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Net Present Value (NPV)
The difference between the market value of a project and its cost
if NPV > 0, Accept project
If NPV < 0, reject project
If NPV = 0, indifferent
Steps for finding NPV
Step 1: estimate the expected future cash flows
Step 2: estimate the required return for projects of this level
Step 3: find the present value of the cash flows and subtract the initial investment
This is the value added
NPV = -(initial cost) + cash flow/(1 + wacc) + cash flow/(1+ wacc) âŠ
Payback period
How long it takes to get the initial cost back in a nominal sense
usually used by smaller firms
Accept if the payback period is less than some present limit
How to find Payback period
Step 1: estimate cash flows
Step 2: subtract the future cash flows from the initial cost until the initial investment has been recovered
Advantages of payback period
easy to understand
adjusts for uncertainty of later cash flows
biased toward liquidity
Disadvantages of Payback Period
ignores the time value of money
requires an arbitrary cut off point
ignores cash flows beyond the cut off date
Biased against long-term projects, such as research and development, and new projects
Discounted payback Period
compute the present value of each cash flow and then determine how long it takes to pay back on a discounted basis
compare to a specific required period
Accept the project if it pays back on a discounted basis within the specified time
Advantages of Discounted Payback Period
includes time value of money
easy to understand
does not accept negative estimated NPV investments when all future cash flows are positive
Biased towards liquidity
Disadvantages for Discounted PayBack Period
may reject positive NPV investments
Requires an arbitrary cutoff point
Ignores cash flows beyond the cutoff point
biased against long-term projects, such as R&D and new products
Internal Rate of Return
most important alternative to NPV
a single rate of return that summarizes the merits of a project
IRR is the return that makes NPV=0
Accept the project if IRR > the required rate of return
NPV vs IRR
Whenever there is a conflict between NPV and another decision rule, always use NPV
Profitability Index
present value of an investmentâs future cash flows divided by its initial cost
Measures the benefit per unit cost, based on the time value of money
This measure can be very useful in situations in which we have limited capital
= PV of cashflows / cost
Advantages of Profitability Index
closely related to NPV, generally leading to identical decisions
easy to understand and communicate
may be useful when available investment funds are limited
Disadvantages of Profitability Index
may lead to incorrect decisions in comparisons of mutually exclusive investments
Evidence from the Field
large firms are more likely to use NPV than small firms
Small firms with CEOs (with longer tenure) without MBAs are more likely to use Payback criteria