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Ct
NPV C0
t
t 1 (1 r )
NPV decision rule:
Accept project if NPV is greater than zero
Reject project is NPV is less than zero
Shortcomings:
Does not provide an overall picture of the gain or loss
associated with a project
Projects with negative NPV can be rejected, but a firm may
be worse off if they do not accept the project
Ct
C0
0
t
t 1 (1 IRR )
IRR Decision Rule:
Accept the project if IRR is greater than the discount rate
Reject the project if IRR is less than the discount rate
Example
Project CF
-10,000
3,000
6,000
4,000
2
(1 IRR ) (1 IRR ) (1 IRR )3
Project A
Project B
-10,000
-20,000
20,000
36,000
Cash Flow
-$500,000
$1,605,000
-$1,716,900
$612,040
Fixing Shortcoming #2
Use Modified IRR (MIRR)
Assumes that any cash inflows are reinvested until
the final period (N) of the project
Example: MIRR
Suppose we had the following cash flows:
Year
Project CF
-50,000
110,000
-70,000
Project A
Project B
-100,000
100,000
120,000
-120,000
Example: CF Timing
Consider the following two projects:
Year
Project A
Project B
-10K
-10K
10K
1K
1K
1K
1K
12K
Profitability Index
Definition: Take the PV of all future cash flows and
divide it by the initial outflow
Decision rule:
Accept project if this ratio is greater than 1
Reject if this ratio is less than 1
Analogous to the NPV calculation, but is essentially a
gross return
Example: NPV v. PI
Suppose you have $1,000,000 available in venture
capital and you can choose to take on any
combination of the following projects:
Project
Cost
PI
200K
300K
100K
1.50
500K
620K
120K
1.24
400K
700K
300K
1.75
200K
275K
75K
1.38
100K
130K
30K
1.30
100K
140K
40K
1.40
Example: NPV v. PI
Payback Period
Definition: the number of years it takes to recover
the initial cost of the investment
An investment costs $100,000 and the future cash
flows at t = 1, 2, 3 are $60,000, $50,000, and
$40,000, respectively
Thus the payback period is 2 years
Discounting is ignored
Payback Period Rule: if the payback period is less
than or equal to t years, invest. Otherwise, reject.
Project A
Project B
-$100
-$100
$150
$50
$50
$20
$10
$1000
Summary
Next Class
Capital Budgeting
Calculating cash flows from accounting figures
Revenues and costs
Depreciation
Net working capital
Salvage value