Ch. 9: Net Present Value and Other Investment Criteria Study

Capital budgeting

trying to determine whether a proposed investment or project will be worth more, once it is in place, than it costs

9.2a Payback period rule

Based on the payback period rule, an investment is acceptable if its calculated payback period is less than some prespecified number of years

9.2b Why do we say that the payback period is, in a sense, an accounting break-even measure?

payback is the time it takes to break even in an accounting sense

because it tells you the time it takes for an investment to recover its initial cost from cash inflows, without accounting for the time value of money or any profits beyond that point.

Discounted Payback period 

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

Discounted payback rule

Based on the discounted payback rule, an investment is acceptable if its discounted payback is less than some prespecified number of years

Discounted Payback period Adv/disadv

• Disadvantages 

  • Still ignores cash flows that occur after the payback period 

• Advantages 

  • Does consider time value of money

  • Allows decisions to be made at all levels of management 

9.3a In words, what is the discounted payback period? why do we say it is, in a sense, a financial or economic break-even measure?

Discounted payback period is the length of time required for an investment's discounted cash flows to equal its initial cost.

what are the three types of projects?

• Replacement 

  • involve updating or replacing existing assets, systems, or processes with more efficient or modern alternatives. These are often undertaken to maintain operational efficiency, reduce costs, or improve reliability.

  • Ex: Replacing old machinery with modern, energy-efficient models.

  • Upgrading software or IT infrastructure to improve performance.

• Expansion 

  • focus on increasing the capacity or capabilities of a company's existing operations. The goal is to grow the business by either producing more of the same product or expanding the business into a new geographical area or market.

  • EX: Adding a new production line to increase manufacturing output.

  • Expanding a retail chain by opening new locations in different regions.

• New Venture

  • entering into a completely new line of business or creating a product/service that the company has never offered before. These projects carry the highest level of risk since they involve exploring untested markets or products.

  • EX: A car manufacturer starting a new electric vehicle line.

  • A hotel starting a restaurants inside

Two primary situations for projects

• Stand-alone

  • Your choice is to do the project or do nothing 

  • EX: A manufacturing company invests $200,000 in installing automated machinery to reduce labor costs and improve production efficiency, with an expected payback period of 3 years.

• Mutually exclusive 

  • Choosing one project excludes the other. Looking at multiple projects

  • EX: A company must choose between upgrading its existing factory for $1 million or building a new one for $3 million, as both options aim to increase production capacity but only one can be pursued.

Three steps in the capital budgeting process 

• 1. Estimate the cash flows that are incremental to the company, only consider cash flows that are incremental from that project, solely from that project (look how to do this in ch 10)

• 2. Evaluate those cash flows with capital budgeting techniques 

• 3. Assess the risk of those cash flows 

Payback period adv/dis

• Disadvantages 

  • Does not consider time value of money (because every cash flow is evenly weighted)

  • Ignores all cash flows that occur after the payback period 

• Advantages

  • It is simple and easy and quick 

  • Allows decisions to be made at all levels of management at a company

NPV adv/dis

• Disadvantages

  • The answer is in present value dollar terms 

• Advantages 

  • Have a reason to use it that's based on financial theory 

  • Does consider time value of money

  • It is easy to calculate

Average accounting return (AAR)

An investment’s average net income divided by its average book value

Internal rate of return (IRR)

The discount rate that makes the NPV of an investment zero

9.5a Under what circumstance will the IRR and NPV rules lead to the same accept-reject decision? when might they conflict?

1. the project's cash flows must be conventional, meaning that the first cash flow (the initial investment) is negative and all the rest are positive-- usually met
2. The project must be independent, meaning that the decision to accept or reject this project does not affect the decision to accept or reject any other

9.5b Is it generally true that an advantage of the IRR rule over the NPV rule is that we don’t need to know the required return to use the IRR rule?

In short, both the IRR and NPV methods require knowledge of the required return, and IRR is not independent of this key input. The NPV rule is generally preferred, as it directly tells you the value added by the project.

Net present value (NPV)

• It is the sum of each cash flow discounted at the cost of capital 

• Only accepted positive NPV projects, should increase the value 

• If you make a mistake and take a negative NPV, you would be lowing value

NPV decision rule

• For stand alone, if NPV is greater than 0 we accept 

• For stand alone, if NPV is less than 0 we reject

• If = 0, we’re indifferent 

• For Mutually exclusive, pick the highest because it is adding value to your company

Profitability index (PI)

The present value of an investment's future cash flows divided by its initial cost, Also called the benefit-cost ratio.

It measures “bang for the buck”

9.6b How would you state the profitability index rule

• A project should be accepted if its Profitability Index (PI) is greater than 1.

• A project should be rejected if its Profitability Index (PI) is less than 1.

9.7a What is the most commonly used capital budgeting procedures?

Profitability index (PI),

Net Present Value (NPV),

Internal rate of Return (IRR),

Payback Period,

Accounting Rate of Return (ARR)

9.7b If NPV is conceptually the best procedure for capital budgeting, why do you think multiple measures are used in practice?

To measure what aspect it lacks in

Multiple capital budgeting measures are used in practice alongside NPV because they offer simplicity, address different risk perspectives, provide comparative insights, and account for practical constraints, making decision-making more comprehensive and flexible.