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Lecture 4: NPV and other investment rule (Average Accounting Return…
Lecture 4: NPV and other investment rule
NPV
Investment Rule
Reject
NPV<0
Accept
NPV>0
Strengths of NPV
Uses all CF
Discounted CF
Weakness of NPV
Size of the project is not measured (eg: a $1 million project will likely have a much higher NPV than a $1,000 project, even if the $1,000 project provides much higher returns in percentage terms)
It requires guesswork on firms cost of capital
Payback Period
Investment Rule
Accept
Period is less than benchmark
Reject
Period is more than benchmark
Strengths
easy to compute
Risk Focus (ie: the analysis focus on when is the shortest time for the project to breakeven)
Good for very small scale invesment
Good for firms with severe capital rationing
Weakness
Do not consider Time value of money
arbitrary cut off period
do not care about cash flow after the payback period
Discounted Payback Period
1.Investment Rule
Accept
Period Less than benchmark
Reject
Period more than benchmark
2.Strengths
Simple
Use time value of money
Weakness
Ignore cash flow beyond benchmark
Arbitrary benchmark
Average Accounting Return
Formula
Average Profit / Average Invesment
Investment Rule
Accept
Greater than target return
Reject
Less than target return
Strengths
Simple Return Base Measure
Weakness
No time value of money
no usage of cash flow
arbitrary target rate
Internal Rate of Return (IRR)
Investment Rule
Accept
Greater than Discount Rate
Reject
Less than Discount Rate
Strengths
Simple to interpret after IRR is calculated
Uses Time Value of Money
Weakness
Specific to Mutually Exclusive Project
Scale of Cash flow
Timing of Cash Flow
Economics of Scale Ignored
Impractical Implicit Assumption of Investment Rate
General Investment Rule NPV and IRR
1st Cash Flow Negative Remaining are Positive
No. of IRR = 1
Accept IRR>R, Reject IRR<R
Accept if NPV>0, Reject NPV<0
1st Cash Flow Positive, Remaining Negative
No.of IRR = 1
Accept IRR<R, Reject IRR>R
Accept NPV>0, Reject NPV<0
Mixture of Positive and Negative CF
No. of IRR = more than 1
No Valid IRR
Accept NPV>0, Reject NPV<0
Profitability Index
Formula
PI= PV of cash flow subsequent investment / Initial Investment
Investment Rule
Accept
PI>1
Reject
PI<1
Strengths
Consider time value of money
Consider All cash flow
PI makes the right in the case of different amount of cash outlay of different project.
PI ascertains the exact rate of return of the project
4.Weakness
It is difficult to understand interest rate or discount rate.
It is difficult to calculate profitability index if two projects having different useful life.