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

Slides:

Advertisements

Similar presentations

Chapter Outline 6.1 Why Use Net Present Value?

Advertisements

Net Present Value and Other Investment Rules Chapter 5 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

McGraw-Hill/Irwin Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 6-0 CHAPTER 6 Some Alternative Investment Rules.

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies,

9-0 Chapter 9: Outline Net Present Value The Payback Rule The Discounted Payback The Average Accounting Return The Internal Rate of Return The Profitability.

Chapter 11: Capital Budgeting: Decision Criteria Overview and “vocabulary” Methods Payback, discounted payback NPV IRR, MIRR Profitability Index.

Capital Budgeting1 Select investments which increase value of firm Maximize wealth of shareholders Important to firm’s long-term success  Substantial.

Key Concepts and Skills

Chapter McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9 Net Present Value and Other Investment Criteria.

Capital Budgeting: To Invest or Not To Invest  Capital Budgeting Decision –usually involves long-term and high initial cost projects. –Invest if a project’s.

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 9 Net Present Value and Other Investment Criteria.

1 The Basics of Capital Budgeting: Evaluating and Estimating Cash Flows Corporate Finance Dr. A. DeMaskey Should we build this plant?

Chapter McGraw-Hill Ryerson © 2013 McGraw-Hill Ryerson Limited 9 Prepared by Anne Inglis Net Present Value and Other Investment Criteria.

1 FINANCE 7311 CAPITAL BUDETING. 2 Outline 4 Projects 4 Investment Criteria 4 NPV v. IRR 4 Sources of NPV 4 Project Cash Flow Checklist.

Chapter 8 Capital Budgeting Techniques © 2005 Thomson/South-Western.

Capital Budgeting Net Present Value Rule Payback Period Rule

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Net Present Value and Other Investment Criteria Chapter 8.

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 6-0 CHAPTER 6 Some Alternative Investment Rules.

CHAPTER 10 The Basics of Capital Budgeting 1. Payback Period 2. Discounted Payback 3. Net Present Value (NPV) 4. Internal Rate of Return (IRR) 5. Modified.

Net Present Value and Other Investment Criteria

0 Net Present Value and Other Investment Criteria.

P.V. VISWANATH FOR A FIRST COURSE IN FINANCE 1. 2 Decision Criteria NPV The Payback Rule Accounting Rate of Return IRR Mutually Exclusive Projects The.

Chapter 9 INVESTMENT CRITERIA Pr. Zoubida SAMLAL GF 200.

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. NPV, Internal Rate of Return (IRR), and the Profitability Index.

© 2003 The McGraw-Hill Companies, Inc. All rights reserved. Net Present Value and Other Investment Criteria Chapter Nine.

GBUS502 Vicentiu Covrig 1 The basics of capital budgeting (chapter 11) Should we build this plant?

8-1 Chapter 8: Capital Budgeting Techniques. 8-2 n The process of planning and evaluating expenditures on assets whose cash flows are expected to extend.

Should we build this plant? The Basics of Capital Budgeting.

Chapter 6 Capital Budgeting Techniques © 2005 Thomson/South-Western.

Key Concepts and Skills

© 2003 The McGraw-Hill Companies, Inc. All rights reserved. Net Present Value and Other Investment Criteria Chapter 9.

10-1 CHAPTER 10 The Basics of Capital Budgeting Should we build this plant?

Capital Budgeting Evaluation Technique Pertemuan 7-10 Matakuliah: A0774/Information Technology Capital Budgeting Tahun: 2009.

Chapter McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9 Net Present Value and Other Investment Criteria.

NPV and Other Investment Criteria P.V. Viswanath Based partly on slides from Essentials of Corporate Finance Ross, Westerfield and Jordan, 4 th ed.

CAPITAL BUDGETING (A Short Review). CAPITAL BUDGETING Recall that one reason money has a time value is because of the opportunity to invest in productive.

Capital Budgeting Investment Rules

P.V. VISWANATH FOR A FIRST COURSE IN FINANCE 1. 2 Decision Criteria NPV IRR The Payback Rule EVA Mutually Exclusive Projects The case of multiple IRRs.

Copyright © 2012 Pearson Prentice Hall. All rights reserved. Chapter 10 Capital Budgeting Techniques.

1 What is capital budgeting? Analysis of potential additions to fixed assets. Long-term decisions; involve large expenditures. Very important to firm’s.

Net Present Value and Other Investment Criteria

© 2003 The McGraw-Hill Companies, Inc. All rights reserved. Net Present Value and Other Investment Criteria Chapter Nine.

Chapter 10: The Basics Of Capital Budgeting. 2 The Basics Of Capital Budgeting :

Good Decision Criteria

9-0 Net Present Value and Other Investment Criteria Chapter 9 Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

11-1 CHAPTER 11 The Basics of Capital Budgeting Should we build this plant?

8-1 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Chapter 8: Capital Budgeting Techniques Copyright © 2000 by Harcourt, Inc. All rights reserved.

Ch 12: Capital Budgeting Decision Criteria

Some Alternative Investment Rules

The Capital Budgeting Decision Chapter 12. Chapter 12 - Outline What is Capital Budgeting? 3 Methods of Evaluating Investment Proposals Payback IRR NPV.

1 Capital-BudgetingTechniques Chapter 9. 2 Capital Budgeting Concepts  Capital Budgeting involves evaluation of (and decision about) projects. Which.

Net Present Value and Other Investment Rules. Percent of CFOs who say they use the following rules to evaluate projects 2.

©2012 McGraw-Hill Ryerson Limited 1 of 45 Learning Objectives 1.Define capital budgeting decisions as long-run investment decisions. (LO1) 2.Explain that.

13-1 Agenda for 30 July (Chapter 9) Assessment of various commonly used methods for deciding how capital is to be allocated. Net Present Value (NPV) The.

Summary of Previous Lecture We covered following topics in our previous lecture; capital budgeting” and the steps involved in the capital budgeting process.

Capital Budgeting: Decision Criteria

Basics of Capital Budgeting. An Overview of Capital Budgeting.

Net Present Value and Other Investment Rules

0 Corporate Finance Ross  Westerfield  Jaffe Seventh Edition 6 Chapter Six Some Alternative Investment Rules.

Net Present Value and Other Investment Rules Chapter 5.

U8-1 UNIT 8 Project Valuation Should we build this plant?

ALL RIGHTS RESERVED No part of this document may be reproduced without written approval from Limkokwing University of Creative Technology 1-1 Chapter 8.

6-0 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Corporate Finance Ross  Westerfield  Jaffe Sixth Edition 6 Chapter Six Some Alternative Investment.

Other Criteria for Capital Budgeting Text: Chapter 6.

1 Capital Budgeting Techniques © 2007 Thomson/South-Western.

Key Concepts and Skills

Chapter Outline 6.1 Why Use Net Present Value?

Net Present Value and Other Investment Rules

Net Present Value (NPV) and Other Investment Rules

Presentation transcript:

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

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

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.

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??

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

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)

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

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

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’???

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%?

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

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