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McGraw-Hill/Irwin
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Chapter Outline
5.1 Why Use Net Present Value?
5.2 The Payback Period Method
5.3 The Discounted Payback Period Method
5.4 The Internal Rate of Return
5.5 Problems with the IRR Approach
5.6 The Profitability Index
5.7 The Practice of Capital Budgeting
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Set by management
Ranking Criteria:
Set by management
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Disadvantages:
Ignores the time value of money
Ignores cash flows after the payback period
Biased against long-term projects
Requires an arbitrary acceptance criteria
A project accepted based on the payback
criteria may not have a positive NPV
Advantages:
Easy to understand
Biased toward liquidity
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Ranking
Criteria:
Reinvestment
to zero
assumption:
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Disadvantages:
Advantages:
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IRR: Example
Consider the following project:
0
-$200
$50
$100
$150
2
3
(1 IRR) (1 IRR) (1 IRR)
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IRR = 19.44%
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Multiple IRRs
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Multiple IRRs
There are two IRRs for this project:
0
$200
$800
1
$200
$8
00
100% = IRR2
0% = IRR1
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Modified IRR
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Project A
0
Project B
$10,000
$1,000
$12,000
0
$10,00
0
$1,000
2
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12.94% = IRRB
16.04% = IRRA
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10.55% = IRR
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Initial
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Accept if PI > 1
Ranking Criteria:
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Disadvantages:
Advantages:
Varies by industry:
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Project B
-$150.00
PV0 of CF1-3
$241.92
$240.80
NPV =
IRR =
PI =
$41.92
0%, 100%
1.2096
$90.80
36.19%
1.6053
CF0
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CF
Cum. CF
NPV for A
-87.52
0.00
59.26
59.48
42.19
20.85
0.00
-18.93
NPV for B
234.77
150.00
47.92
-8.60
-43.07
-65.64
-81.25
-92.52
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NPV
NPV Profiles
$400
$300
IRR 1(A)
IRR (B)
IRR 2(A)
$200
$100
$0
-15%
0%
15%
30%
45%
70%
($100)
($200)
Cross-over Rate
Discount rates
Project A
Project B
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Profitability Index
Benefit-cost ratio
Take investment if PI > 1
Cannot be used to rank mutually exclusive projects
May be used to rank projects in the presence of capital rationing
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Payback period
Quick Quiz
Review
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