Chap 009

Chapte
r9
Net Present Value and
Other
Investment Criteria
9-1
McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
• Capital Budgeting Process
• Payback
• Discounted Payback
• Net Present Value
• Profitability Index
9-2
Chapter Outline
(continued)
• The Average Accounting Return
• The Internal Rate of Return
• Modified Internal Rate of Return
• The Practice of Capital

Budgeting
9-3
Chapter Outline
• Payback
9-4
Capital
Structu
re
Dividen Cost of
d Policy Capital
Profits Capital
or
Losses Budgeti
ng
9-5
Discounted cash flows
(Chiết khấu dòng tiền)
Discount rate Cash flows

(tỷ suất chiết khấu) (Dòng tiền)
Risk Size Timings

(Rủi ro) (How much?) (When?)
6
Capital
Structu
re
Dividen Cost of
d Policy Capital
Profits Capital
or Budgeti
9-7
Losses ng
Uses of Capital
Budgeting
Replace Expand
Maintenance Current Product
or or
Obsolescence Current Service
Cost New Product

Reduction or
New Service
9-8
Comparison
Valuations
Bond
0 1 2 3
P0 C C C
Common Stock M
0 1 2 3
P0 D1 D2 D3 D∞
Project
0 1 2 3
9-9 COST CF1 CF2 CF3

Bonds, Stock and
Project
Similarities
• All three have identified
future dollars that must be
considered
• All three involve bringing

future dollars into present
value terms
• All three involve an

9-10
“accept/reject” decision in the
Bonds, Stocks and
Project
Differences
• A bond has coupon payments
and a lump-sum payment; stock
has dividend payments forever;
projects have cash flows that
end.
• Coupon payments are fixed;

stock dividends change or
“grow” over time; project cash
flows are typically different
9-11
each year.
Bonds, Stocks and
Project
Differences
• With bonds and stock our goal
is to determine the value today
(P0); our goal with projects is to
determine if we will exceed our
cost with the cash flows
identified.
9-12
Our Task:
To determine if
we should
purchase the
project
9-13
And how will
we accomplish
our task?
9-14
B Bring
A All
E Expected
F Future
E Earnings
I Into
P Present
V Value
9-15 T Terms
Just remember:
BAEFEIPVT
9-16
Chapter Outline
• Payback
9-17
Payback Period
Definition: How long does it take
to get the initial cost
back in a nominal sense?
Computation:
1. Estimate the cash flows
2. Subtract the future cash
flows from the initial
cost until the initial
investment has been
9-18
recovered
Project Example
Information
You are reviewing a new project and
have estimated the following cash flows:
Year 0: CF = -165,000
Year 1: CF = 63,120; NI = 13,620
Year 2: CF = 70,800; NI = 3,300
Year 3: CF = 91,080; NI = 29,100
Average Book Value = 72,000
Your required return for assets of this
risk level is 12%.
9-19
Discount rate
Required rate of return

(Tỷ suất sinh lời yêu cầu/đòi hỏi)
Expected rate of return
(Tỷ suất sinh lời kỳ vọng)
Discount rate Hurddle rate (Ngưỡng sinh lời)

(Tỷ suất chiết khấu) (IRR phải vượt ngưỡng sinh lời)
Opportunity cost of investment

(Chi phí cơ hội của việc đầu tư)
Cost of capital
(Chi phí vốn)
20
Project Example -
Visual
R = 12%
0 1 2 3
$ -165,000 CF1 = CF2 = CF3 =

63,120 70,800 91,080
The required return for assets of

9-21
this risk level is 12% (as
determined by the firm).
Payback Computation
R = 12%
1 2 3
$ -165,000 CF1 = CF2 = CF3 =

63,120 70,800 91,080
Year 1: - $165,000 + 63,120 = - 101,880

We need to get to zero so keep going…
9-22
Payback Computation
R = 12%
1 2 3
$ -165,000 CF1 = CF2 = CF3 =

63,120 70,800 91,080
Year 2: - $101,880 + 70,800 = - 31,080

We need to get to zero so keep going…
9-23
Payback Computation
R = 12%
1 2 3
$ -165,000 CF1 = CF2 = CF3 =

63,120 70,800 91,080
Year 3: - $31,080 + 91,080 = 60,000

We “passed” zero so payback is achieved
9-24
Payback Computation
R = 12%
1 2 3
$ -165,000 CF1 = CF2 = CF3 =

63,120 70,800 91,080
PP= 2 + (31080/91080) = 2.34 (years)

We “passed” zero so payback is achieved
9-25
Payback decision
So….Deal or
No Deal?
9-26
Payback Decision
We need to know a
“management’s number. What
does the firm use for the
evaluation of its projects when
they use payback?
Most companies use either 3 or

4 years.
Let’s use 4 in our numerical

9-27
example
Payback Decision
Our computed
payback was
2.34 years
The firm’s uses
4 years as it’s
criteria, so…
YES, we Accept
this project as
9-28
we recover our
cost of the
Decision Criteria
Comparison
Technique Unit Accept
s if:
Payback Time Payback <
Mgt’s #
9-29
Good Decision
Criteria
We need to ask ourselves the
following questions when evaluating
capital budgeting decision rules:
1. Does the decision rule adjust for

the time value of money?
2. Does the decision rule adjust for

risk?
3. Does the decision rule provide

9-30 information on whether we are
Decision Criteria Test
- Payback
1.Does the payback rule account
for the time value of money?
2.Does the payback rule account

for the risk of the cash flows?
3.Does the payback rule provide an

indication about the increase in
value?
9-31
4.Should we consider the payback
rule for our primary decision
- Payback
Q: So if Payback is not that great as
a capital budgeting technique, why
use it?
A: Because it is so easy to compute!
9-32
Payback’s
Advantages
• Easy to understand
and compute (you
just subtract!)
• Adjusts for
uncertainty of later
cash flows
• Biased toward
liquidity
9-33
Payback’s
Disadvantages
• Ignores the time value
of money
• Requires an arbitrary
cutoff point
• Ignores cash flows
beyond the cutoff date
• Biased against long-
term projects, such as
9-34
research and
Payback Period (PBP)
Ignores returns after the PBP
£000 Cash Flow A Cash Flow B
Yr 0 (2,000) (2,000)
Yr 1 500 500
Yr 2 500 500
Yr 3 400 400
Yr 4 500 500
Yr 5 300 300
Yr 6 200 20000
35
Payback Period (PBP)
Ignores timing
£000 Cash Flow C Cash Flow D
Yr 0 (20,000) (20,000)
Yr 1 500 15,000
Yr 2 500
500
Yr 3 4000 4000
Yr 4 15,000 500
Yr 5 3000 3000
Yr 6 2000 2000
36
Chapter Outline
• Payback
9-37
Discounted Payback
Period
Definition: How long does it take
to get the initial cost back after
you bring all of the cash flows to
the present value.
Computation:
1. Estimate the present value of the
cash flows
2. Subtract the future cash flows
from the initial cost until the
9-38 initial investment has been
Discounted Payback
Computation Step 1
R = 12%
1 2 3
$ -165,000 CF1 = CF2 = CF3 =

63,120 70,800 91,080
56,357
56,441
64,829
9-39
Discounted Payback
Computation Step 2
R = 12%
1 2 3
$ -165,000 CF1 = CF2 = CF3 =

63,120 70,800 91,080
56,357
56,441
64,829
9-40 Year 1: -165,000 + 56,357 = -108,643; continue
Discounted Payback
Computation Step 2
R = 12%
1 2 3
$ -165,000 CF1 = CF2 = CF3 =

63,120 70,800 91,080
56,357
56,441
64,829
9-41 Year 2: -108,643 + 56,441 = -52,202; continue
Discounted Payback
Computation Step 2
R = 12%
1 2 3
$ -165,000 CF1 = CF2 = CF3 =

63,120 70,800 91,080
56,357
56,441
64,829
9-42 Year 3: -52,202 + 64,829 = 12,627; finished
Decision Criteria
Comparison
s if:
Mgt’s #
Discounted Time Payback <
Payback Mgt’s #
9-43
– Discounted Payback
1.Does the discounted payback rule
account for the time value of
money?

account for the risk of the cash
flows?

provide an indication about the
9-44
increase in value?
Discounted Payback’s
Advantages
• Includes time value of

money
• Easy to understand
• Biased towards
liquidity
9-45
Discounted Payback’s
Disadvantages
• Requires an arbitrary
cutoff point
• Ignores cash flows

beyond the cutoff point
• Biased against long-term

9-46
projects, such as R&D
Chapter Outline
• Payback
9-47
Net Present Value
Definition: The difference
between the market value of a
project and its cost
Computation:
1. Estimate the future cash flows
2. Estimate the required return for

projects of this risk level.
3. Find the present value of the

cash flows and subtract the initial
9-48
NPV – Decision Rule
• A positive NPV means that the
project is expected to add value
to the firm and will therefore
increase the wealth of the
owners.
• Since our goal is to increase

owner wealth, NPV is a direct
measure of how well this project
will meet our goal, as measured
9-49 in dollar terms.
Project Example -
NPV
R = 12%
1 2 3
$ -165,000 CF1 = CF2 = CF3 =

63,120 70,800 91,080
9-50
Net Present Value
Computation Step 1
R = 12%
1 2 3
$ -165,000 CF1 = CF2 = CF3 =

63,120 70,800 91,080
56,357
56,441
64,829
9-51
177,627 = PV of all cash flows
Net Present Value
Computation Step 2
R = 12%
1 2 3
$ -165,000 CF1 = CF2 = CF3 =

63,120 70,800 91,080
NPV = PV of Inflows – PV of Outflows
NPV =$177,627 - $165,000 = $12,627

9-52
Net Present Value
Decision
If the NPV is positive
(NPV > $0), then we
ACCEPT the project.
Conversely, if the NPV
is negative, then we
REJECT the project.
Thus in our case, the

NPV is $12,627 so we
ACCEPT the project.
9-53
Using your
calculator……
9-54
TI BA II Plus
-165,000 = CF0
12,627.41 C01 = 63,120

F01 = 1; CO2 =70,800
FO2 = 1; CO3 =91,080
FO3 = 1; NPV
I = 12
CPT
NPV = ?
9-55
-165,000 = CF0 HP 12-C
63,120= CF1 70,800= CF2 90,080= CF3
I - 12 NPV = ?
12,627.41
9-56
Capital Budgeting
Decision Criteria
Comparison
s if:
Mgt’s #
Payback Mgt’s #
Net Present $ NPV > $0

Value
9-57
- NPV
• Does the NPV rule account for
• Does the NPV rule account for

the risk of the cash flows?
• Does the NPV rule provide an

value?
• Should we consider the NPV rule

9-58
for our primary decision rule?
Net Present Value
Advantages
• Considers all of the cash flows
in the computation
• Uses the time value of money
• Provides the answer in dollar
terms, which is easy to
understand
• Usually provides a similar
answer to the IRR computation
9-59
Net Present Value
Disadvantages
• Requires the use of the time
value of money, thus a bit more
difficult to compute
• Projects that differ by orders of
magnitude in cost are not
obvious in the NPV final figure
9-60
Calculating NPVs with
a Spreadsheet
• 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

9-61 range of cash flows beginning
with year 1
The intuition of IRR
and NPV
Example:
A coupon bond has time to maturity of 5
years. The face value of the bond is $1000.
Coupons are paid annually. The coupon rate
is 10%. The current price of the bond is $960.
Your money is currently in a bank account
which pays 9% annually. Assume that the
bank account is as risky as the bond. Are you
going to invest in the bond?
9-62
and NPV
What is the present value of the cash flows
from the bond?
PV @9% = 1038.897
The intuition: You must put $ 1038.897 in your

bank account in order to receive the same cash
flows as the bond.
9-63
and NPV
Interest rate: 9%
Year Beginning Interest Withdraw Ending

balance balance
1 1038.897 100
2 100
3 100
4 100
5 1100 0
9-64
and NPV
What is the present value of the cash flows
from the bond?
PV @9% = 1038.897
The intuition of NPV: By investing in the bond,

you get the extra value compared to leaving
money in the bank account: 1038.897-960
9-65
and NPV
IRR of the bond: 11.085% >9%  accept
The intuition of IRR: If you want to receive

the same cash flows as the bond with the
initial investment of $960. You have to put
$960 in a bank which pays the annual interest
of 11.085%.
9-66
and NPV
Interest rate: 11.085%
Year Beginning Interest Withdraw Ending

balance balance
1 960 100
2 100
3 100
4 100
5 1100 0
9-67
and NPV
IRR of the bond: 11.085%
The intuition of IRR: If you want to receive

the same cash flows as the bond with the
initial investment of $960. You have to put
$960 in a bank which pays the annual interest
of 11.085%. Because the riskiness of the two
banks is the same, you will choose to invest in
the bank which pays 11.085%.
9-68
and NPV
IRR of the bond: 11.085%
The intuition of IRR: IRR is the rate of return

that you can receive from the cash flows of the
project.
9-69
Chapter Outline
• Payback
9-70
Profitability Index
Definition: The PI measures the
benefit per unit cost of a project,
based on the time value of money. It
is very useful in situations where you
have multiple projects of hugely
different costs and/or limited capital
(capital rationing).
Computation:
PI = PV of Inflows/PV of Outflows
9-71
Profitability Index
Example
PI = PV of Inflows/ PV of
Outflows
$177,627/$165,000 =
1.0765
A Profitability Index of 1.076

implies that for every $1 of
investment, we create an
9-72
additional $0.0765 in value. A PI
Profitability Index
If you have four projects as follows:
A: PI = 1.2 and PV of Outflows = 18

billion
B: PI = 1.3 and PV of Outflows = 10
billion
C: PI =1.4 and PV of Outflows =7
billion
D: PI = 1.3 and PV of Outflows = 13
billion
9-73
You only have 31 billion to invest in
these projects so you cannot choose
Capital Budgeting
Decision Criteria
Comparison
s if:
Mgt’s #
Payback Mgt’s #
Net Present $ NPV > $0

Value
Profitability Non PI > 1.0
Index (PI) e
9-74
Profitability Index
Advantages
• Closely related to NPV, generally
leading to identical decisions
• Easy to understand and

communicate
• May be useful when available

investment funds are limited
9-75
Profitability Index
Disadvantages
May lead to incorrect

decisions in comparisons of
mutually exclusive
investments
9-76
Chapter Outline
(continued)
• Modified Internal Rate of

Return

9-77
Budgeting
Average Accounting
Return
Definition: The AAR is a measure of
the average accounting profit
compared to some measure of
average accounting value of a project.
The AAR is then compared to a
required return by the company.
AAR =
Computation: Average
Net Income
Average Book
9-78
Value
Project Example
Information
You are reviewing a new project and
have estimated the following cash flows:
Year 0: CF = -165,000
Year 1: CF = 63,120; NI = 13,120
Year 2: CF = 70,800; NI = 20,800
Year 3: CF = 91,080; NI = 26,080
Assume that the Resale value = Residual
value = 15,000
Average Book Value = 90,000
Your required return for assets of this
risk level is 12%.
9-79
Average Accounting
Return
Using the figures of our previous
example:
1. ($13,120 + 20,800 + 26,080)
=60,000
2.60,000/ 3 = $20,000
3.AAR = 20,000 /90,000 = .2222
or 22.2%
9-80
4.If we compare this to our firm’s
Decision Criteria
Comparison
s if:
Mgt’s #
Payback Mgt’s #
Net Present Value $ NPV > $0
Profitability Index None PI > 1.0

(PI)
Average Acct.
Return
% AAR > Mgt’s #
9-81
- AAR
1.Does the AAR rule account for
2.Does the AAR rule account for

the risk of the cash flows?
3.Does the AAR rule provide an

value?
4.Should we consider the AAR rule

for our primary decision rule?
9-82
Average Accounting
Return Advantages
• Easy to
calculate
• Needed
information
will usually
be available
9-83
Return
Disadvantages
• Not a true rate of
return; time value
of money is
ignored
• Uses an arbitrary
benchmark cutoff
rate
• Based on
9-84
accounting net
Chapter Outline
(continued)

Return

9-85 Budgeting
Internal Rate of
Return
• This is the most important
alternative to NPV
• It is often used in practice
and is intuitively appealing
• It is based entirely on the
estimated cash flows and is
independent of interest
rates found elsewhere
9-86
Internal Rate of
Return
Definition: It is the discount rate (or
required return) that will bring all of
the cash flows into present value time
and total the exact value of the cost
of the project.
Said another way, it is the return that

will yield a NPV = $0.
9-87
Computing IRR for
the Project
• If you do not have a financial
calculator, then this becomes a trial
and error process
• Calculator:
• Enter the cash flows as you did
with NPV
• Press IRR and then CPT
9-88 • IRR = 16.13% > 12% required

Calculating IRRs With
A Spreadsheet
• You start with the cash flows the
same as you did for the NPV
• You use the IRR function

• First enter your range of cash
flows, beginning with the initial
cash flow
• You can enter a guess, but it is not
necessary
9-89 • The default format is a whole
IRR – Decision Rule
• If the IRR of a project is greater
than the firm’s cost of capital,
then we would accept the project
• Since our goal is to increase

owner wealth, IRR is a direct
measure of how well this project
will meet our goal, as measured in
interest rate terms.
9-90
Discount rate
Required rate of return

(Tỷ suất sinh lời yêu cầu/đòi hỏi)
Expected rate of return
(Tỷ suất sinh lời kỳ vọng)
Discount rate Hurddle rate (Ngưỡng sinh lời)

(Tỷ suất chiết khấu) (IRR phải vượt ngưỡng sinh lời)
Opportunity cost of investment

(Chi phí cơ hội của việc đầu tư)
Cost of capital
(Chi phí vốn)
91
The NPV Payoff Profile for This
Example
If we graph NPV versus discount rate, we can see the
IRR as the x-axis intercept.
Discount Rate NPV $120.00

0% $100.00 $100.00
4% $71.04
$80.00
8% $47.32
12% $27.79 $60.00
16% $11.65 $40.00
NPV
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
92
Capital Budgeting Decision Criteria
Comparison
s if:
Mgt’s #
Payback Mgt’s #

(PI)
Average Acct. AAR > Mgt’s #
Return
%
Internal Rate of IRR > R
Return
%
9-93
- IRR
1. Does the IRR rule account for the
time value of money?
2. Does the IRR rule account for the

risk of the cash flows?
3. Does the IRR rule provide an

value?
4. Should we consider the IRR rule for

9-94
our primary decision criteria?
Internal Rate of
Return Advantages
• Considers all of the cash flows
in the computation
• Uses the time value of money
• If the IRR is high enough, you
may not need to estimate a
required return, which is often
a difficult task
9-95
• Usually provides a similar
Internal Rate of
Return
Disadvantages
• Uses the firm’s required rate
of return for comparison
purposes.
• Unusually high numbers can
often occur when a significant
amount of the project’s cash
flows occur early in the life of
the project.
9-96
Mutually Exclusive
Projects
Mutually exclusive projects:
If you choose one, you can’t choose the
other
Example: You can choose to attend
graduate school at either Harvard or
Stanford, but not both
Intuitively, you would use the following

decision rules:
NPV – choose the project with the
9-97 higher NPV
Mutually Exclusive
Projects
Period Project Project
A B
0 -500 -400
1 325 325
2 325 200 If the required

rate of return for
IRR 19.43 22.17 the firm is 10%
% % and Projects A
and B are both of
NPV $64.05 $60.74 equal risk, which
9-98
project would
you select?
NPV Profiles
IRR for A = 19.43%
IRR for B = 22.17%
Crossover Point =
11.8%
9-99
NPV vs. IRR
• NPV and IRR will generally give us the
same decision
• Exceptions:
• Nonconventional cash flows – cash

flow signs change more than once
• Mutually exclusive projects

• Initial investments are
substantially different (issue of
scale)
• Timing of cash flows is
9-100
substantially different
NPV Profile
IRR = 10.11%
and 42.66%
9-101
Conflicts Between NPV
and IRR
• NPV directly
measures the
increase in value to
the firm.
• Whenever there is
a conflict between
NPV and another
decision rule, you
should
always use
NPV!
9-102
Chapter Outline
(continued)

Return

9-103 Budgeting
Modified Internal Rate
of Return (MIRR)
Definition: MIRR differentiates itself
from IRR in that the reinvestment rate
for the cash flows is determined by the
evaluator. It is the interest rate that
compares the future value of the cash
flows with the cost of the project.
The benefit of MIRR over IRR is that we

can produce a single number with
specific rates for borrowing and
9-104
reinvestment.
Modified Internal
Rate of Return (MIRR)
Computation:
Step 1: Take the Cash flows to the
end of the project and add them up;
this is labeled the “terminal value”.
Step 2: Find the rate of return that

equates the cost with the terminal
value for the life of the project. This
is the MIRR.
9-105
MIRR Computation
Step 1
R = 12%
1 2 3
$ -165,000 CF1 = CF2 = CF3 =

63,120 12% 70,800 91,080
79177.728
12%
79296
9-106
TV = $249553.728
MIRR Computation
Step 2
R = 12%
1 2 3
$ -165,000 TV = 249553.728
165,000(1+MIRR)3=249553.728
MIRR= (249553.728 /165,000)(1/3)-1= %14.787%
MIRR = 14.787% which is

9-107
greater than 12%, therefore
ACCEPT the project
Capital Budgeting Decision Criteria
Comparison
s if:
Mgt’s #
Payback Mgt’s #

(PI)
Average Acct.
Return
% AAR > Mgt’s #
9-108 Internal Rate of

Return
% IRR > R
Chapter Outline
(continued)

Return

9-109 Budgeting
Capital Budgeting In
Practice
• We should consider several
investment criteria when making
decisions
• Most managers will be using the

techniques of capital budgeting as
part of their job.
• Payback is a commonly used

secondary investment criteria and is
used when the project costs are small
9-110
• NPV and IRR are the most commonly
Ethics Issues I
ABC poll in the spring of 2004 found that
one-third of students age 12 – 17
admitted to cheating and the percentage
increased as the students got older and
felt more grade pressure.
If a book entitled “How to Cheat: A

User’s Guide” would generate a positive
NPV, would it be proper for a publishing
company to offer the new book?
9-111
Ethics Issues II
Should a firm exceed the minimum legal

limits of government imposed
environmental regulations and be
responsible for the environment, even if
this responsibility leads to a wealth
reduction for the firm?
Is environmental damage merely a cost of

doing business?
9-112
Quick Quiz
 Consider an investment that costs
$100,000 and has a cash inflow of
$25,000 every year for 5 years. The
required return is 9%, and required
payback is 4 years.
 What is the payback period?
 What is the discounted payback period?
 What is the NPV?
 What is the IRR?
 Should we accept the project?
 What decision rule should be the
primary decision method?
9-113
Comprehensive
Problem
1. An investment project has the
following cash flows: CF0 = -
1,000,000; C01 – C08 = 200,000
each
2. If the required rate of return is
12%, what decision should be
made using NPV?
3. How would the IRR decision rule
be used for this project, and
what decision would be
9-114
reached?
4. How are the above two
Terminology
• Capital budgeting
• Decision criteria
• Project’s cash flows
• Payback
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Modified IRR (MIRR)
9-115
Formulas
Profitability Index = PV of
Inflows
PV of
Outflows
9-116
Summary – Payback
Criteria
Payback period
Length of time until initial investment is
recovered
Take the project if it pays back within some
specified period
Doesn’t account for time value of money,
and there is an arbitrary cutoff period
Discounted payback period
Length of time until initial investment is
recovered on a discounted basis
Take the project if it pays back in some
specified period
9-117 There is an arbitrary cutoff period
Summary –
Discounted Cash Flow
Criteria
Net present value
Difference between market value and cost
Take the project if the NPV is positive
Has no serious problems
Preferred decision criterion
Internal rate of return
Discount rate that makes NPV = 0
Take the project if the IRR is greater than the
required return
Same decision as NPV with conventional cash flows
IRR is unreliable with nonconventional cash flows
or mutually exclusive projects
Profitability Index
Benefit-cost ratio
Take investment if PI > 1
Cannot be used to rank mutually exclusive projects
9-118 May be used to rank projects in the presence of
capital rationing
Key Concepts and
Skills
• Compute payback and
discounted payback & evaluate
their shortcomings
• Compute accounting rates of

return and explain its
shortcomings
• Compute the NPV and explain

why it is superior to the other
techniques of capital budgeting
9-119
Key Concepts and
Skills
• Compute both internal
rate of
return (IRR) and modified
internal
rate of return (MIRR) and
differentiate between
them
• Compute the profitability

index (PI) and explain its
relationship to net
9-120
present value
What are the most
important topics of
this chapter?
1. Capital budgeting
techniques basically
involves comparing
anticipated cash flows to
that of a project’s cost
2. Payback and AAR do not

utilize the time value of
money
9-121
3. NPV, IRR and MIRR are

What are the most
important topics of
this chapter?
4. The profitability index (PI)

assists with the evaluation
of unequal costing projects
5. All projects may not have

the identical risk
classification and we can
adjust this using a risk-
adjusted discount rate
9-122
Questions?
9-123

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Chapte

• Net Present Value

• The Internal Rate of Return

• Modified Internal Rate of Return

• The Practice of Capital

• Capital Budgeting Process

• Net Present Value

Discount rate Cash flows

Risk Size Timings

Cost New Product

9-9 COST CF1 CF2 CF3

• All three involve bringing

• All three involve an

• Coupon payments are fixed;

• Capital Budgeting Process

• Net Present Value

Required rate of return

Discount rate Hurddle rate (Ngưỡng sinh lời)

Opportunity cost of investment

$ -165,000 CF1 = CF2 = CF3 =

The required return for assets of

$ -165,000 CF1 = CF2 = CF3 =

Year 1: - $165,000 + 63,120 = - 101,880

$ -165,000 CF1 = CF2 = CF3 =

Year 2: - $101,880 + 70,800 = - 31,080

$ -165,000 CF1 = CF2 = CF3 =

Year 3: - $31,080 + 91,080 = 60,000

$ -165,000 CF1 = CF2 = CF3 =

PP= 2 + (31080/91080) = 2.34 (years)

Most companies use either 3 or

Let’s use 4 in our numerical

1. Does the decision rule adjust for

2. Does the decision rule adjust for

3. Does the decision rule provide

2.Does the payback rule account

3.Does the payback rule provide an

A: Because it is so easy to compute!

• Net Present Value

$ -165,000 CF1 = CF2 = CF3 =

$ -165,000 CF1 = CF2 = CF3 =

$ -165,000 CF1 = CF2 = CF3 =

$ -165,000 CF1 = CF2 = CF3 =

2.Does the discounted payback rule

3.Does the discounted payback rule

• Includes time value of

• Ignores cash flows

• Biased against long-term

• Net Present Value

2. Estimate the required return for

3. Find the present value of the

• Since our goal is to increase

$ -165,000 CF1 = CF2 = CF3 =

$ -165,000 CF1 = CF2 = CF3 =

$ -165,000 CF1 = CF2 = CF3 =

NPV =$177,627 - $165,000 = $12,627

Thus in our case, the

12,627.41 C01 = 63,120

Net Present $ NPV > $0

• Does the NPV rule account for

• Does the NPV rule provide an