Measuring Investment Value: You Can Trust NPV
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Transcript Measuring Investment Value: You Can Trust NPV
Chapter 6 --Alternate Measures of
Capital Investment Desirability
Goals for this chapter:
Know
how to calculate the following measures of
investment desirability:
Net present value
Profitability index
Internal rate of return
Payback period
Strengths
Modified profitability index
Modified internal rate of return
Present value payback
and weaknesses of various methods
Know the reasons for multiple measures and when each
would be appropriately used in reality
Calculating a Net Present Value
Steps
to calculate the net present value:
Step 1 -- Lay out the years and cash flows
Step 2 -- Discount back to present with the
NPV function
Step 3 -- Net the result of step 2 with the
initial outlay
Calculating a Profitability Index
Steps
to calculate the profitability index:
Step 1 -- Calculate the net present value
Step 2 -- Use the formula in the book to
calculate the PI
PI = 1 + NPV/ Initial outlay (always
positive)
When Would You Use the
Profitability Index?
As
a very crude short cut when your firm is facing capital
rationing
Capital rationing may exist when the firm is not large
enough or profitable enough to raise money in the capital
markets
This is not uncommon for small, new or rapidly growing
businesses
You must still watch for size differentials
Might use this when you cannot see all your projects at one
time (which is often the case)
Calculating the Internal
Rate of Return
Steps
to calculate the internal rate of return:
Lay out the years and cash flows
Discount back to present with
the IRR function on the calculator as
described in earlier chapters
Must use the goal seek tool (under the
tools menu) on the computer if you have
mid-year cash flows
Weaknesses of the
Internal Rate of Return
Weaknesses
of the internal rate of return:
It assumes that new projects will come along
in future years that will pay at least the
internal rate of return (reinvestment rate
assumption
It ignores the size of the project
Calculating the Modified
Internal Rate of Return
Steps
to calculate the modified internal rate of return:
Begin with year 1 and grow to the end of the project
by multiplying by 1 plus the discount rate raised to the
remaining years
Do this for all remaining cash flows
Sum the terminal values
Fill the intermediate years with zeros
Use the IRR function to solve for the modified IRR
Strengths of the Modified
Internal Rate of Return
Strengths
It
of the modified internal rate of return:
eliminates the reinvestment rate assumption
There appears to be many cases where companies in
the US are generating more cash than worthwhile
projects. In this case, the MIRR may give a better
indication of the return from the project
MIRR is a worst case scenario which assumes that
excess cash is used to retire debt and equity. By
definition this action earns the cost of money
Calculating a Payback Period
Steps
to calculating the payback period:
Lay out your years and cash flow
Accumulate the cash flows
Identify where the accumulation goes from
negative to positive
Use the year on the left
Use the result in step 4 and add the amount
needed divided by the amount received
Strengths and Weaknesses of the
Payback Period Method
Weaknesses
of the payback method:
It ignores the time value of money
It ignores all cash flows after the payback
period
It ignores risk
Strengths of the payback method:
It is a measure of liquidity
It can be used as a short cut in industries
where the product life is very short
Reasons for Multiple Measures
Different
measures for different
circumstances
Multiple measure allow members of the
committee to use the measures with
which they are comfortable
Multiple measures may provide better
information