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1、McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.6-0Chapter Outline6.1 Why Use Net Present Value?6.2 The Payback Period Rule6.3 The Discounted Payback Period Rule6.4 The Average Accounting Return6.5 The Internal Rate of Return6.6 Problems with the IRR Approach6.7
2、The Profitability Index6.8 The Practice of Capital Budgeting6.9 Summary and ConclusionsMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.6-16.1 Why Use Net Present Value?Accepting positive NPV projects benefits shareholders.NPV uses cash flowsNPV uses all the cash
3、flows of the projectNPV discounts the cash flows properlyMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.6-2The Net Present Value(NPV)RuleNet Present Value(NPV)=Total PV of future CFs+Initial InvestmentEstimating NPV:1.Estimate future cash flows:how much?and when
4、?2.Estimate discount rate3.Estimate initial costsMinimum Acceptance Criteria:Accept if NPV 0Ranking Criteria:Choose the highest NPVMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.6-3Good Attributes of the NPV Rule1.Uses cash flows2.Uses ALL cash flows of the proj
5、ect3.Discounts ALL cash flows properlyReinvestment assumption:the NPV rule assumes that all cash flows can be reinvested at the discount rate.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.6-46.2 The Payback Period RuleHow long does it take the project to“pay ba
6、ck”its initial investment?Payback Period=number of years to recover initial costsMinimum Acceptance Criteria:set by managementRanking Criteria:set by managementMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.6-5The Payback Period Rule(continued)Disadvantages:Igno
7、res the time value of moneyIgnores cash flows after the payback periodBiased against long-term projectsRequires an arbitrary acceptance criteriaA project accepted based on the payback criteria may not have a positive NPVAdvantages:Easy to understandBiased toward liquidityMcGraw-Hill/IrwinCopyright 2
8、002 by The McGraw-Hill Companies,Inc.All rights reserved.6-66.3 The Discounted Payback Period RuleHow long does it take the project to“pay back”its initial investment taking the time value of money into account?By the time you have discounted the cash flows,you might as well calculate the NPV.McGraw
9、-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.6-76.4 The Average Accounting Return RuleAnother attractive but fatally flawed approach.Ranking Criteria and Minimum Acceptance Criteria set by managementDisadvantages:Ignores the time value of moneyUses an arbitrary benc
10、hmark cutoff rateBased on book values,not cash flows and market valuesAdvantages:The accounting information is usually availableEasy to calculateMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.6-8 6.5 The Internal Rate of Return(IRR)RuleIRR:the discount that sets
11、 NPV to zero Minimum Acceptance Criteria:Accept if the IRR exceeds the required return.Ranking Criteria:Select alternative with the highest IRRReinvestment assumption:All future cash flows assumed reinvested at the IRR.Disadvantages:Does not distinguish between investing and borrowing.IRR may not ex
12、ist or there may be multiple IRR Problems with mutually exclusive investmentsAdvantages:Easy to understand and communicateMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.6-9The Internal Rate of Return:ExampleConsider the following project:0123$50$100$150-$200The
13、internal rate of return for this project is 19.44%McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.6-10The NPV Payoff Profile for This ExampleIf we graph NPV versus discount rate,we can see the IRR as the x-axis intercept.IRR=19.44%McGraw-Hill/IrwinCopyright 2002
14、by The McGraw-Hill Companies,Inc.All rights reserved.6-116.6 Problems with the IRR ApproachMultiple IRRs.Are We Borrowing or Lending?The Scale Problem.The Timing Problem.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.6-12Multiple IRRsThere are two IRRs for this
15、project:0 1 2 3$200$800-$200-$800100%=IRR20%=IRR1Which one should we use?McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.6-13The Scale ProblemWould you rather make 100%or 50%on your investments?What if the 100%return is on a$1 investment while the 50%return is on
16、 a$1,000 investment?McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.6-14The Timing Problem0 1 2 3$10,000$1,000$1,000-$10,000Project A0 1 2 3$1,000$1,000$12,000-$10,000Project BThe preferred project in this case depends on the discount rate,not the IRR.McGraw-Hill
17、/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.6-15The Timing Problem10.55%=crossover rate12.94%=IRRB16.04%=IRRAMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.6-16Calculating the Crossover RateCompute the IRR for either project“A-B”or“
18、B-A”10.55%=IRRMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.6-17Mutually Exclusive vs.Independent ProjectMutually Exclusive Projects:only ONE of several potential projects can be chosen,e.g.acquiring an accounting system.RANK all alternatives and select the bes
19、t one.Independent Projects:accepting or rejecting one project does not affect the decision of the other projects.Must exceed a MINIMUM acceptance criteria.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.6-186.7 The Profitability Index(PI)RuleMinimum Acceptance Cr
20、iteria:Accept if PI 1Ranking Criteria:Select alternative with highest PIDisadvantages:Problems with mutually exclusive investmentsAdvantages:May be useful when available investment funds are limitedEasy to understand and communicateCorrect decision when evaluating independent projectsMcGraw-Hill/Irw
21、inCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.6-196.8 The Practice of Capital BudgetingVaries by industry:Some firms use payback,others use accounting rate of return.The most frequently used technique for large corporations is IRR or NPV.McGraw-Hill/IrwinCopyright 2002 by The
22、 McGraw-Hill Companies,Inc.All rights reserved.6-20Example of Investment RulesCompute the IRR,NPV,PI,and payback period for the following two projects.Assume the required return is 10%.Year Project AProject B0-$200-$1501$200$502$800$1003-$800$150McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Com
23、panies,Inc.All rights reserved.6-21Example of Investment RulesProject AProject BCF0-$200.00-$150.00PV0 of CF1-3$241.92$240.80NPV=$41.92$90.80IRR=0%,100%36.19%PI=1.20961.6053 McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.6-22Example of Investment RulesPayback Pe
24、riod:Project AProject BTimeCFCum.CFCFCum.CF0-200-200-150-1501200050-100280080010003-8000150150Payback period for project B=2 years.Payback period for project A=1 or 3 years?McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.6-23Relationship Between NPV and IRRDiscou
25、nt rateNPV for A NPV for B-10%-87.52234.770%0.00150.0020%59.2647.9240%59.48-8.6060%42.19-43.0780%20.85-65.64100%0.00-81.25120%-18.93-92.52McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.6-24Project AProject B($200)($100)$0$100$200$300$400-15%0%15%30%45%70%100%130
26、%160%190%Discount ratesNPVIRR 1(A)IRR(B)NPV ProfilesIRR 2(A)Cross-over RateMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.6-256.9 Summary and ConclusionsThis chapter evaluates the most popular alternatives to NPV:Payback periodAccounting rate of returnInternal rate of returnProfitability indexWhen it is all said and done,they are not the NPV rule;for those of us in finance,it makes them decidedly second-rate.