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ºc NPV is the future stream of benefits and costs converted into
equivalent values today.

ºc Programs with a positive NPV are generally cost effective.

ºc Programs with negative NPV are generally not cost effective.

Dc Ætrengths
c Tells whether firm value is increased.
c Considers all cash flows.
c Considers the time value of money.
c Considers the riskiness of future cash flows.
Dc ]eaknesses
c Requires estimate of cost of capital.
c Expressed in terms of dollars, not as a percentage.

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The Internal Rate of Return is the interest rate that equates the present
value of an investment with it cost.
6c The internal rate of return (IRR) is that discount rate that causes
the NPV of the project to equal zero.
6c If IRR > ] CC, then the project is acceptable because it will
return a rate of return on invested capital that is likely to be
greater than the cost of funds used to invest in the project.
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ºc doth methods use the same basic decision inputs.
ºc The only difference is the assumed discount rate.
ºc The IRR assumes intermediate cash flows are reinvested at IRR«NPV
assumes they are reinvested at ] CC
Õc This difference, however, can produce conflicting decision results
under specific conditionsc
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6c The discount rate which causes the PV of a project¶s terminal value
(TV) to equal the PV of costs. TV is found by compounding inflows at
] CC.
6c The internal rate of return on a project assuming that cash inflows are
reinvested at some specified rate.

Note: -
Dc IRR is most commonly used. Managers like rates -- prefer IRR to NPV
comparisons.
Dc More than one evaluation technique is used.
Dc NPV is used most often.
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Dc MIRR correctly assumes reinvestment at opportunity cost = ] CC.
MIRR also avoids the problem of multiple IRRs.
Dc Managers like rate of return comparisons, and MIRR is better for this
than IRR.
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Dc Ætrengths
c Tells whether firm value is increased.
c Considers all cash flows.
c Considers the time value of money.
c Considers the riskiness of future cash flows.
Dc ]eaknesses
c May not give value-maximizing decisions for mutually exclusive
projects.
c May not give value-maximizing decisions under capital rationing.

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Uses exactly the same decision inputs as NPV simply expresses the
relative profitability of the projects incremental after-tax cash flow
benefits as a ratio to the project¶s initial cost.

PI = PV of incremental TCF benefits

PV of initial cost of project
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 then we accept; because the PV o bene ts exceeds the PV o
costs.

ºc PI is a ratio of the present value of benefits to costs.

ºc s a pure coefficient, as long as it exceeds 1.00 the project will
increase the value of the firm if accepted.
ºc PI of more than 1.0 indicates that the project is expected to earn a
return greater than the required return.
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c This is a simple approach to capital budgeting that
is designed to tell you how many years it will take to recover the initial
investment.
It is often used by financial managers as one of a set of investment
screens, because it gives the manager an intuitive sense of the
project¶s risk.

 
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ºc gvercomes the lack of consideration of the time value of money«
ºc ôraphing the cumulative PV of cash flows can help us see the pattern
of cash flows beyond the payback point.
ºc If carried to the end of the projects¶ useful life«will tell us the project¶s
NPV (if you are using the firm¶s ] CC).c
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The Modigliani ± Miller hypothesis is identical with the net operating Income
approach.
Modigliani and Miller argued that, in the absence of taxes the cost of capital
and the value of the firm are not affected by the changes in capital
structure. In other words, capital structure decisions are irrelevant and value
of the firm is independent of debt ± equity mix.

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c M - M Hypothesis can be explained in terms of two
propositions of Modigliani and Miller.

c They are :
i. The overall cost of capital (Kg) and the value of the firm
are independent of the capital structure. The total market
value of the firm is given by capitalising the expected net
operating income by the rate appropriate for that risk
class.
ii. The financial risk increases with more debt content in
the capital structure. s a result cost of equity (Ke)
increases in a manner to offset exactly the low ± cost
 advantage of debt. Hence, overall cost of capital remains
the same.
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1. There is a perfect capital market. Capital markets are perfect when

i) Investors are free to buy and sell securities,

ii) They can borrow funds without restriction at the same terms as the firms
do,
iii) They behave rationally,
iv) They are well informed, and
v) There are no transaction costs.

2. Firms can be classified into homogeneous risk classes. ll the firms in the
same risk class will have the same degree of financial risk.

3. ll investors have the same expectation of a firm¶s net operating income

(EdIT).

4. The dividend payout ratio is 100%, which means there are no retained
earnings.

5. There are no corporate taxes. This assumption has been removed later.
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ccording to M ± M, for the firms in the same risk class, the total market
value is independent of capital structure and is determined by capitalising
net operating income by the rate appropriate to that risk class. Proposition I
can be expressed as follows:

V = S +D =X/K0 =NgI/K0

]here, V = the market value of the firm

Æ = the market value of equity
D = the market value of debt

ccording the proposition I the average cost of capital is not affected by

degree of leverage and is determined as follows:

K o = X/V
ccording to M ±M, the average cost of capital is constant.
 

 
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M ± M¶s proposition II defines cost of equity. ccording to them, for any firm
in a given risk class, the cost of equity is equal to the constant average cost
of capital (Ko) plus a premium for the financial risk, which is equal to debt ±
equity ratio times the spread between average cost and cost of debt. Thus,
cost of equity is:

Ke = Ko+(Ko-Kd) = D/Æ.

]here,
Ke = cost of equity
D/Æ = debt ± equity ratio

M ± M argue that Ko will not increase with the increase in the leverage,
because the low ± cost advantage of debt capital will be exactly offset by the
increase in the cost of equity as caused by increased risk to equity
shareholders. The crucial part of the M ± M Thesis is that an excessive use of
leverage will increase the risk to the debt holders which results in an
increase in cost of debt (Ko). However, this will not lead to a rise in Ko. M ±
M maintain that in such a case Ke will increase at a decreasing rate or even
it may decline. This is because of the reason that at an increased leverage,
the increased risk will be shared by the debt holders. Hence Ko remain
constant.

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The arbitrage process is the behavioral and operational foundation for M M
Hypothesis. dut this process fails the desired equilibrium because of the
following limitations.

1. Rates of interest are not the same for the individuals and firms. The firms
generally have a higher credit standing because of which they can borrow
funds at a lower rate of interest as compared to individuals.
2. Home ± Made leverage is not a perfect substitute for corporate leverage.
If the firm borrows, the risk to the shareholder is limited to his shareholding
in that company. dut if he borrows personally, the liability will be extended
to his personal property also.
Hence, the assumption that personal or home ± made leverage is a perfect
substitute for corporate leverage is not valid.

3. The assumption that transaction costs do not exist is not valid because
these costs are necessarily involved in buying and selling securities.
4. The working of arbitrage is affected by institutional restrictions, because
the institutional investors are not allowed to practice home ± made leverage.

5. The major limitation of M ± M hypothesis is the existence of corporate

taxes. Æince the interest charges are tax deductible, a levered firm will have
a lower cost of debt due to tax advantage when taxes exist.
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