After studying this chapter you will be able to: Understand the payback rule and its shortcomings, understand accounting rates of return and their problems, understand the internal rate of return and its strengths and weaknesses, understand the net present value rule and why it is the best decision criteria. | McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. 8. 8- Key Concepts and Skills Understand: The payback rule and its shortcomings Accounting rates of return and their problems The internal rate of return and its strengths and weaknesses The net present value rule and why it is the best decision criteria The modified internal rate of return The profitability index and its relation to NPV 8. 8- Chapter Outline Net Present Value The Payback Rule The Average Accounting Return The Internal Rate of Return The Profitability Index The Practice of Capital Budgeting 8. 8- Capital Budgeting Analysis of potential projects Long-term decisions Large expenditures Difficult/impossible to reverse Determines firm’s strategic direction 8. 8- All cash flows considered? TVM considered? Risk-adjusted? Ability to rank projects? Indicates added value to the firm? Good Decision Criteria 8. 8- Net Present . | McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. 8. 8- Key Concepts and Skills Understand: The payback rule and its shortcomings Accounting rates of return and their problems The internal rate of return and its strengths and weaknesses The net present value rule and why it is the best decision criteria The modified internal rate of return The profitability index and its relation to NPV 8. 8- Chapter Outline Net Present Value The Payback Rule The Average Accounting Return The Internal Rate of Return The Profitability Index The Practice of Capital Budgeting 8. 8- Capital Budgeting Analysis of potential projects Long-term decisions Large expenditures Difficult/impossible to reverse Determines firm’s strategic direction 8. 8- All cash flows considered? TVM considered? Risk-adjusted? Ability to rank projects? Indicates added value to the firm? Good Decision Criteria 8. 8- Net Present Value 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. 8. 8- 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 8. 8- NPV – Decision Rule If NPV is positive, accept the project NPV > 0 means: Project is expected to add value to the firm Will increase the wealth of the owners NPV is a direct measure of how well this project will meet the goal of increasing shareholder wealth. 8. 8- Sample Project Data You are looking at a new project and have estimated the following cash flows, net income and book value data: Year 0: CF = -165,000 Year 1: CF = 63,120 NI = 13,620 Year 2: CF = 70,800 NI = 3,300 Year 3: .
