Capital Budgeting Techniques Chapter 8

Net Present Value and Other Investment Criteria • • • • • Net Present Value The Payback Rule The Average Accounting Return The Internal Rate of Return The Profitability Index

Net Present Value

• The difference between the market value of a project and its cost • How much value is created from undertaking an investment?

– The first step is to estimate the expected future cash flows. – The second step is to estimate the required return for projects of this risk level. – The third step is to find the present value of the cash flows and subtract the initial investment.

NPV Decision Rule

• If the NPV is positive, accept the project • A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners. • Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal.

Payback Period

• How long does it take to get the initial cost back in a nominal sense? • Computation

– Estimate the cash flows – Subtract the future cash flows from the initial cost until the initial investment has been recovered

Decision Criteria Test - Payback

• Does the payback rule account for the time value of money? • Does the payback rule account for the risk of the cash flows? • Does the payback rule provide an indication about the increase in value? • Should we consider the payback rule for our primary decision criteria?

• Decision Rule – Accept if the payback period is less than some preset limit

Advantages and Disadvantages of Payback

• Advantages

– Easy to understand – Adjusts for uncertainty of later cash flows – Biased towards liquidity

Average Accounting Return

• There are many different definitions for average accounting return • The one used in the book is:

– Average net income / average book value – Note that the average book value depends on how the asset is depreciated.

• Disadvantages

– Ignores the time...