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Alternative Investment Rules in Capital Budgeting NPV vs. Payback Period (PP), Accounting ROR, and Internal Rate of Return (IRR)

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Presentation on theme: "Alternative Investment Rules in Capital Budgeting NPV vs. Payback Period (PP), Accounting ROR, and Internal Rate of Return (IRR)"— Presentation transcript:

1 Alternative Investment Rules in Capital Budgeting NPV vs. Payback Period (PP), Accounting ROR, and Internal Rate of Return (IRR)

2 Chhachhi/519/Ch. 62 How Important is CB to a firm? Why is Capital Budgeting (CB) so critical to a firm’s long-term survival? Magnitude of $s involved: Amplifies both, the positive impact of “good” decisions, and negative impact of “poor” decisions Repercussions of CB decisions extend over long periods of time

3 Chhachhi/519/Ch. 63 Evaluation of Investment Rules Criterion to be used to judge investment rules: Uses Cash Flows and NOT earnings Uses ALL Cash flows Does NOT ignore Time Value of $ Makes Accept/Reject decisions that are consistent with S/H wealth Max.

4 Chhachhi/519/Ch. 64 NPV-- A benchmark for other Investment Rules! NPV: PV of future CFs - Initial Investment Accept if NPV > 0 (Independent Projects) In case of mutually exclusive (M.E.) projects, choose the highest NPV Accepting +NPV projects will Always increase S/H wealth and vice versa. Why look at other rules??

5 Chhachhi/519/Ch. 65 Payback Period (PP) Rule Length of time it takes for a firm to recover its investment if PP < a cutoff time:Accept Disadvantages Ignores Time Value of money Ignores CFs beyond Payback Period. Biased against Long-term projects Cutoff time is arbitrarily decided

6 Chhachhi/519/Ch. 66 PP Rule (continued) Advantages Easy to understand/use Favors liquidity might be appropriate for quick decisions for repetitive or low budget projects Read: discounted PP (sec. 6.3) & Average Accounting Return (sec. 6.4)

7 Chhachhi/519/Ch. 67 Internal Rate of Return (%) (IRR) The discount rate for which: PV of future CFs = Initial Investment OR NPV of the project = 0 Accept if IRR > Required return M.E.: select alternative with the highest IRR. IRR is independent of discount rate NPV profile: Discount rate, NPV graph downward sloping

8 Chhachhi/519/Ch. 68 Potential Problems with IRR (Independent OR M.E.) CF 0 =$100, CF 1 =-$130; r = 10% NPV = -$18.20, IRR = 30%; Accept???? NO; This is a Financing project for Financing, accept if IRR < r CF 0 = -$60, CF 1 =$155 CF 2 = -$100; Multiple IRRs Neither has any economic meaning Possible if >1 reversal of sign of CFs NPV does not have these 2 problems

9 Chhachhi/519/Ch. 69 Potential Problems with IRR (M.E. projects only) Scale Problem: Comparing small and large projects: A: CF 0 = -$100, CF 1 = $150; r = 0% NPV = $50, IRR = 50% B: CF 0 = -$1,000, CF 1 = $1,250; NPV = $250, IRR = 25% ‘A’ or ‘B’???

10 Chhachhi/519/Ch. 610 IRR problems (continued) Timing Problem: CFs occur at differing times: CF 0 = -$1,000, CF 1 = $500 CF 2 = $400, CF 3 = $300 CF 4 = $100 IRR S = 14.5% CF 0 = -$1,000, CF 1 = $100 CF 2 = $300, CF 3 = $400 CF 4 = $600 IRR L = 11.8% If ‘r’= 10%, ‘S’ or ‘L’???if r = 5%?

11 Chhachhi/519/Ch. 611 Reinvestment Assumption NPV: NPV rule assumes that all future CFs can be reinvested at the discount rate IRR: IRR calculation assumes that all future CFs can be reinvested at the IRR Which is more Realistic? IRR is easy to understand and communicate

12 Chhachhi/519/Ch. 612 Profitability Index (PI)& Capital Rationing PI: PV of future CFs/Initial Investment Accept if >1 (independent projects) Can lead to incorrect decision for M.E. (choosing highest PI) Similar to NPV Capital Rationing: Limited funds PI useful for making optimal decisions H.W. 1, 3, 7, 8, 10 (a-c, f), 12, 13, 19

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