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Chapter 8 NPV and others investment criteria (payback period (Criteria…
Chapter 8 NPV and others investment criteria
Net Present Value
If NPV is positive (more than zero), accept the project
measure of how well the project will meet the goal of increasing shareholder wealth.
dominant/ primary method of evaluation
Criteria Evaluation
consider all cash flow
consider time value of money
adjusts for the risk
can rank mutually exclusive projects
Average accounting return
If AAR greater than target rate, accept the project
Criteria Evaluation
ignore Time value of money
not count the future cash flow
Advantages
easy to calculate
needed information usually avaiiable
Disadvantages
not true rate of return
ignore time value of money
arbitrary benchmark cutoff rate
based on accounting net income and book values
payback period
how long does it take to recover the initial cost of a project.
compute
estimate the cash flow
substract future cash flow from initial cost
if payback period less than preset limit, accept the project
Criteria Evaluation
not consider time value of money
not adjusts for the risk
can rank the projects
measure break-even only
Advantages
easy to understand
adjust for uncetainty of later cash flow
biased towards liquidity
Disadvantages
ignore TVM
arbitrary cutoff point
ignore future cash flow beyond cutoff
biased againts long term project
profitability index
measure the benefit per unit cost, based on the time value of money
very useful in situation of capital rationing
Advantages
closely related to NPV
easy to understand
useful for capital rationing
Disadvantages
may lead to incorrect decisions in comparison mutually exclusive (conflict with NPV)
independent vs mutually exclusive
independent
acceptance of one project is unaffected by acceptance of the other
mutually exclusive
the acceptance of one project precludes accepting the others.
