Net Present Value and Other Investment Criteria, Lecture notes of International Finance and Trade

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Chapter

McGraw-Hill/Irwin Copyright^ © 2006 by The McGraw-Hill Companies, Inc. All

• Net Present Value and Other

Investment Criteria

• Net Present Value and Other

Investment Criteria

Capital Budgeting Decision Project Generation Project Evaluation Project Selection Project Execution Cash Flow Estimates Selection of Appraisal Method Risk Return Trade off Market Value Per Share Certainty Uncertainty Payback Period Accounting Rate of Return Net Present Value Internal Rate of Return Profitability Index Capital Rationing Constraint An overview of capital budgeting decision

What is Present Value?

• The difference between an investment’s market

value and its cost

• The amount that an investor would pay today or the

right to receive that future amount.

• Relies on the amount of future cash flows, the

length of time that investor must wait and the rate of

return required by the investor.

• Present Value of Cash Flow as the same as

discounted cash flow.

• Discount rate viewed as an investor’s required rate

of return.

• Present Value: the maximum amount that an

investor willing to pay for the investment.

Steps Involved in the NPV Method

• (^) Selected an appropriate rate of interest
• (^) Computed the present value of investment proceeds and the present value of investment outlay using cost of capital as the discounting rate.
• (^) Found net present value subtracting the presenting value of cash outflows from the present value of cash inflows.

Net present value

NPV $ 24 , 000

1 2 3 4

What is the payback period? The number of years required to recover a project’s cost, or how long does it take to get the business’s money back?

Payback

A project has an initial cost of $199,000. The project produces cash inflows of $46,000, $54,000, $57,500, $38,900 and $46,500 over the next five years, respectively. What is the payback period for this project? Should the project be accepted if the required payback period is 3 years?

Payback

Year Cash flow Cumulative cash flow 1 $46,000 $ 46, 2 $54,000 $100, 3 $57,500 $157, 4 $38,900 $196, 5 $46,500 $242,

4. 0559 4. 06 years $ 46 , 500

Payback 4   

The Discounted Payback

• (^) The length of time until the sum of the discounted cash flows is equal to the initial investment
• (^) Discounted payback rule
  • (^) An investment is acceptable if its discounted

payback is less than some prespecified

number of years

Discounted payback

A project has an initial cost of $200,000 and produces cash inflows of $86,000, $93,600, $42,000 and $38,000 over the next four years, respectively. What is the discounted payback period if the discount rate is 10%? Should this project be accepted if the required discounted payback period is 3 years?

Advantages and Disadvantages of the Discounted Payback Period Rule

What is Return on Average Investment (ROI)?

• (^) The average annual net income from an investment expressed as a percentage of the average amount invested.
• (^) ROI = Average Estimated Net Income * 100 Average Investment Average Investment = Original Cost+ Salvage Value 2
• a common weakness: fails to consider that the present value of an investment, timing of its future cash flow.
• (^) Fails to consider whether the purchase price of the investment must be paid in advance or installment stretching over a period of year

Average accounting return

8. 25 %

. 08246 $ 67 , 000 $ 5 , 525 2 $ 134 , 000 $ 0 4 $ 4 , 700 $ 5 , 100 $ 5 , 800 $ 6 , 500 Average book value Averagenet income AAR         

Advantages and Disadvantages of the Average Accounting Return