Finance Chapter 9 Homework Net Present Value And Other Investment Criteria

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

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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

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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

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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

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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

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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

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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

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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

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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

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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.

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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?

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“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