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UT FIN 357 - Chapter 7. Investment Decision Rules v2

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Slide 1NPV RuleAre Alternatives to NPV good?Payback Period MethodPayback Period MethodPayback Period RulePayback Period ExamplePayback Period ExampleProblems with Payback MethodDiscounted Payback Period MethodDiscounted Payback Period MethodDiscounted Payback Period ExampleDiscounted Payback Period ExampleDiscounted Payback Period ExampleProblems with Discounted Payback MethodAverage Accounting Return MethodAAR ExampleAAR CalculationProblems with AAR MethodInternal Rate of Return (IRR)IRR Decision RulesCalculating IRR with a CalculatorAnother IRR ExampleAnother IRR ExampleProblems with IRRModified IRR (MIRR)Independent vs. Mutually Exclusive ProjectsIRR and ScaleIncremental IRR ExampleIncremental IRR Smaller ExampleMutually Exclusive Project DecisionsReason to Use IRRProfitability IndexUsing the Profitability IndexIncremental Profitability IndexPrevalence of Valuation Methods© J. David Miller 2017Investment Decision RulesChapter 7Finance 357NPV 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 project2Are Alternatives to NPV good?Benefits of NPV1. NPV uses cash flow2. NPV uses all cash flows of a project3. NPV discounts cash flows properly (TVM)Alternative methods•Payback Period•Discounted Payback Period•Average Accounting Return•Internal Rate of Return•Profitability Index3Payback Period MethodThe 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.Year Cash Flow0 - $10,0001 $ 5,0002 $ 5,0003 $ 5,0004Payback Period MethodIn this project, it takes 2 years to repay the original $10,000 spent on the project. Year Cash Flow Paid Back0 - $10,0001 $ 5,000 5,0002 $ 5,000 10,0003 $ 5,0005Payback Period RuleThe 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.6Payback Period ExampleAlpha 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 Flow0 - $125,0001 $ 5,0002 $ 90,0003 $ 20,0004 $100,0005 $100,0007Payback Period ExampleAlpha 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?After 3 years, only $115,000 is repaid. The project should not be accepted.Year Cash Flow Paid Back0 - $125,0001 $ 5,000 5,0002 $ 90,000 95,0003 $ 20,000 115,00004 $100,0005 $100,0008Problems with Payback MethodProblems with Payback Method1. Timing of cash flows within payback period are not considered2. Payments after the payback period are ignored3. Arbitrary standard for payback periodWhat are some instances where the payback method makes sense?9Discounted Payback Period MethodTo correct one flaw of the Payback Period Method, the Discounted Payback Period Method discounts cash flows before calculating the payback period.Payback is 2.16 years.Year Cash Flow Discounted Value @ 5%0 - $10,000 -10,0001 $ 5,000 4,761.902 $ 5,000 4,535.153 $ 5,000 4,319.1910Discounted Payback Period MethodAt 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 = 0.16275The Project’s Payback is 2.16275 years.Year Cash Flow Discounted Value @ 5%Paid Back0 - $10,000 -10,0001 $ 5,000 4,761.90 4,761.902 $ 5,000 4,535.15 9,297.053 $ 5,000 4,319.1911Discounted Payback Period ExampleBeta 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 Flow0 - $125,0001 $ 15,0002 $ 110,0003 $ 10,00012Discounted Payback Period ExampleBeta 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 Flow0 - $125,0001 $ 15,0002 $ 110,0003 $ 10,00013Discounted Payback Period ExampleBeta 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?At the end of two years, only $108,196.20 is repaid, so we reject the project.Year Cash Flow Discounted @ 8%Paid Back0 - $125,0001 $ 15,000 13,888.89 13,888.892 $ 110,000 94,307.27 108,196.203 $ 10,000 7,938.3214Problems with Discounted Payback MethodProblems with Payback Method1. Payments after the payback period are ignored2. Arbitrary standard for payback periodIs this any better than the regular payback method?15Average Accounting Return MethodThe 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 steps1. Determine average net income2. Determine average investment3. Determine AAR16AAR ExampleKappa 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?17AAR Calculation1. Average Net Income = (75,000 + 82,500 + 56,250) / 3 = 71,2502. Average Investment = (300,000 + 200,000 + 100,000 + 0) / 4 = 150,0003. Average Accounting Return = 71,250 / 150,000 = 47.5%Year 1 Year 2 Year 3Revenue 400,000 425,000 450,000Expenses 200,000 215,000 275,000Before Tax cash flow200,000 210,000 175,000Depreciation 100,000 100,000 100,000EBIT 100,000 110,000 75,000Taxes (25%) 25,000 27,500


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