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Net Present Value and Other Investment Rules Chapter 5 Copyright 169。 2021 by the McGrawHill Companies, Inc. All rights reserved. McGrawHill/Irwin 51 Key Concepts and Skills ? Be able to pute payback and discounted payback and understand their shortings ? Be able to pute the internal rate of return and profitability index, understanding the strengths and weaknesses of both approaches ? Be able to pute present value and understand why it is the best decision criterion 52 Chapter Outline Why Use Net Present Value? The Payback Period Method The Discounted Payback Period Method The Internal Rate of Return Problems with the IRR Approach The Profitability Index The Practice of Capital Budgeting 53 Why Use Net Present Value? ? Accepting positive NPV projects benefits shareholders. ? NPV uses cash flows ? NPV uses all the cash flows of the project ? NPV discounts the cash flows properly 54 The Net Present Value (NPV) Rule ? Net Present Value (NPV) = Total PV of future CF’s + Initial Investment ? Estimating NPV: 1. Estimate future cash flows: how much? and when? 2. Estimate discount rate 3. Estimate initial costs ? Minimum Acceptance Criteria: Accept if NPV 0 ? Ranking Criteria: Choose the highest NPV 55 Calculating NPV with Spreadsheets ? Spreadsheets are an excellent way to pute NPVs, especially when you have to pute the cash flows as well. ? Using the NPV function: ? The first ponent is the required return entered as a decimal. ? The second ponent is the range of cash flows beginning with year 1. ? Add the initial investment after puting the NPV. 56 The Payback Period Method ?How long does it take the project to “pay back” its initial investment? ? Payback Period = number of years to recover initial costs ? Minimum Acceptance Criteria: ? Set by management ? Ranking Criteria: ? Set by management 57 The Payback Period Method ? Disadvantages: ? Ignores the time value of money ? Ignores cash flows after the payback period ? Biased against longterm proje