Chapter 11 Investment Decision Criteria Updated 2-2015

Investment Decision Criteria Analytical tools to determine the desirability of investment projects: Net Present Value (NPV) Profitability Index (PI) Internal Rate of Return (IRR) Payback Period (PB)

Independent vs. Mutually Exclusive Investment Projects An independent investment project: The project that stands alone and can be undertaken without influencing the acceptance or rejection of any other projects. Ex. The decision to replace a company’s computer system would be considered independent of the decision to build a new factory. A mutually exclusive project: The project where the acceptance of such project will have an effect on the acceptance of another project. Ex. Conveyor-belt system or Forklifts – to move goods in a warehouse

1. Net Present Value (NPV) Difference between present value of cash inflows and the cash outflows. NPV estimates the amount of wealth ($) that the project creates. Decision Rules: Accept if NPV is positive. Reject if NPV is negative.

Checkpoint 1 Calculating NPV for Project Long Project Long requires an initial investment of $100,000 and is expected to generate a cash flow of $70,000 in year one, $30,000 per year in years two and three, $25,000 in year four, and $10,000 in year 5. The discount rate (k) appropriate for calculating NPV of Project Long is 17 percent. Calculate NPV of Project Long? Is Project Long a good investment opportunity?

Checkpoint 1 Accept or Reject?

Checkpoint 1

2. Profitability Index (PI) Present value of project’s future cash flows divided by its initial cost. Benefit-Cost ratio Decision Rules: Accept if PI > 1 Benefit > Cost NPV is positive Reject if PI < 1 Benefit < Cost NPV is negative

Calculating PI for Project Long Checkpoint 3 Calculating PI for Project Long Project Long requires an initial investment of $100,000 and is expected to generate a cash flow of $70,000 in year one, $30,000 per year in years two and three, $25,000 in year four, and $10,000 in year 5. The discount rate (k) appropriate for calculating PV of future cash flows for Project Long is 17 percent. Calculate PI of Project Long? Is Project Long a good investment opportunity?

Checkpoint 3 Accept or Reject?

3. Internal Rate of Return (IRR) IRR is the discount rate that makes project’s NPV equals zero. The same concept as Yield to maturity (YTM) of a bond defined in Chapter 9. Decision Rules: Compare with discount rate used to calculate NPV Accept if IRR > WACC Reject if IRR < WACC

Checkpoint 4 Calculating the IRR for Project Long Project Long requires an initial investment of $100,000 and is expected to generate a cash flow of $70,000 in year one, $30,000 per year in years two and three, $25,000 in year four, and $10,000 in year 5. The required rate of return or discount rate that is appropriate for valuing the cash flows of Project Long is 17 percent. Calculate IRR of Project Long? Is Project Long a good investment opportunity?

Checkpoint 4 Accept or Reject? NPV = -100,000+70,000(PVIFIRR, 1)+30,000(PVIFIRR, 2)+30,000 (PVIFIRR, 3)+25,000 (PVIFIRR, 4)+10,000 (PVIFIRR, 5) = 0

Checkpoint 4

Checkpoint 4

4. Payback Period (PB) Number of years needed to recover the initial cash outlay required to invest in the project. Decision Rules: Compare with the benchmark (cut off period) Accept if PB < Cut off period Reject if PB > Cut off period

Which project is better? PB = ? Which project is better?

Limitations of Payback Period Ignore time value of money. Ignore cash flows beyond payback period. Acceptance or Rejection depends on cutoff criterion. PB = 2 yrs If cut off = 1 yr  Accept or Reject? If cut off = 3 yrs  Accept or Reject?

Table 3

Exercises (End of Chapter) Q. 26: You are considering two independent projects, Project A & Project B. The initial cash outlay associated with Project A is $50,000 and the initial cash outlay associated with Project B is $70,000. The discount rate on both projects is 12 percent. The expected annual cash flows from each project are as follows: Calculate the NPV, PI, IRR and PB for each project and indicate of the project should be accepted or not.

Personal Summary Write down one thing you learned in this chapter that is interesting, new, or useful to you. ____________________________________________________________________________________________________________________________________________