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CHAPTER
5
NPV and Other
Investment Rules
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Chapter Outline
6.1 Why Use Net Present Value?
6.2 The Payback Period Rule
6.3 The Discounted Payback Period Rule
6.4 The Average Accounting Return
6.5 The Internal Rate of Return
6.6 Problems with the IRR Approach
6.7 The Profitability Index
6.8 The Practice of Capital Budgeting
6.9 Summary and Conclusions
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Estimating NPV:
1. Estimate future cash flows: how much? and when?
2. Estimate discount rate
3. Estimate initial costs
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0 1 2 3
-$200
The internal rate of return for this project is 19.44%
$50 $100 $150
NPV 0
(1 IRR) (1 IRR) (1 IRR)3
2
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20% ($1.74)
$20.00
IRR = 19.44%
24% ($12.88)
28% ($22.17) $0.00
32% ($29.93) ($20.00)
-1% 9% 19% 29% 39%
36% ($36.43) ($40.00)
40% ($41.86)
($60.00)
Discount rate
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Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
Since managers prefer the IRR to the NPV method,
is there a better IRR measure?
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Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
Calculating MIRR
0 r = 10% 1 2 3
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Multiple IRRs
There are two IRRs for this project:
$200 $800
Which one
0 1 2 3 should we use?
- $800
-$200
NPV
$100.00
100% = IRR2
$50.00
$0.00
-50% 0% 50% 100% 150% 200%
($50.00)
0% = IRR1 Discount rate
($100.00)
($150.00)
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$1,000.00
$0.00
($1,000.00) 0% 10% 20% 30% 40%
($2,000.00)
($3,000.00)
($4,000.00) 12.94% = IRRB 16.04% = IRRA
Discount rate
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$3,000.00
$2,000.00
10.55% = IRR
$1,000.00
A-B
NPV
$0.00
B-A
($1,000.00) 0% 5% 10% 15% 20%
($2,000.00)
($3,000.00)
Discount rate
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NPV Profiles
$400
NPV
$300
IRR 1(A) IRR (B) IRR 2(A)
$200
$100
$0
-15% 0% 15% 30% 45% 70% 100% 130% 160% 190%
($100)
($200)
Project A
Discount rates
Cross-over Rate Project B
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