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Investment
Decision Criteria
• Learning Objectives
• Principles Used in This Chapter
1. An Overview of Capital Budgeting
2. Net Present Value
3. Other Investment Criteria
4. A Glance at Actual Capital Budgeting Practices
• Key Terms
k=20% 0 1 2 3 4 5
Years
Cash flows -$3M +$0.5M +$0.75M +$1.5M $2M $2M
(in $ millions)
Net
Present
Value =?
Copyright © 2011 Pearson Prentice Hall. All rights reserved. Step 3 cont. 11-41
Checkpoint 11.2
Step 3 cont.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
11-42
Checkpoint 11.2
k=9% 0 1 2 3 4 5 6
Years
Cash flows -$50 -$6 -$6 -$6 -$6 -$6 $6
(in $, thousands)
EAC =?
• It requires 2 steps:
– Computation of NPV
• Here the cash inflows are equal so we can use the
annuity equation to determine the PV of cash inflows.
– Computation of EAC
Enter
– N=6
– 1/y = 9
– PV = -76915
– FV = 0
– PMT = -17,145.86
• Decision Criteria:
– If PI is greater than one, it indicates that the
present value of the investment’s future cash
flows exceeds the cost of making the
investment and the investment should be
accepted. If PI is greater than one, the NPV will
be positive.
– If PI is less than one, the project should be
rejected. If PI is less than one, the NPV will be
negative.
Year Expected
Cash Flow
0 -$50,000
1 $15,000
2 $8,000
3 $10,000
4 $12,000
5 $14,000
6 $16,000
k=10% 0 1 2 3 4 5 6
Years
Cash flows -$50 +$15 +$8 +$10 +$12 +$14 +$16
(in $, thousands)
PI =?
2. Compute PI
Step 3 cont.
Copyright © 2011 Pearson Prentice Hall. All rights reserved. Step 3 cont. 11-74
Checkpoint 11.4
0 1 2 3 4
Years
Cash flows -$10,010 +$1,000 +$3,000 +$6,000 +$7,000
IRR =?
0 1 2 3
Years
Cash flows -$200,000 +$1.2m -$2.2m +$1.2m
IRR =?
= -$22,222.22
i=8%
0 1 2
Years
Cash flows -$235,000 $540,500 -$310,200
Second
First Sign
Sign change
change
-$265,947
-$500,947
• Capital rationing
• Discounted payback
• Equivalent annual cost (EAC)
• Independent investment project
• Internal rate of return (IRR)
• Modified internal rate of return (MIRR)
• Mutually exclusive investments