The document discusses and compares net present value (NPV) and payback rules for capital budgeting and investment decisions. It defines NPV as the present value of expected future cash flows less the initial investment, and that projects with positive NPV should be accepted. It also defines payback period as the time required to recover the initial cost of an investment. While payback period is easy to understand, it ignores the time value of money and cash flows beyond the payback date. The discounted payback rule includes time value but still ignores later cash flows and may reject positive NPV projects. NPV is generally considered a better method for investment decisions as it captures the full financial impact of projects.

1. GROUP 1

2. THE BASICTHE BASIC
IDEAIDEA

3.  The difference between an investment’s marketThe difference between an investment’s market
value and its costvalue and its cost
 A measure of how much value is created or addedA measure of how much value is created or added
today by undertaking an investmenttoday by undertaking an investment
 Given our goal of creating value for the stockholders,Given our goal of creating value for the stockholders,
the capital budgeting process can be viewed as athe capital budgeting process can be viewed as a
search for investments with positive NPVsearch for investments with positive NPV
NET PRESENT VALUE

4.  How much value is created from undertaking anHow much value is created from undertaking an
investment?investment?
 The first step is to estimate the expected future cashThe first step is to estimate the expected future cash
flowflow
 The second step is to estimate the requiredThe second step is to estimate the required
return forreturn for
projects of this risk levelprojects of this risk level
 The third step is to find the present value of theThe third step is to find the present value of the
cashcash
flows and subtract the initial investmentsflows and subtract the initial investments

5. NPV – Decision RuleNPV – Decision Rule
 If NPV is POSITIVE, ACCEPT the projectIf NPV is POSITIVE, ACCEPT the project
 A positive NPV means that the project isA positive NPV means that the project is
expected to add value to the firm and willexpected to add value to the firm and will
therefore increase the wealth of the ownerstherefore increase the wealth of the owners
 Since our goal is to increase owner wealth,Since our goal is to increase owner wealth,
NPV is a direct measure of how well thisNPV is a direct measure of how well this
project will meet our goalproject will meet our goal

6. Project ExampleProject Example
InformationInformation
Based on projected sales and costs, we expect that theBased on projected sales and costs, we expect that the
cash flows over the five year life of the project will becash flows over the five year life of the project will be
RM2000 in the first two years, RM4000 in the next twoRM2000 in the first two years, RM4000 in the next two
years, and RM5000 in the last year. It will costs aboutyears, and RM5000 in the last year. It will costs about
RM10000 to begin the production. We use a 10 percentRM10000 to begin the production. We use a 10 percent
discount rate to evaluate new products. What should wediscount rate to evaluate new products. What should we
do?do?

7. Computing NPV for theComputing NPV for the
ProjectProject
Using the formulas:Using the formulas:
Present Value: (RM 2000/1.1) + (RM 2000/1.1)2Present Value: (RM 2000/1.1) + (RM 2000/1.1)2
+ (RM 4000/1.1)3 + (RM 4000/1.1)4 + (RM+ (RM 4000/1.1)3 + (RM 4000/1.1)4 + (RM
5000/1.1)55000/1.1)5
=RM (1818+1653+3005+2732+3105)=RM (1818+1653+3005+2732+3105)
=RM 12313=RM 12313
NPV : RM (12313-10000)=RM 2313NPV : RM (12313-10000)=RM 2313

8. Payback Rule
Payback PeRiod
 The amount of time required for an investment
to generate cash flows sufficient to recover its
initial cost.
 How long does it take to get the initial cost
back in a nominal sense.

9. decision Rule
Accept if the payback period is less than some preset
limit.

10. THE PAYBACK RULETHE PAYBACK RULE
• There are several disadvantages for the payback rule.There are several disadvantages for the payback rule.
i.i. The time value of money is ignored.The time value of money is ignored.
The payback period is calculated by simply adding upThe payback period is calculated by simply adding up
the future cash flows.the future cash flows.
• Analyzing the RuleAnalyzing the Rule
No discounting involved.No discounting involved.
ii.ii.Fails to consider any risk differences.Fails to consider any risk differences.
iii.iii.Coming up with the right cutoff period.Coming up with the right cutoff period.
No objective basis for choosing a particular year.No objective basis for choosing a particular year.
No economic rationale for looking at payback.No economic rationale for looking at payback.
No guide on how to pick the cutoff.No guide on how to pick the cutoff.
Using a number that is chosen without any rationalUsing a number that is chosen without any rational
reason.reason.

11. Redeeming Qualities Of The RuleRedeeming Qualities Of The Rule
• The payback period rule is often used by largeThe payback period rule is often used by large
companies when making minor decision.companies when making minor decision.
• In addition to its simplicity, the payback ruleIn addition to its simplicity, the payback rule
has two other positive features.has two other positive features.

12. • First, because it is biased toward short-termFirst, because it is biased toward short-term
project, it is biased towards liquidity.project, it is biased towards liquidity.
• Second, the cash flows that are expected toSecond, the cash flows that are expected to
occur later in a project’s life are probably moreoccur later in a project’s life are probably more
uncertain.uncertain.

13. THE PAYBACK RULETHE PAYBACK RULE
AdvantagesAdvantages DisadvantagesDisadvantages
 Easy to understand.Easy to understand.
 Adjusts for uncertaintyAdjusts for uncertainty
of later cash flows.of later cash flows.
 Biased towardsBiased towards
liquidity.liquidity.
Ignores the time valueIgnores the time value
of money.of money.
Requires a cutoff pointRequires a cutoff point
without any reason.without any reason.
Ignores cash flowsIgnores cash flows
beyond the cutoff date.beyond the cutoff date.
Biased against long-Biased against long-
term projects, such asterm projects, such as
research andresearch and
development, and newdevelopment, and new
projects.projects.

14. THE PAYBACK RULETHE PAYBACK RULE
• SummarySummary
• Payback period is a kind of “break-even”Payback period is a kind of “break-even”
measure.measure.
Because time value is ignored.Because time value is ignored.
Payback period as the length of time it takesPayback period as the length of time it takes
to break even in an accounting sense, butto break even in an accounting sense, but
not in an economic sense.not in an economic sense.
Payback rule doesn’t ask the right question.Payback rule doesn’t ask the right question.
Nevertheless, companies use it as a screenNevertheless, companies use it as a screen
for dealing with a large number of minorfor dealing with a large number of minor
investment decision that they have to makeinvestment decision that they have to make

15. THE DISCOUNTED PAYBACK
 The length of time until the sum of discounted cash
flows is equal to the initial investment.
 The discounted payback rule would be :-
 Based on the discounted payback rule, an
investment is acceptable if its discounted payback
is less than some prespecified number of years.

16. Computing disCounted paybaCk
for the projeCt
 Assume we will accept the project if it pays
back on a discounted basis in 2 years.
 Compute the PV for each cash flow and
determine the payback period using discounted
cash flows
 YEAR 1 : 165,000 – 63,120/1.12^1= 108,643
 YEAR 2 : 108,643 – 70,800/1.12^2 = 52,202
 YEAR 3 : 52,202 – 91,080/1.12^3 = -12,627
PROJECT PAY BACK IN YEAR 3

17. adVantages and disadVantages of disCounted
paybaCk
ADVANTAGESADVANTAGES
*INCLUDES TIME VALUE OF*INCLUDES TIME VALUE OF
MONEYMONEY
*EASY TO UNDERSTAND*EASY TO UNDERSTAND
*DOES NOT ACCEPT NEGATIVE*DOES NOT ACCEPT NEGATIVE
ESTIMATED NPVESTIMATED NPV
INVESTMENTS WHEN ALLINVESTMENTS WHEN ALL
FUTURE CASHFUTURE CASH
FLOWS ARE POSITIVEFLOWS ARE POSITIVE
*BIASED TOWARDS LIQUIDITY*BIASED TOWARDS LIQUIDITY
DISADVANTAGESDISADVANTAGES
*MAY REJECT POSITIVE NPV*MAY REJECT POSITIVE NPV
INVESTMENTSINVESTMENTS
*REQUIRES AN ARBITRAY*REQUIRES AN ARBITRAY
CUTOFF POINTCUTOFF POINT
*IGNORES CASH FLOWS*IGNORES CASH FLOWS
BEYOND THE CUTOFF POINTBEYOND THE CUTOFF POINT
*BAISED AGAINST LONG-TERM*BAISED AGAINST LONG-TERM
PROJECTS, SUCH AS R&D ANDPROJECTS, SUCH AS R&D AND
NEW PRODUCTS.NEW PRODUCTS.