answers in some situations.
- IRR is the discount rate that yields an NPV of zero, but it has limitations like multiple rates of return or being unreliable for mutually exclusive projects.
- Payback period ignores the time value of money and cash flows after
The document discusses various capital budgeting techniques for evaluating investment projects. It outlines steps for estimating cash flows, including determining net cash outflows, annual cash flows, and final year cash flows. It then explains several evaluation techniques like average rate of return, payback period, discounted payback period, net present value, internal rate of return, and profitability index. The techniques consider factors like time value of money, risk, and whether the technique is consistent with maximizing shareholder wealth. NPV is highlighted as the preferred technique, though others provide supplementary insights into risk, costs, and returns.
OJP data from firms like Vicinity Jobs have emerged as a complement to traditional sources of labour demand data, such as the Job Vacancy and Wages Survey (JVWS). Ibrahim Abuallail, PhD Candidate, University of Ottawa, presented research relating to bias in OJPs and a proposed approach to effectively adjust OJP data to complement existing official data (such as from the JVWS) and improve the measurement of labour demand.
Abhay Bhutada, the Managing Director of Poonawalla Fincorp Limited, is an accomplished leader with over 15 years of experience in commercial and retail lending. A Qualified Chartered Accountant, he has been pivotal in leveraging technology to enhance financial services. Starting his career at Bank of India, he later founded TAB Capital Limited and co-founded Poonawalla Finance Private Limited, emphasizing digital lending. Under his leadership, Poonawalla Fincorp achieved a 'AAA' credit rating, integrating acquisitions and emphasizing corporate governance. Actively involved in industry forums and CSR initiatives, Abhay has been recognized with awards like "Young Entrepreneur of India 2017" and "40 under 40 Most Influential Leader for 2020-21." Personally, he values mindfulness, enjoys gardening, yoga, and sees every day as an opportunity for growth and improvement.
Falcon stands out as a top-tier P2P Invoice Discounting platform in India, bridging esteemed blue-chip companies and eager investors. Our goal is to transform the investment landscape in India by establishing a comprehensive destination for borrowers and investors with diverse profiles and needs, all while minimizing risk. What sets Falcon apart is the elimination of intermediaries such as commercial banks and depository institutions, allowing investors to enjoy higher yields.
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For more market updates, subscribe to The Independent Market Observer at https://blog.commonwealth.com/independent-market-observer.
Vicinity Jobs’ data includes more than three million 2023 OJPs and thousands of skills. Most skills appear in less than 0.02% of job postings, so most postings rely on a small subset of commonly used terms, like teamwork.
Laura Adkins-Hackett, Economist, LMIC, and Sukriti Trehan, Data Scientist, LMIC, presented their research exploring trends in the skills listed in OJPs to develop a deeper understanding of in-demand skills. This research project uses pointwise mutual information and other methods to extract more information about common skills from the relationships between skills, occupations and regions.
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Do elements of globalization, such as Foreign Direct Investment (FDI), negatively affect the ability of countries in the Global South to preserve their culture? This research aims to answer this question by employing a cross-sectional comparative case study analysis utilizing methods of difference. Thailand and Cambodia are compared as they are in the same region and have a similar culture. The metric of difference between Thailand and Cambodia is their ability to preserve their culture. This ability is operationalized by their respective attitudes towards FDI; Thailand imposes stringent regulations and limitations on FDI while Cambodia does not hesitate to accept most FDI and imposes fewer limitations. The evidence from this study suggests that FDI from globally influential countries with high gross domestic products (GDPs) (e.g. China, U.S.) challenges the ability of countries with lower GDPs (e.g. Cambodia) to protect their culture. Furthermore, the ability, or lack thereof, of the receiving countries to protect their culture is amplified by the existence and implementation of restrictive FDI policies imposed by their governments.
My study abroad in Bali, Indonesia, inspired this research topic as I noticed how globalization is changing the culture of its people. I learned their language and way of life which helped me understand the beauty and importance of cultural preservation. I believe we could all benefit from learning new perspectives as they could help us ideate solutions to contemporary issues and empathize with others.
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Solution Manual For Financial Accounting, 8th Canadian Edition 2024, by Libby, Hodge, Verified Chapters 1 - 13, Complete Newest Version Solution Manual For Financial Accounting, 8th Canadian Edition by Libby, Hodge, Verified Chapters 1 - 13, Complete Newest Version Solution Manual For Financial Accounting 8th Canadian Edition Pdf Chapters Download Stuvia Solution Manual For Financial Accounting 8th Canadian Edition Ebook Download Stuvia Solution Manual For Financial Accounting 8th Canadian Edition Pdf Solution Manual For Financial Accounting 8th Canadian Edition Pdf Download Stuvia Financial Accounting 8th Canadian Edition Pdf Chapters Download Stuvia Financial Accounting 8th Canadian Edition Ebook Download Stuvia Financial Accounting 8th Canadian Edition Pdf Financial Accounting 8th Canadian Edition Pdf Download Stuvia
2. 9-2
Chapter Outline
• Capital Budgeting Process
• Payback
• Discounted Payback
• Net Present Value
• Profitability Index
3. 9-3
Chapter Outline
(continued)
• The Average Accounting Return
• The Internal Rate of Return
• Modified Internal Rate of Return
• The Practice of Capital Budgeting
4. 9-4
Chapter Outline
• Capital Budgeting Process
• Payback
• Discounted Payback
• Net Present Value
• Profitability Index
8. 9-8
Comparison Valuations
1 2 3
Bond
C C
C
M
P0
0
1 2 3
Common Stock
D1 D2 D3 D∞
P0
0
1 2 3
Project
CF3
CF2
CF1
COST
0
9. 9-9
Bonds, Stock and Project
Similarities
• All three have identified future dollars
that an must be considered
• All three involve bring future dollars
into present value terms
• All three involve an “accept/reject”
decision in the form of purchasing or
not purchasing the entity.
10. 9-10
Project
Differences
• A bond has coupon payments and a lump-
sum payment; stock has dividend
payments forever; projects have cash flows
that end.
• Coupon payments are fixed; stock
dividends change or “grow” over time;
project cash flows are typically different
each year.
11. 9-11
Project
Differences
• With bonds and stock our goal is to
determine the value today (P0); our goal
with projects is to determine if we will
exceed our cost with the cash flows
identified.
16. 9-16
Chapter Outline
• Capital Budgeting Process
• Payback
• Discounted Payback
• Net Present Value
• Profitability Index
17. 9-17
Payback Period
Definition: How long does it take to get the
initial cost back in a nominal
sense?
Computation:
1. Estimate the cash flows
2. Subtract the future cash flows
from the initial cost until the
initial investment has been
recovered
18. 9-18
Project Example
Information
You are reviewing a new project and have
estimated the following cash flows:
Year 0: CF = -165,000
Year 1: CF = 63,120; NI = 13,620
Year 2: CF = 70,800; NI = 3,300
Year 3: CF = 91,080; NI = 29,100
Average Book Value = 72,000
Your required return for assets of this risk level
is 12%.
19. 9-19
Project Example - Visual
R = 12%
$ -165,000
1 2 3
CF1 =
63,120
CF2 =
70,800
CF3 =
91,080
The required return for assets of this risk level
is 12% (as determined by the firm).
20. 9-20
Payback Computation
R = 12%
$ -165,000
1 2 3
CF1 =
63,120
CF2 =
70,800
CF3 =
91,080
Year 1: $165,000 – 63,120 = 101,880
We need to get to zero so keep going…
21. 9-21
Payback Computation
R = 12%
$ -165,000
1 2 3
CF1 =
63,120
CF2 =
70,800
CF3 =
91,080
Year 2: $101,880 – 70,800 = 31,080
We need to get to zero so keep going…
22. 9-22
Payback Computation
R = 12%
$ -165,000
1 2 3
CF1 =
63,120
CF2 =
70,800
CF3 =
91,080
Year 3: $31,080 – 91,080 = -60,000
We “passed” zero so payback is achieved
24. 9-24
Payback Decision
We need to know a “management’s
number. What does the firm use for the
evaluation of its projects when they use
payback?
Most companies use either 3 or 4 years.
Let’s use 4 in our numerical example
25. 9-25
Payback Decision
Our computed
payback was 3 years
The firm’s uses 4
years as it’s criteria,
so…
YES, we Accept this
project as we recover
our cost of the
project early.
27. 9-27
Good Decision Criteria
We need to ask ourselves the following questions
when evaluating capital budgeting decision rules:
1. Does the decision rule adjust for the time
value of money?
2. Does the decision rule adjust for risk?
3. Does the decision rule provide information
on whether we are creating value for the
firm?
28. 9-28
Decision Criteria Test -
Payback
1. Does the payback rule account for the time
value of money?
2. Does the payback rule account for the risk
of the cash flows?
3. Does the payback rule provide an indication
about the increase in value?
4. Should we consider the payback rule for our
primary decision rule?
29. 9-29
Decision Criteria Test -
Payback
Q: So if Payback is not that great as a capital
budgeting technique, why use it?
A: Because it is so easy to compute!
30. 9-30
Payback’s Advantages
• Easy to understand and
compute (you just
subtract!)
• Adjusts for uncertainty
of later cash flows
• Biased toward liquidity
31. 9-31
Payback’s Disadvantages
• Ignores the time value of
money
• Requires an arbitrary cutoff
point
• Ignores cash flows beyond the
cutoff date
• Biased against long-term
projects, such as research and
development, and new projects
32. 9-32
Chapter Outline
• Capital Budgeting Process
• Payback
• Discounted Payback
• Net Present Value
• Profitability Index
33. 9-33
Discounted Payback
Period
Definition: How long does it take to get the
initial cost back after you bring all of the
cash flows to the present value.
Computation:
1. Estimate the present value of the cash flows
2. Subtract the future cash flows from the
initial cost until the initial investment has
been recovered
39. 9-39
Decision Criteria Test –
Discounted Payback
1. Does the discounted payback rule account for
the time value of money?
2. Does the discounted payback rule account for
the risk of the cash flows?
3. Does the discounted payback rule provide an
indication about the increase in value?
4. Should we consider the discounted payback
rule for our primary decision rule?
42. 9-42
Chapter Outline
• Capital Budgeting Process
• Payback
• Discounted Payback
• Net Present Value
• Profitability Index
43. 9-43
Net Present Value
Definition: The difference between the
market value of a project and its cost
Computation:
1. Estimate the future cash flows
2. Estimate the required return for
projects of this risk level.
3. Find the present value of the cash flows
and subtract the initial investment.
44. 9-44
NPV – Decision Rule
• 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, as measured in
dollar terms.
46. 9-46
Net Present Value Computation
Step 1
R = 12%
$ -165,000
1 2 3
CF1 =
63,120
CF2 =
70,800
CF3 =
91,080
56,357
56,441
64,829
177,627 = PV of all cash flows
47. 9-47
Net Present Value Computation
Step 2
R = 12%
$ -165,000
1 2 3
CF1 =
63,120
CF2 =
70,800
CF3 =
91,080
NPV =$177,627 - $165,000 = $12,627
NPV = PV of Inflows – PV of Outflows
48. 9-48
Net Present Value
Decision
If the NPV is positive
(NPV > $0), then we ACCEPT
the project. Conversely, if the
NPV is negative, then we
REJECT the project.
Thus in our case, the NPV is
$12,627 so we ACCEPT the
project.
53. 9-53
Decision Criteria Test -
NPV
• Does 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?
54. 9-54
Net Present Value
Advantages
• Considers all of the cash flows in the
computation
• Uses the time value of money
• Provides the answer in dollar terms,
which is easy to understand
• Usually provides a similar answer to the
IRR computation
55. 9-55
Net Present Value
Disadvantages
• Requires the use of the time value of
money, thus a bit more difficult to
compute
• Projects that differ by orders of
magnitude in cost are not obvious in the
NPV final figure
56. 9-56
Calculating NPVs with a
Spreadsheet
• Spreadsheets are an excellent way to
compute NPVs, especially when you have
to compute the cash flows as well.
• Using the NPV function:
• The first component is the required return
entered as a decimal
• The second component is the range of cash
flows beginning with year 1
• Subtract the initial investment after
computing the NPV
57. 9-57
Chapter Outline
• Capital Budgeting Process
• Payback
• Discounted Payback
• Net Present Value
• Profitability Index
58. 9-58
Profitability Index
Definition: The PI measures the benefit per unit
cost of a project, based on the time value of money.
It is very useful in situations where you have
multiple projects of hugely different costs and/or
limited capital (capital rationing).
Computation: PI = PV of Inflows
PV of Outflows
59. 9-59
Profitability Index
Example
PI = PV of Inflows
PV of Outflows
$177,627 = 1.0765
$165,000
A Profitability Index of 1.076 implies that for
every $1 of investment, we create an additional
$0.0765 in value. A PI >1 means the firm is
increasing in value.
60. 9-60
Capital Budgeting Decision
Criteria Comparison
Technique Unit
s
Accept
if:
Payback Time Payback <
Mgt’s #
Discounted
Payback
Time Payback <
Mgt’s #
Net Present Value $ NPV > $0
Profitability Index
(PI)
None PI > 1.0
61. 9-61
Profitability Index
Advantages
• Closely related to NPV, generally
leading to identical decisions
• Easy to understand and communicate
• May be useful when available
investment funds are limited
63. 9-63
Chapter Outline
(continued)
• The Average Accounting Return
• The Internal Rate of Return
• Modified Internal Rate of Return
• The Practice of Capital Budgeting
64. 9-64
Average Accounting
Return
Definition: The AAR is a measure of the average
accounting profit compared to some measure of
average accounting value of a project. The AAR is
then compared to a required return by the
company.
Computation: AAR = Average Net Income
Average Book Value
65. 9-65
Project Example
Information
You are reviewing a new project and have
estimated the following cash flows:
Year 0: CF = -165,000
Year 1: CF = 63,120; NI = 13,620
Year 2: CF = 70,800; NI = 3,300
Year 3: CF = 91,080; NI = 29,100
Average Book Value = 72,000
Your required return for assets of this risk level
is 12%.
66. 9-66
Average Accounting
Return
Using the figures of our previous example:
1. ($13,620 + 3,300 + 29,100) / 3
2. 46,020/ 3 = $15,340
3. AAR = 15,340 /72,000 = .2131 or 21%
4. If we compare this to our firm’s
requirement of 25%, then we would Reject
this project as the AAR < 25%
67. 9-67
Decision Criteria
Comparison
Technique Units Accept if:
Payback Time Payback < Mgt’s #
Discounted Payback Time Payback < Mgt’s #
Net Present Value $ NPV > $0
Profitability Index (PI) None PI > 1.0
Average Acct. Return % AAR > Mgt’s #
68. 9-68
Decision Criteria Test -
AAR
1.Does the AAR rule account for the time
value of money?
2.Does the AAR rule account for the risk
of the cash flows?
3.Does the AAR rule provide an
indication about the increase in value?
4.Should we consider the AAR rule for
our primary decision rule?
70. 9-70
Average Accounting
Return Disadvantages
• Not a true rate of
return; time value of
money is ignored
• Uses an arbitrary
benchmark cutoff rate
• Based on accounting net
income and book values,
not cash flows and
market values
71. 9-71
Chapter Outline
(continued)
• The Average Accounting Return
• The Internal Rate of Return
• Modified Internal Rate of Return
• The Practice of Capital Budgeting
72. 9-72
Internal Rate of Return
• This is the most important alternative
to NPV
• It is often used in practice and is
intuitively appealing
• It is based entirely on the estimated
cash flows and is independent of
interest rates found elsewhere
73. 9-73
Internal Rate of Return
Definition: It is the discount rate (or required
return) that will bring all of the cash flows into
present value time and total the exact value of the
cost of the project.
Said another way, it is the return that will yield a
NPV = $0.
74. 9-74
Computing IRR for the
Project
• If you do not have a financial calculator, then this
becomes a trial and error process
• Calculator:
• Enter the cash flows as you did with NPV
• Press IRR and then CPT
• IRR = 16.13% > 12% required return:
thus we ACCEPT the project.
75. 9-75
Calculating IRRs With A
Spreadsheet
• You start with the cash flows the same as you did
for the NPV
• You use the IRR function
• First enter your range of cash flows, beginning
with the initial cash flow
• You can enter a guess, but it is not necessary
• The default format is a whole percent – you
will normally want to increase the decimal
places to at least two
76. 9-76
IRR – Decision Rule
• If the IRR of a project is greater than the
firm’s cost of capital, then we would accept
the project
• Since our goal is to increase owner wealth,
IRR is a direct measure of how well this
project will meet our goal, as measured in
interest rate terms.
77. 9-77
Capital Budgeting Decision Criteria
Comparison
Technique Unit
s
Accept
if:
Payback Time Payback <
Mgt’s #
Discounted
Payback
Time Payback <
Mgt’s #
Net Present Value $ NPV > $0
Profitability
Index (PI)
None PI > 1.0
Average Acct.
Return
% AAR > Mgt’s
#
Internal Rate of
Return
% IRR > R
78. 9-78
Decision Criteria Test -
IRR
1. Does the IRR rule account for the time value of
money?
2. Does the IRR rule account for the risk of the
cash flows?
3. Does the IRR rule provide an indication about
the increase in value?
4. Should we consider the IRR rule for our
primary decision criteria?
79. 9-79
Internal Rate of Return
Advantages
• Considers all of the cash flows in the
computation
• Uses the time value of money
• If the IRR is high enough, you may not
need to estimate a required return, which
is often a difficult task
• Usually provides a similar answer to the
NPV computation
80. 9-80
Internal Rate of Return
Disadvantages
• Uses the firm’s required rate of return
for comparison purposes.
• Unusually high numbers can often occur
when a significant amount of the
project’s cash flows occur early in the life
of the project.
81. 9-81
Mutually Exclusive
Projects
Mutually exclusive projects:
If you choose one, you can’t choose the other
Example: You can choose to attend graduate school
at either Harvard or Stanford, but not both
Intuitively, you would use the following decision rules:
NPV – choose the project with the higher NPV
IRR – choose the project with the higher IRR
82. 9-82
Mutually Exclusive
Projects
Period Project
A
Project
B
0 -500 -400
1 325 325
2 325 200
IRR 19.43% 22.17%
NPV $64.05 $60.74
If the required rate
of return for the firm
is 10% and Projects
A and B are both of
equal risk, which
project would you
select?
84. 9-84
NPV vs. IRR
• NPV and IRR will generally give us the same
decision
• Exceptions:
• Nonconventional cash flows – cash flow signs
change more than once
• Mutually exclusive projects
• Initial investments are substantially
different (issue of scale)
• Timing of cash flows is substantially
different
86. 9-86
Conflicts Between NPV and
IRR
• NPV directly measures
the increase in value to
the firm.
• Whenever there is a
conflict between NPV and
another decision rule, you
should
always use NPV!
87. 9-87
Chapter Outline
(continued)
• The Average Accounting Return
• The Internal Rate of Return
• Modified Internal Rate of Return
• The Practice of Capital Budgeting
88. 9-88
Modified Internal Rate of
Return (MIRR)
Definition: MIRR differentiates itself from IRR in
that the reinvestment rate for the cash flows is
determined by the evaluator. It is the interest rate
that compares the future value of the cash flows
with the cost of the project.
The benefit of MIRR over IRR is that we can
produce a single number with specific rates for
borrowing and reinvestment.
89. 9-89
Modified Internal Rate of
Return (MIRR)
Computation:
Step 1: Take the Cash flows to the end of the
project and add them up; this is labeled the
“terminal value”.
Step 2: Find the rate of return that equates the
cost with the terminal value for the life of the
project. This is the MIRR.
91. 9-91
MIRR Computation Step 2
R = 12%
$ -165,000
1 2 3
TV = $249,554
MIRR: PV = -165,000; FV =
249,554; N = 3; Solve for I
MIRR = 14.79% which is greater than
12%, therefore ACCEPT the project
92. 9-92
Capital Budgeting Decision Criteria
Comparison
Technique Units Accept if:
Payback Time Payback < Mgt’s #
Discounted Payback Time Payback < Mgt’s #
Net Present Value $ NPV > $0
Profitability Index (PI) None PI > 1.0
Average Acct. Return % AAR > Mgt’s #
Internal Rate of Return % IRR > R
Modified Internal Rate
of Return (MIRR)
% IRR > R
93. 9-93
Chapter Outline
(continued)
• The Average Accounting Return
• The Internal Rate of Return
• Modified Internal Rate of Return
• The Practice of Capital Budgeting
94. 9-94
Capital Budgeting In
Practice
• We should consider several investment criteria
when making decisions
• Most managers will be using the techniques of
capital budgeting as part of their job.
• Payback is a commonly used secondary investment
criteria and is used when the project costs are
small
• NPV and IRR are the most commonly used
primary investment criteria and especially when
the project costs are large
95. 9-95
Ethics Issues I
ABC poll in the spring of 2004 found that one-
third of students age 12 – 17 admitted to
cheating and the percentage increased as the
students got older and felt more grade pressure.
If a book entitled “How to Cheat: A User’s Guide”
would generate a positive NPV, would it be
proper for a publishing company to offer the new
book?
96. 9-96
Ethics Issues II
Should a firm exceed the minimum legal limits of
government imposed environmental regulations
and be responsible for the environment, even if
this responsibility leads to a wealth reduction for
the firm?
Is environmental damage merely a cost of doing
business?
97. 9-97
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
required payback 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?
What decision rule should be the primary
decision method?
98. 9-98
Comprehensive Problem
1. An investment project has the
following cash flows: CF0 = -1,000,000;
C01 – C08 = 200,000 each
2. If the required rate of return is 12%,
what decision should be made using
NPV?
3. How would the IRR decision rule be
used for this project, and what
decision would be reached?
4. How are the above two decisions
related?
99. 9-99
Terminology
• Capital budgeting
• Decision criteria
• Project’s cash flows
• Payback
• Discounted Payback
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Modified IRR (MIRR)
101. 9-101
Summary – Payback Criteria
Payback period
Length of time until initial investment is recovered
Take the project if it pays back within some specified
period
Doesn’t account for time value of money, and there is an
arbitrary cutoff period
Discounted payback period
Length of time until initial investment is recovered on a
discounted basis
Take the project if it pays back in some specified period
There is an arbitrary cutoff period
102. 9-102
Summary – Discounted
Cash Flow Criteria
Net present value
Difference between market value and cost
Take the project if the NPV is positive
Has no serious problems
Preferred decision criterion
Internal rate of return
Discount rate that makes NPV = 0
Take the project if the IRR is greater than the required return
Same decision as NPV with conventional cash flows
IRR is unreliable with nonconventional cash flows or mutually
exclusive projects
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
103. 9-103
Key Concepts and Skills
• Compute payback and
discounted payback & evaluate their
shortcomings
• Compute accounting rates of
return and explain its shortcomings
• Compute the NPV and explain why it is
superior to the other techniques of capital
budgeting
104. 9-104
Key Concepts and Skills
• Compute both internal rate of
return (IRR) and modified internal
rate of return (MIRR) and
differentiate between them
• Compute the profitability index
(PI) and explain its relationship to
net present value
105. 9-105
1. Capital budgeting techniques
basically involves comparing
anticipated cash flows to that of a
project’s cost
2. Payback and AAR do not utilize
the time value of money
3. NPV, IRR and MIRR are superior
to other techniques
What are the most
important topics of this
chapter?
106. 9-106
4. The profitability index (PI) assists
with the evaluation of unequal
costing projects
5. All projects may not have the
identical risk classification and
we can adjust this using a risk-
adjusted discount rate
What are the most
important topics of
this chapter?