CHAPTER 7

F I N A N C I A L S T A T E M E N T S A N A LY S I S A N D F I N A N C I A L
MODELS

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 CHAPTER OUTLINE

7.1 Why Use Net Present Value?

7.2 The Payback Period Method
7.3 The Discounted Payback Period Method
7.4 The Average Accounting Return Method
7.5 The Internal Rate of Return
7.6 The Profitability Index
7.7 The Practice of Capital Budgeting

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7.1 NET PRESENT VALUE (NPV) AND ITS
RULES
• Net Present Value (NPV) = PV-Cost
Total PV of future project CF’s less the Initial Investment
• Estimating NPV:
1. Estimate future cash flows: how much? and
when?
2. Estimate discount rate
3. Estimate initial costs
• Minimum Acceptance Criteria: Accept if NPV >
0
• Ranking Criteria: Choose the highest NPV

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 WHY USE NPV?

• Reinvestment assumption: the NPV rule assumes

that all cash flows can be reinvested at the
discount rate
• Accepting positive NPV projects benefits
shareholders
 NPV uses cash flows
 NPV uses all relevant cash flows of the project
 NPV discounts the cash flows properly
• The value of the firm rises by the NPV of the
project.

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 NPV: EXAMPLE

• Suppose Big Deal Co. has an opportunity to make an

investment of $100,000 that will return $33,000 in year 1,
$38,000 in year 2, $43,000 in year 3, $48,000 in year 4,
and $53,000 in year 5. If the company’s required return is
12% should it make the investment?

Cash PV of
Year Flow Cash Flow YES! The NPV is
0 $ (100,000) $ (100,000)
greater than $0.
1 $ 33,000 $ 29,464 Answe
2 $ 38,000 $ 30,293
Therefore, the
3 $ 43,000 $ 30,607
r: investment does
4 $ 48,000 $ 30,505 return at least the
5 $ 53,000 $ 30,074 required rate of
return.
Net Present Value $ 50,943

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 CALCULATING NPV WITH
SPREADSHEETS
• Spreadsheets are an excellent way to compute
NPVs, especially when you have to compute the
cash flows as well.
• Using the NPV function:
• The first component is the required return entered as a
decimal.
• The second component is the range of cash flows
beginning with year 1.
• Add the initial investment after computing the NPV.

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 PRACTICE
What is the key reason why a positive NPV project
should be accepted?
• A) The project is expected to increase shareholder
value.
• B) The present value of the expected cash flows
equals the project's cost.
• C) The project will produce positive cash flows in the
future.
• D) The project's payback will be positive during its life.
• E) The project's PI will be less than 1, which indicates
acceptance.
Answer: A
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 PRACTICE
• A project requires an initial investment of $59,600 and
will produce cash inflows of $21,200, $44,500, and
$11,700 over the next 3 years, respectively. What is
the project's NPV at a required return of 16 percent?
• A) –$687.22
• B) –$757.69
• C) –$204.15
• D) –$878.92
• E) –$696.94

Answer: B
Explanation: NPV = –$59,600 + $21,200 / 1.16 + $44,500 / 1.16 2 + $11,700 / 1.163
= –$757.69 7-8
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 PRACTICE
• You are considering two independent projects. The
required rate of return is 13.75 percent for Project A
and 14.25 percent for Project B. Project A has an initial
cost of $51,400 and cash inflows of $21,400, $24,900,
and $22,200 for Years 1 to 3, respectively. Project B
has an initial cost of $38,300 and cash inflows of
$23,000 a year for 2 years. Which project(s), if either,
should you accept?
• A) Accept both A and B
• B) Reject both A and B
• C) Accept A and reject B
• D) Accept B and reject A
• E) Accept either A or B but not both A and B
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 PRACTICE

• Answer: C
• Explanation: NPVA = –$51,400 + $21,400 / 1.1375 +
$24,900 / 1.13752 + $22,200 / 1.13753 = $1,740.62;
Accept
•
• NPVB = –$38,300 + $23,000 / 1.1425 + $23,000 /
1.14252 = –$548.32; Reject

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 7.2 THE PAYBACK PERIOD METHOD

• How long does it take the project to “pay back”

its initial investment?
• Payback Period = number of years to recover
initial costs
• Minimum Acceptance Criteria:
• Set by management; a predetermined time period
• Ranking Criteria:
• Set by management; often the shortest payback period
is preferred

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 EXAMPLE: PAYBACK PERIOD
• Consider a project with an investment of $50,000
and cash inflows in years 1,2, & 3 of $30,000,
$20,000, $10,000

• The timeline above clearly illustrates that

payback in this situation is 2 years. The first two
years of return = $50,000 which exactly “pays
back” the initial investment
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 THE PAYBACK PERIOD METHOD:
ADVANTAGES AND DISADVANTAGES
• Advantages:
• Easy to understand
• Biased toward liquidity

• 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

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 PRACTICE
• The payback method
• A) discounts all cash flows properly.
• B) requires each firm to set a firmwide cash flow cutoff
period.
• C) considers all relevant cash flows.
• D) superior to the net present value method.
• E) ignores the time value of money.

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7.3 THE DISCOUNTED PAYBACK PERIOD

• How long does it take the project to “pay back”

its initial investment, taking the time value of
money into account?
• Decision rule: Accept the project if it pays back on
a discounted basis within the specified time.
• By the time you have discounted the cash flows,
you might as well calculate the NPV.

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 EXAMPLE: DISCOUNTED PAYBACK
PERIOD
• Suppose Big Deal Co. has an opportunity to make an
investment of $100,000 that will return $33,000 in year 1,
$38,000 in year 2, $43,000 in year 3, $48,000 in year 4,
and $53,000 in year 5. If the company’s required return is
12% and predetermined payback period is 3 years, should
it make the investment?

Cash PV of Cumulative Answer: NO! At the

Year Flow Cash Flow PV of Cash Flows end of three years the
0 $ (100,000) $ (100,000) $ (100,000) project has still not
1 $ 33,000 $ 29,464 $ (70,536) broken even or “ paid
2 $ 38,000 $ 30,293 $ (40,242) back”. Therefore, it
3 $ 43,000 $ 30,607 $ (9,636) must be rejected.
4 $ 48,000 $ 30,505 $ 20,869
5 $ 53,000 $ 30,074 $ 50,943

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 7.4 AVERAGE ACCOUNTING RETURN
METHOD (AAR)

Average N et Income
AAR 
Average Book Value of Investment

• Another attractive, but fatally flawed, approach

• Ranking Criteria and Minimum Acceptance
Criteria set by management

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 EXAMPLE: AAR

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 AAR: ADVANTAGES AND
DISADVANTAGES
• Advantages:
• The accounting information is usually available
• Easy to calculate

• Disadvantages:
• Ignores the time value of money
• Uses an arbitrary benchmark cutoff rate
• Based on book values, not cash flows and market values

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 PRACTICE
• An investment is acceptable if its average accounting
return (AAR)
• A) exceeds the target AAR.
• B) is less than the target AAR.
• C) exceeds the firm's return on equity (ROE).
• D) is less than the firm's return on assets (ROA).
• E) is equal to zero.

Answer: A

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