Investment CriteriaFINC 3610 ‐ YostInvestment Criteria204Net Present Value (NPV)• What: NPV is a measure of how much value is created or added today by undertaking an investment (the difference between the investment’s market value205between the investment s market value and its cost).• How: Estimate future cash flows. Calculate the present value of those cash flows minus the initial cost.NPV Example• You plan to buy a machine that will cost $2,000 today and produce cash flows of $1,500 in each of the next two years. The salvage value will be zero The cost of capital206salvage value will be zero. The cost of capital is 15 percent. Should you buy the machine?Investment CriteriaFINC 3610 ‐ YostNet Present Value (NPV)• The Rule: An investment should be accepted if the net present value is positive and rejected if it is negative.*Assumes cash flows are reinvested at _____________________.207• Pros:1.2.• Cons:1.2.Internal Rate of Return (IRR)• What: The internal rate of return is the discount rate that makes the net present value of a project equal to zero.208• How: Set NPV equal to zero and solve for “r”. Calculating IRR is identical to calculating the yield to maturity on bonds. IRR Example• You plan to buy a machine that will cost $2,000 today and produce cash flows of $1,500 in each of the next two years. The salvage value will be zero The cost of capital209salvage value will be zero. The cost of capital is 15 percent. Should you buy the machine?Investment CriteriaFINC 3610 ‐ YostInternal Rate of Return (IRR)• The Rule: An investment is acceptable if the IRR exceeds the required rate of return. It should be rejected otherwise. *Assumes cash flows are reinvested at ______________________.•Pros210•Pros:1.2.• Cons:1.2.Net Present Value Profile• What is it?211• What information does it provide?1.2.3.4.Internal Rate of Return (IRR)• BEWARE – Nonconventional Cash flows• Example: Assume you are considering a project with the following cash flows:212gYear Cash Flows0 ‐$ 2521 $1,4312 ‐$3,0353 $2,8504 ‐$1,000Investment CriteriaFINC 3610 ‐ YostInternal Rate of Return (IRR)Calculate the NPV:• at 25.00%: NPV = _______________• at 33.33%: NPV = _______________213_______________• at 42.86%: NPV = _______________• at 66.67%: NPV = _______________What’s the IRR? Internal Rate of Return (IRR)• BEWARE – Mutually Exclusive Projects• Example: Assume you are considering two mutually exclusive investments with the following cash flows:214cash flows:Year Project A Project B0 ‐$350 ‐$2501$ 50 $1252 $100 $1003 $150 $ 754 $200 $ 50Internal Rate of Return (IRR)• Which project should we choose based on the IRR?215• Should we always choose that project?• What is the crossover rate?Investment CriteriaFINC 3610 ‐ YostModified Internal Rate of Return (MIRR)• What: MIRR is a calculation of IRR on modified cash flows. For the combination approach, it is the discount rate that equates the present value of all cash outflows to the216the present value of all cash outflows to the future value of all cash inflows.• How: For the combination approach, discount all cash outflows to time 0 and compound all cash inflows to the end of the project. Then, calculate the discount rate the makes them equal.MIRR Example• You plan to buy a machine that will cost $2,000 today and produce cash flows of $1,500, ‐$500, and $1,200 in each of the next three yearsThe salvage value will be zero217three years. The salvage value will be zero. The cost of capital is 15 percent. Should you buy the machine?Modified Internal Rate of Return (MIRR)• The Rule: An investment is acceptable if the MIRR exceeds the required rate of return. It should be rejected otherwise. *Assumes cash flows are reinvested at ____________________.218f• Pros:1.2.• Cons:1.Investment CriteriaFINC 3610 ‐ YostThe Profitability Index (PI)• What: The profitability index is the present value of an investment’s future cash flows divided by its initial cost (absolute value). 219Also called a benefit‐cost ratio.• How: Calculate the present value of the future cash flows (the PV not the NPV) and divide by the initial cost. If a project has a positive (negative) NPV, the PI will be greater (less) than 1. PI Example #1• You plan to buy a machine that will cost $2,000 today and produce cash flows of $1,500 in each of the next two years. The l l ill b Th t f220salvage value will be zero. The cost of capital is 15 percent. What is its profitability index? Should you buy the machine?PI Example #2• You must choose between the two following mutually exclusive projects: A: Cost is $ 25 and PV is $ 50.i $00 d i $0221B: Cost is $100 and PV is $150. • Which one should you choose?Investment CriteriaFINC 3610 ‐ YostThe Profitability Index (PI)• The Rule: Only accept projects with a PI greater than 1, and invest in projects with the largest PI’s first.222• Pros:1.2.• Cons:1.The Payback Rule• What: The payback is the length of time it takes to recover our initial investment. 223• How: Assume cash flows are received uniformly throughout the year. Calculate the number of years it will take for the future cash flows to match the initial cash outflow.Payback Example• You plan to buy a machine that will cost $2,000 today and produce the following cash flows: $500 in year 1, $750 in year 2, $300 in year 3 $1 000 in year 4 and $5 000 in year 5224year 3, $1,000 in year 4, and $5,000 in year 5. Our firm only accepts projects with a payback of 4 years or less. Should you purchase the machine? Investment CriteriaFINC 3610 ‐ YostThe Payback Rule• The Rule: An investment is acceptable if its calculated payback period is less than some pre‐specified number of years. • Pros:2251.2.• Cons:1.2.3.4.The Discounted Payback Rule• What: The discounted payback period is the length of time it takes for the sum of the discounted cash flows to equal the initial investment226investment. • How: Assume cash flows are received uniformly throughout the year. Calculate the number of years it will take for the present value of the future cash flows to match the initial cash outflow. Discounted Payback Example• You plan to buy a machine that will cost $2,000 today and produce the following cash flows: $500 in year 1, $750 in year 2, $300 in year 3 $1 000 in year 4 and $5 000 in year 5227year 3, $1,000 in year 4, and $5,000 in year