FINC Ch 9

is a measure of how much value is created or added today by undertaking an investment (the difference between the investment’s market value and its cost).

NPV

WHAT:

PV of Future CF’s - Initial Cost

NPV=

Estimate future cash flows. Calculate the present value of those cash flows minus the initial cost.

• Shift NPV or CF Button

NPV

HOW:

CF0=Initial cost

CF0=Initial cost

Cost of Capital means “I”

Cost of Capital means “I”

The investment should be accepted if the net present value is positive and rejected if it is negative

• assumes cash flows are reinvested at the cost of capital

NPV

The Rule:

1. Uses all cash flows; NPV IS KING!!!

2. Adjusts for the time value of money

NPV

Pros:

1. Need appropriate discount rate (I)

2. Relatively more difficult to communicate

NPV

Cons:

Yes, if NPV > 0

NPV

YES:

NPV = 0 means Indifferent

NPV

if NPV=0

graphical representation of NPV at various I’s

NPV Profile

What is it:

The internal rate of return is the discount rate that makes the net present value of a project equal to zero.

• I => NPV=0

•  what I do i need to input so NPV can be zero? = The IRR/Breakeven rate of return

• IRR is also called “Breakeven rate of return”

IRR

WHAT:

Set NPV equal to zero and solve for “r”. Calculating IRR is identical to calculating the yield to maturity on bonds.

• CF buttons → Shift IRR

IRR

HOW:

Yes if IRR > I (uppercase i)

IRR

YES:

An investment is acceptable if the IRR exceeds the required rate of return. It should be rejected otherwise.

• Assumes cash flows are reinvested at the IRR.

IRR

The Rule:

1. Closely related to the NPV rule

2. Relatively easier to communicate

IRR

Pros:

1. May result in multiple answers (nonconventional cash flows); means more than 1 IRR. we can compare to I if multiple IRR. cash flow signs change more than once.

2. May result in incorrect decisions (mutually exclusive investments); means out of all methods if multiple methods can be used, we are not going to use IRR) 

IRR

Cons:

Crossover Rate

NPV is same between 2 projects

The profitability index is the present value of an investment’s future cash flows divided by its initial cost (absolute value). Also called a benefit-cost
ratio.

• PI=PV of Future CF’s / Initial Cost

PI

WHAT:

Calculate the present value of the future cash flows (the PV not the NPV) and divide by the initial cost. If a project has a positive (negative) NPV, the PI will be greater (less) than 1.

PI

HOW:

Yes if PI > 1 (number)

PI (BANK 4 BUCK)

YES:

every dollar you invest, you get $PI back.

PI

Bank for Buck

Only accept projects with a PI greater than 1, and invest in projects with the largest PI’s first.

PI

The Rule:

1. Closely related to the NPV rule

2. May be useful when investment funds are limited (we would want the biggest bang for buck)

PI

Pros:

1. May result in incorrect decisions (mutually exclusive investments); something different than NPV says

PI

Cons:

The payback is the length of time it takes to recover our initial investment.

• how long does it take CF0?

Payback Rule

WHAT:

Assume cash flows are received uniformly throughout the year. Calculate the number of years it will take for the future cash flows to match the initial cash outflow.

Payback Rule

HOW:

An investment is acceptable if its calculated payback period is less than some pre-specified number of years.

The Payback Rule

The Rule:

1. Simple/Easy to do

2. Biased toward liquidity

The Payback Rule

Pros:

1. Ignores the time value of money (we are doing horrible finance, comparing number between different years)

2. Ignores cash flows beyond the cutoff; requires an arbitrary cutoff (why 4 year? Why not 4.2? Why not 5 yrs?), biased against long term liab

The Payback Rule

Cons:

The discounted payback period is the length of time it takes for the sum of the discounted cash flows to equal the initial investments

• Adjusts for Time Value of Money

• Correct to bad finance

• Definition is still same as payback, but will not compare year 4 to year 0. But will be what is it worth in year 4 to year 0.

The Discounted Payback Rule

WHAT:

Assume cash flows are received uniformly throughout the year. Calculate the number of years it will take for the present value of the future cash flows to match the initial cash outflow.

The Discounted Payback Rule

HOW:

1. Adjusts for the time value of money (adjusts bad finance)
   *Does not accept negative NPV projects

2. Biased toward liquidity

The Discounted Payback Rule

Pros:

1. Ignores cash flows beyond the cutoff

2. Requires an arbitrary cutoff

3. Biased against long-term projects

The Discounted Payback Rule

Cons:

The average accounting return is the ratio of the average net income
of the project to the average book value of the investment.

• = avg NI / avg BV

The Average Accounting Return (AAR)

WHAT:

Calculate the average net income and divide it by the average book value.

The Average Accounting Return (AAR)

HOW:

An investment is acceptable if its average accounting return is greater than some pre-specified benchmark.

The Average Accounting Return (AAR)

The Rule:

1. Simple/Easy to do

The Average Accounting Return (AAR)

Pros:

1. Ignores the time value of money

2. Requires an arbitrary benchmark

3. Accounting numbers and book values

4. Just Very Wrong to do

The Average Accounting Return (AAR)

Cons: