Alternative Investment Rules in Capital Budgeting

Alternative Investment Rules in Capital Budgeting

Alternative Investment Rules in Capital Budgeting NPV vs. Payback Period (PP), Accounting ROR, and Internal Rate of Return (IRR) How Important is CB to a firm? Why is Capital Budgeting (CB) so critical to a firms 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. 6 2 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. 6 3 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. 6 4 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. 6 5 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. 6 6 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. 6 7 Potential Problems with IRR (Independent OR M.E.) CF0 =$100, CF1 =-$130; r = 10% NPV = -$18.20, IRR = 30%; Accept???? NO; This is a Financing project for Financing, accept if IRR < r CF0 = -$60, CF1 =$155 CF2 = -$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. 6 8 Potential Problems with IRR (M.E. projects only) Scale Problem: Comparing small and large projects: A: CF0 = -$100, CF1 = $150; r = 0% NPV = $50, IRR = 50% B: CF0 = -$1,000, CF1 = $1,250; NPV = $250, IRR = 25%

A or B??? Chhachhi/519/Ch. 6 9 IRR problems (continued) Timing Problem: CFs occur at differing times: CF0= -$1,000, CF1= $500 CF2= $400, CF3= $300 CF4= $100 IRRS = 14.5% CF0= -$1,000, CF1= $100 CF2= $300, CF3= $400 CF4= $600 IRRL = 11.8%

If r= 10%, S or L??? Chhachhi/519/Ch. 6 if r = 5%? 10 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. 6 11 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 Chhachhi/519/Ch. 6 12

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