IF accpet / reject==> not affect the cash flows of another project.

IF accept ==> preculde the acceptance of competing projects

NON-discounting methods

1) The number of years required to recover a project's cost

2) How long it takes to get our money back.

Decision Rule:
An investment is acceptable if its calculated pay back < a pre-specified cut off rate.

A:
1) Provides an indication of a project's risk and liquidity
2) Easy to calculated and understand

DIS:
1) Ignores the time of the value of money
2) Ignores CFs occurring after the payback period

1) The required rate of return (r)=the minimum return that a project must earn in order to be acceptable
2) The cost of capital (k)= the minimum required rate of return for capital budgeting purposes
3)The cost of capital (k) is the cost of investment funds= a weighted average of the cost of funds from all sources

Discounted Rule: Accept a project if NPV >0
NPV: Sum of the PVs of inflows and outflows -cost CF0 = often negative

1) NPV= PV( Benefits or Inflows)-PV( Costs)=Net gain in wealth;
2) choose between mutually exclusive projects on the basis of higher NPV
3) The project with the highest NPV +greatest value

-IF projects S & L are mutually exclusive: Accept S NPV s> NPV l
-IF S&L are independent : Accept both as NPV > 0 for both project.

A:
1) Uses cash flows (not earnings)
2) Uses ALL cash flows of a project
3) Discounts cahs flows properly

DIS:
1) Relies on accurate estimate of CFs & the discount rate
2) Projects likely to be replicated with maturity of differing lengths

1) IRR = the discount rate that forces PV inflows= cost
This is the same as forcing the NPV=0
2) IRR is popular==> provides a single number that summarizes the merit of a project.

Decision Rule:
IF IRR>0=accept project
IF IRR<k= reject project
( The project's IRR > its cost ---some return id left over to boost stockholders' returns
e.g.:IF k=10% and IRR= 15%, the project is profitable

IRR: Enter NPV=0, Solve for IRR

Decisions on Projects S and L using the IRR method:

IF S AND Lare independent projects:
accept both becsuse IRRs>K

IF S AND L are mutually exclusive projects :
accept S ---IRRs > IRR l

NOTE:
there are some potential errors with the use of IRR in deciding between mutually exclusive projects.

Conflict between IRR & NPV
1) when k > crossover rate==IRR & NPV leads to the same decision
2) when k < crossover ==Conflict between NPV & IRR

Among projects with equal lives, NPV is always preferred as it measures additional wealth obtained (which should we use?)

To find the crossover Rate:
1) Find cash flow differences between the projects (the incremental cash flows -
the change in cash flows )

2) Incremental CF's L-S and calculate the IRR of incremental cash flow

3) Subtract S from L or vice versa, but better to have first CF negative

4) IF profiles don's cross, one project fominates the other.

2 Reasons NPV profiles Cross
1) Size (scale) differences: smaller project frees up funds at T=0 for investment

(the higher the opportunity cost, the more valuable these funds, so high K favours small projects.)
2) Timing differences
Project with faster payback provides more CF in early years for reinvestment

(If k is high, early CFs are especially good, NPVs > NPV L)

Reinvestment Rate Assumptions:
1) NPV assumes reinvestment at k
IRR assumes reinvestment at IRR
Reinvestment at opportunity cost, k, is more realistic ==NPV method is best
NPV should always be used to choose betwenn mutually exculsive projects( cash is king)