# UT FIN 357 - Chapter 7. Investment Decision Rules v2 (36 pages)

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## Chapter 7. Investment Decision Rules v2

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- Pages:
- 36
- School:
- University of Texas at Austin
- Course:
- Fin 357 - Business Finance

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Investment Decision Rules J David Miller 2017 Chapter 7 Finance 357 NPV Rule NPV discounts cash flows to period 0 and then compares them Accept a project if the NPV is 0 Reject a project if the NPV is 0 Accepting positive NPV projects benefits stockholders by creating wealth The value of the firm rises by the NPV of the project 2 Are Alternatives to NPV good Benefits of NPV 1 NPV uses cash flow 2 NPV uses all cash flows of a project 3 NPV discounts cash flows properly TVM Alternative methods Payback Period Discounted Payback Period Average Accounting Return Internal Rate of Return Profitability Index 3 Payback Period Method The Payback Period Method of capital budgeting is interested in how long it takes for a project to bring in enough cash flows to break even or pay itself off A rule is set to determine the maximum time allowed for projects to pay themselves back 4 Year Cash Flow 0 10 000 1 5 000 2 5 000 3 5 000 Payback Period Method Year Cash Flow Paid Back 0 10 000 1 5 000 5 000 2 5 000 10 000 3 5 000 In this project it takes 2 years to repay the original 10 000 spent on the project 5 Payback Period Rule The payback period rule states that all projects must be paid back before a particular cutoff date This date is arbitrary and up to management to select 6 Payback Period Example Alpha Inc is considering a project with the following cash flows Alpha Management has decided that all projects must pay themselves back within 3 years Using the Payback Period Method should Alpha accept this project 7 Year Cash Flow 0 125 000 1 5 000 2 90 000 3 20 000 4 100 000 5 100 000 Payback Period Example Alpha Inc is considering a project with the following cash flows Alpha Management has decided that all projects must pay themselves back within 3 years Using the Payback Period Method should Alpha accept this project Year Cash Flow Paid Back 0 125 000 1 5 000 5 000 2 90 000 95 000 3 20 000 115 0000 4 100 000 5 100 000 After 3 years only 115 000 is repaid The project should not be accepted 8 Problems with Payback Method Problems with Payback Method 1 Timing of cash flows within payback period are not considered 2 Payments after the payback period are ignored 3 Arbitrary standard for payback period What are some instances where the payback method makes sense 9 Discounted Payback Period Method To correct one flaw of the Payback Period Method the Discounted Payback Period Method discounts cash flows before calculating the payback period Year Cash Flow Discounted Value 5 0 10 000 10 000 1 5 000 4 761 90 2 5 000 4 535 15 3 5 000 4 319 19 Payback is 2 16 years 10 Discounted Payback Period Method Year Cash Flow Discounted Value 5 Paid Back 0 10 000 10 000 1 5 000 4 761 90 4 761 90 2 5 000 4 535 15 9 297 05 3 5 000 4 319 19 At the end of 2 years 702 95 still needs to be repaid We must divide the remaining portion to be repaid by the discounted cash flow of year 3 to determine the percentage of the 3rd year that it will take to repay all the money 702 95 4319 19 0 16275 The Project s Payback is 2 16275 years 11 Discounted Payback Period Example Beta Inc is considering a project with the following cash flows Beta Management has decided that all projects must pay themselves back within 2 years Using the Discounted Payback Period Method and a 8 discount rate should Alpha accept this project 12 Year Cash Flow 0 125 000 1 15 000 2 110 000 3 10 000 Discounted Payback Period Example Beta Inc is considering a project with the following cash flows Beta Management has decided that all projects must pay themselves back within 2 years Using the Discounted Payback Period Method and a 8 discount rate should Alpha accept this project 13 Year Cash Flow 0 125 000 1 15 000 2 110 000 3 10 000 Discounted Payback Period Example Beta Inc is considering a project with the following cash flows Beta Management has decided that all projects must pay themselves back within 2 years Using the Discounted Payback Period Method and a 8 discount rate should Alpha accept this project Year Cash Flow Discounted 8 Paid Back 0 125 000 1 15 000 13 888 89 13 888 89 2 110 000 94 307 27 108 196 20 3 10 000 7 938 32 At the end of two years only 108 196 20 is repaid so we reject the project 14 Problems with Discounted Payback Method Problems with Payback Method 1 Payments after the payback period are ignored 2 Arbitrary standard for payback period Is this any better than the regular payback method 15 Average Accounting Return Method The Average Accounting Return method uses the net income generated by projects to analyze whether they will add value to a company The calculation of average accounting return can be broken down into 3 steps 1 Determine average net income 2 Determine average investment 3 Determine AAR 16 AAR Example Kappa Inc is considering building a new store to sell their products The store will cost 300 000 will have a useful life of 3 years and will then need to be scrapped at that time Kappa requires an average accounting return of 25 to undertake a project See the table below for the project details Should Kappa undertake this project 17 AAR Calculation Year 1 Year 2 Year 3 Revenue 400 000 425 000 450 000 Expenses 200 000 215 000 275 000 Before Tax cash flow 200 000 210 000 175 000 Depreciation 100 000 100 000 100 000 EBIT 100 000 110 000 75 000 Taxes 25 25 000 27 500 18 750 Net Income 75 000 82 500 56 250 1 Average Net Income 75 000 82 500 56 250 3 71 250 2 Average Investment 300 000 200 000 100 000 0 4 150 000 3 Average Accounting Return 71 250 150 000 47 5 18 Problems with AAR Method Problems with Average Accounting Return Method 1 AAR does not use actual financial cash flows 2 AAR does not consider the timing of cash flows and ignores the time value of money 3 AAR uses an arbitrary return target Is AAR used in the business world 19 Internal Rate of Return IRR The internal rate of return on a project is the interest rate that would make a project have a 0 NPV Year Cash Flow 0 100 1 110 Discount to Time 0 What is the value of R that makes the NPV 0 Try 8 Try 10 20 IRR 10 IRR Decision Rules Accept the project if IRR is greater than the discount rate Reject the project if IRR is less than the discount rate 21 Calculating IRR with a Calculator …

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