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In chapter 1 we identifi ed the three key areas of concern to the financial manager. The first of these involved the question: What fixed assets should we buy? We called this the capital budgeting decision. In this chapter, we begin to deal with the issues that arise in answering this question. | T9.1 Chapter Outline Chapter 9 Net Present Value and Other Investment Criteria Chapter Organization 9.1 Net Present Value 9.2 The Payback Rule 9.3 The Average Accounting Return 9.4 The Internal Rate of Return 9.5 The Profitability Index 9.6 The Practice of Capital Budgeting 9.7 Summary and Conclusions CLICK MOUSE OR HIT SPACEBAR TO ADVANCE Irwin/McGraw-Hill copyright © 2002 McGraw-Hill Ryerson, Ltd. T9.2 NPV Illustrated Assume you have the following information on Project X: Initial outlay -$1,100 Required return = 10% Annual cash revenues and expenses are as follows: Year Revenues Expenses 1 $1,000 $500 2 2,000 1,000 Draw a time line and compute the NPV of project X. T9.2 NPV Illustrated (concluded) 0 1 2 Initial outlay ($1,100) Revenues $1,000 Expenses 500 Cash flow $500 Revenues $2,000 Expenses 1,000 Cash flow $1,000 – $1,100.00 +454.55 +826.45 +$181.00 1 $500 x 1.10 1 $1,000 x 1.10 2 NPV T9.3 Underpinnings of the NPV Rule Why does the NPV rule work? And what does “work” mean? Look at it this way: A “firm” is created when securityholders supply the funds to acquire assets that will be used to produce and sell a good or a service; The market value of the firm is based on the present value of the cash flows it is expected to generate; Additional investments are “good” if the present value of the incremental expected cash flows exceeds their cost; Thus, “good” projects are those which increase firm value - or, put another way, good projects are those projects that have positive NPVs! Moral of the story: Invest only in projects with positive NPVs. T9.4 Payback Rule Illustrated Initial outlay -$1,000 Year Cash flow 1 $200 2 400 3 600 Accumulated Year Cash flow 1 $200 2 600 3 1,200 Payback period = 2 2/3 years T9.5 Discounted Payback Illustrated Initial outlay -$1,000 R = 10% PV of Year Cash flow Cash flow 1 $ 200 $ 182 2 400 331 3 700 526 4 300 205 Accumulated Year discounted cash flow 1 $ 182 2 513 3 1,039 4 1,244 Discounted payback period is just under 3 years T9.6 | T9.1 Chapter Outline Chapter 9 Net Present Value and Other Investment Criteria Chapter Organization 9.1 Net Present Value 9.2 The Payback Rule 9.3 The Average Accounting Return 9.4 The Internal Rate of Return 9.5 The Profitability Index 9.6 The Practice of Capital Budgeting 9.7 Summary and Conclusions CLICK MOUSE OR HIT SPACEBAR TO ADVANCE Irwin/McGraw-Hill copyright © 2002 McGraw-Hill Ryerson, Ltd. T9.2 NPV Illustrated Assume you have the following information on Project X: Initial outlay -$1,100 Required return = 10% Annual cash revenues and expenses are as follows: Year Revenues Expenses 1 $1,000 $500 2 2,000 1,000 Draw a time line and compute the NPV of project X. T9.2 NPV Illustrated (concluded) 0 1 2 Initial outlay ($1,100) Revenues $1,000 Expenses 500 Cash flow $500 Revenues $2,000 Expenses 1,000 Cash flow $1,000 – $1,100.00 +454.55 +826.45 +$181.00 1 $500 x 1.10 1 $1,000 x 1.10 2 NPV T9.3 Underpinnings of the NPV Rule Why does the NPV rule work? And what does “work” mean? Look
