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◉ Investment R ule:
◉ Accept project if NPV is positive or equal to zero.
◉ R eject project if NPV is negative.
Net Present Value (NPV)
◉ F ormula:
NPV = PV
- R equired Investment
E xample:
Given:
C0 = -$375,000
t =3
C1 = $25,000
C2 = $25,000
C3 = $475,000 ($450,000 + $25,000)
r = 7%
Net Present Value (NPV)
◉ Investment R ule:
◉ Accept project if IR R is greater than the opportunity
cost of capital (required return).
◉ Otherwise, reject project.
Internal R ate of R eturn
(IR R )
◉ F ormula: Pr ofit
IRR
Investment
Let NPV=0,
Ct
0 C0
1 IRR
Internal R ate of R eturn
(IR R )
Note:
◉ Leads to the same decision or result as the NPV for
independent projects with conventional cash flows.
E xample of mutually
exclusive projects using NPV
& IR R
◉ E xample:
CASH FLOWS (in millions)
D -5 5 20 16 16/5=3.2
E -5 5 15 12 12/5=2.4
Profitability Index
◉ Investment R ule:
◉ If the Profitability Index > 1.0, Accept
◉ This measure can be very useful in situations where
we have limited capital.
Profitability Index
C APITAL R ATIONING
◉ Limit set on the amount of funds available for
investment.
◉ Two reasons:
○ S oft R ationing
○ Hard R ationing
Profitability Index
S OF T R ATIONING
◉ It is when the restriction is imposed by the
management.
◉ R easons:
○ PROMOTERS’ DE C IS ION
○ AN INC R E AS E IN OPPOR TUNITY C OS T OF
C APITAL
○ F UTUR E S C E NAR IOS
Profitability Index
HAR D R ATIONING
◉ It is when the capital infusion is limited by
external sources.
◉ R easons:
○ S TAR T-UP F IR MS
○ POOR MANAGE ME NT / TR AC K R E C OR D
○ LENDER’S R E S TR IC TIONS
○ INDUS TR Y S PE C IF IC F AC TOR S
Payback Period
◉ Investment R ule:
◉ Accept project if the payback period is less than
some preset limit (specified number of years).
Payback Period
Initial Investment
◉ F ormula: Payback Period
Cash flow per period
◉ E xample:
Year of Cost of PV NPV at Year of
NPV Today Decision
Purchase Purchase Savings Purchase (r=10%)
0 $50 $70 $20 $20.0
1 45 70 25 22.7
2 40 70 30 24.8
3 36 70 34 25.5 optimal purchase date
4 33 70 37 25.3
5 31 70 39 24.2
The Choice between Long-
and Short-Lived E q uipment
PV of costs
Equivalent annual annuity
Annuity factor
The Choice between Long-
and Short-Lived E q uipment
◉ S teps:
1. Get the P resent Value of the costs of machine
2. Get the Annuity F actor
3. C alculate the E quivalent Annual Annuity of the project
4. S elect the project that has the lowest E AA
Costs (in thousands) PV at
EAA
0 1 2 3 6%
Machine I 15 4 4 4 ? ?
Machine J 10 6 6 - ? ?
When to R eplace an Old
Machine
◉ When to replace?
◉ E xample:
Costs (in thousands) PV at
EAA
0 1 2 3 4 5 6%
Machine I 25 8 8 8 8 8 $58.70 ?