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Chapter Outline
6.1 NPV and Stand-Alone Projects 6.2 The Internal Rate of Return Rule 6.3 The Payback Rule 6.4 Choosing Between Projects 6.5 Project Selection with Resource Constraints
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Learning Objectives
1. Define net present value, payback period, internal rate of return, profitability index, and incremental IRR. 2. Describe decision rules for each of the tools in objective 1, for both stand-alone and mutually exclusive projects.
3. Given cash flows, compute the NPV, payback period, internal rate of return, and profitability index for a given project, and the incremental IRR for a pair of projects.
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Learning Objectives
4. Compare each of the capital budgeting tools above, and tell why NPV always gives the correct decision. 5. Discuss the reasons IRR can give a flawed decision. 6. Describe situations in which profitability index cannot be used to make a decision.
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NPV Rule
The NPV of the project is calculated as:
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If FFFs cost of capital is 10%, the NPV is $100 million and they should undertake the investment.
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The IRR is greater than the cost of capital. Thus, the IRR rule indicates you should accept the deal.
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Since the NPV is negative, the NPV rule indicates you should reject the deal.
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When the benefits of an investment occur before the costs, the NPV is an increasing function of the discount rate. 6Copyright 2011 Pearson Prentice Hall. All rights reserved.
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No IRR exists because the NPV is positive for all values of the discount rate. Thus the IRR rule cannot be used.
Copyright 2011 Pearson Prentice Hall. All rights reserved.
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Project B
$120 $30 = 4.0 years
Project C
$150 $35 = 4.29 years
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IRR Rule
Selecting the project with the highest IRR may lead to mistakes.
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Cash FlowYear 1
Annual Growth Rate Cost of Capital
$63,000
3% 8%
$80,000
3% 8%
IRR
NPV
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24%
$960,000
23%
$1,200,000
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Consider again the coffee shop and the music store investment in Example 6.3. Both have the same initial scale and the same horizon. The coffee shop has a lower IRR, but a higher NPV because of its higher growth rate.
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What is the IRR of each proposal? What is the incremental IRR? If your firms cost of capital is 10%, what should you do?
Copyright 2011 Pearson Prentice Hall. All rights reserved.
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Given
Solve for rate
-100
200
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Given
Solve for rate
-100
125
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(contd)
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(contd)
Because the 12.47% incremental IRR is bigger than the cost of capital of 10%, the long-term project is better than the short-term project, even though the short-term project has a higher IRR.
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Profitability Index
The profitability index can be used to identify the optimal combination of projects to undertake.
From Table 6.1, we can see it is better to take projects II & III together and forego project I.
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Project 2
Project 3 Project 4 Project 5 Total
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88,000
80,000 50,000 12,000 330,000
30,000
38,000 24,000 1,000 133,000
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Project 5
12,000
1,000
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Chapter Quiz
1. Explain the NPV rule for stand-alone projects. 2. If the IRR rule and the NPV rule lead to different decisions for a stand-alone project, which should you follow? Why? 3. For mutually exclusive projects, explain why picking one project over another because it has a larger IRR can lead to mistakes. 4. Explain why ranking projects according to their NPV might not be optimal when you evaluate projects with different resource requirements. 5. How can the profitability index be used to identify attractive projects when there are resource constraints?
Copyright 2011 Pearson Prentice Hall. All rights reserved.
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