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Investment Criteria: NPV, Payback Rule, IRR, Profitability Index

Explore different investment criteria including Net Present Value, Payback Rule, Average Accounting Return, Internal Rate of Return, and Profitability Index. Understand the advantages and disadvantages of each rule and evaluate their effectiveness in capital budgeting decisions.

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Investment Criteria: NPV, Payback Rule, IRR, Profitability Index

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  1. Ch. 8: Net Present Value and Other Investment Criteria • Net Present Value • The Payback Rule • The Average Accounting Return • The Internal Rate of Return • The Profitability Index

  2. Decision Rules for Capital Budgeting • Capital Budgeting • NPV is the correct rule • Other rules are commonly used, are simpler, but can give wrong answers • Each rule has advantages & disadvantages • Evaluation of decision rules: • Does the rule adjust for time value of money? • Does the rule adjust for risk? • Is the rule based on creating value for the firm?

  3. 1. Net Present Value • Each cash flow is net (inflow - outflow) • Ch. 9 & 12: WACC • “The difference between an investment’s market value and its cost” (p. 209) • The Net Present Value Rule • HP 10B calculation • Excel’s NPV glitch (p. 211)

  4. Example a) Suppose WACC = 15%, initial CF = -$70,000, and cash flows after 1-5 years are $10,000, $30,000, $30,000, $30,000 and $10,000. b) Re-calculate for WACC = 18%. HP-10B: clear all; set P/YR=1, I/YR=15; enter -$70,000 and press CFj; enter remain- ing data, pressing CFj for each, and press NPV to get net present value of this project = If I/YR=18, NPV = Excel, etc.: be sure CF0 is not discounted.

  5. Comparing NPVs

  6. 2. The Payback Rule • Payback is the length of time to recover the original investment • The Payback Rule • Advantages: • Disadvantages:

  7. 3. The Average Accounting Return • AAR = Ave. Net Income/Ave. Book Value • The Average Accounting Return Rule • Advantages: • Disadvantages:

  8. 4. Internal Rate of Return • IRR is the discount rate that forces the NPV of a project to equal zero • The IRR Rule: • NPV Profile • HP-10B calculation • Advantages: • Disadvantages:

  9. 5. The Profitability Index • PI = PV of future cash flows/initial cost • The Profitability Index Rule • Advantages: • Disadvantages:

  10. Recommended Practice • Self-Test Problems 8.1 - 8.3 on pp. 229-30 • Questions 2, 9, 11 on pp. 230-2 • Problems on pp. 232-4: 3, 5, 9, 11, 13, 15, (answers are on p. 548)

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