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k=10%
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k=10%
0 1 2 3 4
k=10%
0 1 2 3 4
k=10%
0 1 2 3 4
k=10%
0 1 2 3 4
k=10%
0 1 2 3 4
Mutually Exclusive:
Means that the acceptance of one project precludes the
acceptance of the other projects under consideration.
(You may only choose one.)
12
Net Present Value Profile
Net Present Value Profile:
a graph of the NPV of a project at different
discount rates shows the NPV at 3 different
points:
a zero discount rate
the normal discount rate (or cost of capital)
the IRR
allows an easy way to visualize whether or
not an investment should be undertaken
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0
5% 10% 15% 20%
Cost of Capital
0
5% 10% 15% 20%
Cost of Capital
0
5% 10% 15% 20%
Cost of Capital
0
5% 10% 15% 20%
Cost of Capital
0
5% 10% 15% 20%
Cost of Capital
PROJECT A
0
5% 10% 15% 20%
Cost of Capital
0
5% 10% 15% 20%
Cost of Capital
500
NPV(0%) = + 500 + 4,6003 + 10,000 – 10,000
(1+ 0 ) (1+ 0)2 (1+ 0 ) (1+ 0)
4
= $5,600
20
0
5% 10% 15% 20%
Cost of Capital
500
NPV(5%) = + 500 2 + 4,600 3 + 10,000 4 – 10,000
(1+.05) (1+.05) (1+ .05) (1+ .05)
= $3,130
21
0
5% 10% 15% 20%
Cost of Capital
500
NPV(10%) = + 500 2 + 4,600 3 + 10,000 4 – 10,000
(1+.10) (1+.10) (1+ .10) (1+ .10)
= $1,154
22
0
5% 10% 15% 20%
Cost of Capital
500
NPV(15%) = + 500 2 + 4,600 3 + 10,000 4 – 10,000
(1+.15) (1+.15) (1+ .15) (1+ .15)
= –$445
23
0
5% 10% 15% 20%
Cost of Capital
3,000
0
5% 10% 15% 20%
Cost of Capital
25
3,000
PROJECT A
0
5% 10% 15% 20%
Cost of Capital
27
Definition:
The IRR is the discount rate where NPV = 0
28
Definition:
The IRR is the discount rate in which NPV = 0
6,000
N
P PROJECT B
V
3,000
NPV = $0
0
5% 10% 15% 20%
Cost of Capital
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Definition:
The IRR is the discount rate in which NPV = 0
6,000
N
P PROJECT B
V
3,000
IRRA ≈ 15%
NPV = $0
IRRB ≈ 14%
0
5% 10% 15% 20%
Cost of Capital
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Outflow = PV of Inflows
Solve for Discount Rates
33
Independent Projects
Accept Projects with
IRR ≥ required rate
Profitability Index
PI = PV of Inflows
Initial Outlay
PI =
10,000
11,095
PI = = 1.1095
10,000
40
Comparison of Methods
Comparison of Methods
Time Value of Money
Payback - Does not adjust for timing differences
NPV, IRR and PI take into account the time value of
money
Relevant Cash Flows?
NPV, IRR and PI use all Cash Flows
Payback method ignores Cash Flows that occur
after the Payback Period.
Project 1
0 1 2
Both Projects have
(10,000) 5,000 5,000
Identical Payback
Project 2
0 1 2 3
Comparison of Methods
NPV & PI indicated accept Project B while IRR
indicated that Project A should be accepted. Why?
Reinvestment Rate
NPV assumes cash flows are reinvested at the
required rate, k.
IRR assumes cash flows are reinvested at IRR.
Reinvestment Rate of k more realistic as most
projects earn approximately k (due to competition)
Conclusion: NPV is the Better Method for project
evaluation
44
Summary Problem:
A project costs $900 and will repay $300, $400, $400,
$500, and $600 over the first five years, respectively.
0 1 2 3 4 5
45
Summary Problem:
Answers:
• IRR = 34.37%.
• Using a discount rate of 15%,
NPV = $510.52.
• PI = 1.57.
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