Finance - Chapter 9

Investment Criteria

Discounted Cash Flow Criteria

• NPV

• IRR
  MIRR (modified Internal Rate of Return)

Payback Criteria

• Payback Period

• Discounted Payback Period

Net Present Value (NPV)

difference between an investment’s market value and its cost

***only accept if npv is positive

• don’t use time 0, use time 1 then add time 0

Payback Period

amount of time it takes to recover from our initial investment

**accept if calculated payback period is less than prespecified number of years

• may include fractional year

Payback Period Advantages/Disadvantaged

Advantages

• easy to understand

• adjusts for uncertainty of later cash flows

• biased towards liquidity

Disadvantages

• ignores the time value of money

• required an arbitrary cutoff point

• ignores cash flows beyond the cutoff date

• biased against long-term investments

Discounted Payback Period

length of time required for an investment’s discounted cash flows to equal its initial cost

**accept if discounted payback is less than some prespecified number of years

Discounted Payback Period Advantages/Disadvantges

Advantages

• includes time value of money

• easy to understand

• biased towards liquidity

Disadvantages

• may reject positive NPV investments

• required an arbitrary cutoff point

• ignores cash flows beyond the cutoff date

• biased against long-term investments

Internal Rate of Return (IRR)

discount rate that makes NPV of an investment zero

**accept if IRR exceeds required rate

IRR Advantages/Disadvantages

Advantages

• closely related to NPV, often leading to identical decisions

• easy to understand and communicate

Disadvantages

• may result in multiple answers or not deal with conventional cash flows

• may lead to incorrect decisions in comparisons of mutally exclusive investments

IRR and NPV always lead to identical decisions, as long as 2 conditions are met…

Project cash flows must be conventional

• first cash flow is negative, rest are positive

project must be independent

• decisions to accept or reject this project does not affect the decision to accept or reject any other

Multiple Rates of Return

possibility that one discount rate will make NPV of investment zero

• NPV rule will still work

Mutually Exclusive Investment Decision

situation in which taking one investment prevents the taking of another

• NPV is preferred option

Crossover Rate

discount rate that makes NPVs of 2 projects equal

• take the difference in cash flows and calculate IRR using the difference

Modified Internal Rate of Return (MIRR)

• modify the cash flows first and then calculate the IRR using the modified cash flows

• depends on an external discount rate, so does not produce a true “internal” rate of return

MIRR Method: The Combination Approach

1. calculate present value of all negative cash flows using finance rate

2. calculate future value of all positive cash using reinvestment rate

3. calculate rate at which the answer from step 1 grows into the answer from step 2. this rate is the MIRR

Practice of Capital Budgeting

• NPV is only an estimate (estimated future cash flows)

• most firms use multiple criteria for evaluating a project

• IRR and NPV methods are used more frequently in large firms than in small firms

• Payback method is used roughly the same amongst larger firms and small firms