Unlock document.
This document is partially blurred.
Unlock all pages and 1 million more documents.
Get Access
Chapter 09 - Net Present Value and Other Investment Criteria
Chapter 9
NET PRESENT VALUE AND OTHER INVESTMENT
CRITERIA
CHAPTER ORGANIZATION
9.1 Net Present Value
9.2 The Payback Rule
Defining the Rule
9.3 The Discounted Payback
9.4 The Average Accounting Return
ANNOTATED CHAPTER OUTLINE
Lecture Tip: A logical prerequisite to the analysis of investment
Chapter 09 - Net Present Value and Other Investment Criteria
9-2
9.1. Net Present Value
A. The Basic Idea
Net present value – the difference between the market value of an
investment and its cost. Estimating cost is usually straightforward;
however, finding the market value of assets can be tricky. The
principle is to find the market price of comparables.
Lecture Tip: You may wish to take the opportunity to use this
B. Estimating Net Present Value
Lecture Tip: Although this point may seem obvious, it is often
helpful to stress the word “net” in net present value. It is not
uncommon for some students to carelessly calculate the PV of a
Chapter 09 - Net Present Value and Other Investment Criteria
9-3
Lecture Tip: Here’s another perspective on the meaning of NPV. If
Lecture Tip: In practice, financial managers are rarely presented
with zero NPV projects for at least two reasons. First, in an
However, several real-world considerations make such
comparisons difficult. For example, adjusting for risk in capital
Chapter 09 - Net Present Value and Other Investment Criteria
9-4
Ethics Note: Because a project is financially sound, it must be
ethically sound, right? Well … the question of ethical
9.2. The Payback Rule
A. Defining the Rule
Chapter 09 - Net Present Value and Other Investment Criteria
9-5
B. Analyzing the Rule
Real-World Tip: Teaching the payback rule seems to put one in a
delicate situation – as the text indicates, the rule is flawed as an
indicator of project desirability. Yet, past surveys suggest that
practitioners often use it as a secondary decision measure. How
can we explain this apparent discrepancy between theory and
practice?
C. Redeeming Qualities of the Rule
Real-World Tip: Interestingly, the payback period technique is
used quite heavily in determining the viability of certain investment
projects in the health care industry. Why? Consider the nature of
Chapter 09 - Net Present Value and Other Investment Criteria
9-6
D. Summary of the Rule
Advantages:
Disadvantages:
Lecture Tip: The payback period can be interpreted as a naïve
form of discounting if we consider the class of investments with
9.3. The Discounted Payback
Discounted payback rule – An investment is acceptable if its
Chapter 09 - Net Present Value and Other Investment Criteria
9-7
Lecture Tip: The discounted payback period is the length of time
until accumulated discounted cash flows equal or exceed the initial
investment. Use of this technique entails all the work of NPV, but
9.4. The Average Accounting Return
The average accounting return = measure of accounting profit /
measure of average accounting value. In other words, it is a
Chapter 09 - Net Present Value and Other Investment Criteria
9-8
Real-World Tip: Surveys indicate that few large firms employ the
payback period and/or the AAR methods exclusively; rather, these
Lecture Tip: An alternative view of the AAR is that it is the micro-
level analogue to the ROA discussed in a previous chapter. As you
9.5. The Internal Rate of Return
Internal rate of return (IRR) – the rate that makes the present value
of the future cash flows equal to the initial cost or investment. In
other words, the discount rate that gives a project a $0 NPV.
IRR decision rule – the investment is acceptable if its IRR exceeds
the required return.
Ethics Note: Assume that to comply with the Air Quality Control
Chapter 09 - Net Present Value and Other Investment Criteria
9-9
A. Problems with the IRR
Non-conventional cash flows – the sign of the cash flows changes
more than once or the cash inflow comes first and outflows come
later.
Lecture Tip: A good introduction to mutually exclusive projects
and non-conventional cash flows is to provide examples that
Chapter 09 - Net Present Value and Other Investment Criteria
9-10
B. Redeeming Qualities of the IRR
C. The Modified Internal Rate of Return (MIRR)
One method for eliminating multiple IRRs and removing the
Profitability index – present value of future cash flows divided by
the initial investment.
Chapter 09 - Net Present Value and Other Investment Criteria
9-11
9.7. The Practice of Capital Budgeting
It is common among large firms to employ a discounted cash flow
Lecture Tip: While uncertainty about inputs and interpretation of
the outputs helps explain why multiple criteria are used to judge
Ethics Note: The use of various financial incentives to induce
firms to locate in a given municipality raises some interesting
issues in the capital budgeting area. From the viewpoint of the
firm’s analysts, how do you estimate the impact of such incentives?
A reduction in the initial outlay? Increases in future cash inflows?
And what discount rate should be assigned to these tax reductions?
Are these promises riskless?
And what about the municipal officials who offer such incentives?
Chapter 09 - Net Present Value and Other Investment Criteria
9-12
“Alabama offered Mercedes-Benz a package valued
at more than the cost of the plant itself. To lure the
Several incentives described above directly affect the costs and
benefits of the proposed project and would be accounted for in the
Video Note: “Capital Budgeting” looks at how Navistar International does its capital
budgeting analysis.
9.8. Summary and Conclusions
