MGT 181 chapter 9

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) …

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 investment’s 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