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* * * * * * * * * * * * * * Chapter 5 * Accepting positive NPV projects benefits shareholders. NPV uses cash flows NPV uses all the cash flows of the project NPV discounts the cash flows properly * Net Present Value (NPV) = Total PV of future CF’s + Initial Investment Estimating NPV: 1. Estimate future cash flows: how much? and when? 2. Estimate discount rate 3. Estimate initial costs Accept / reject: Accept NPV 0 Ranking Criteria: Choose the highest NPV * 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 Ranking Criteria: Set by management * 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 * IRR: the discount rate that sets NPV to zero Minimum Acceptance Criteria: Accept if the IRR exceeds the required return Ranking Criteria: Select alternative with the highest IRR Reinvestment assumption: All future cash flows are assumed to be reinvested at the IRR * Disadvantages: Does not distinguish between investing and borrowing IRR may not exist, or there may be multiple IRRs Problems with mutually exclusive investments Advantages: Easy to understand and communicate * Consider the following project: 0 1 2 3 $50 $100 $150 -$200 The internal rate of return for this project is 19.44% * If we graph NPV versus the discount rate, we can see the IRR as the x-axis intercept. IRR = 19.44% * Multiple IRRs Are We Borrowing or Lending The Scale Problem The Timing Problem * Mutually Exclusive Projects: Independent Projects: * 0 1 2 3 $200 $800 -$200 - $800 * Would you rather make 100% or 50% on your investments? * 0 1 2 3 $10,000 $1,0
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