1. 6 Corporate Financial Management 2e Emery Finnerty Stowe Business Investment Rules

8. Generating ideas for capital budgeting projects Research and Development Division Management Plant Management Production Management Strategic Planning ideas ideas ideas ideas ideas ideas ideas ideas

16. IRR example 7.03 A project costs $10,000 and is expected to generate cash flows of $2,100 each year for six years. What is the project’s IRR? CALCULATOR SOLUTION Data Input Function Key N I PV PMT FV 6 10,000 – 2,100 0

19. NPV Profile: Example Cash Flow Initial Investment Cash Flow in years 1 to 5 Cash Flow in years 6 to 9 Cash Flow in year 10 - $3,985,000 $806,000 $926,000 $1,151,000 Consider a 10-year project with these cash flows:

20. NPV Profile NPV ($ thousands) Discount Rate The project has a positive NPV at discount rates less than 16.95% And a negative NPV at discount rates more than 16.95% IRR 16.95%

26. If the discount rate is less than 45%, project A is the best choice. If the discount rate is more than 45%, project B is the best choice. If the discount rate is more than 68% don’t take A or B rate -over Cross 45%

29. NPV Profile of Non-Conventional Projects Discount Rate NPV IRR 2 = 25% Here we see that the project actually has two IRRs: 12% and 25% You have to be careful interpreting IRR. IRR 1 = 12%

32. Profitability Index Decision Rule: Undertake the project if PI > 1.0 PI PV of Future Cash Flows Initial Investment NPV Initial Investment = = + 1

34. Profitability Index Project Alpha Project Beta Year 0 Cash Flow Year 1 Cash Flow ($1,000) $1,200 ($8,000) $9,200 NPV @ 12% PI $71.43 1.071 $214.29 1.027

39. Payback and Discounted Payback Year Project X Project Y 0 1 2 3 4 ($8,000) $4,000 $4,000 $2,000 $2,000 ($8,000) $2,000 $2,000 $4,000 $6,000

40. Payback and Discounted Payback for Project X Discounted Year Cash Flow Cumulative Cash Flow Cash Flow Cumulative Cash Flow 0 1 2 3 4 ($8,000) $4,000 $4,000 $2,000 $2,000 ($8,000) ($4,000) $0 ($8,000) $3,571 $3,189 $1,424 $1,271 ($8,000) ($4,429) ($1,240) $184

41. Payback and Discounted Payback for Projects X and Y * Discount rate = 12% Project X Project Y Payback Discounted Payback* NPV* 2 years 2.87 years $1,455 3 years 3.46 years $2,040

43. Average Rate of Return (ARR) The ARR method distorts all cash flows by averaging them over time. It ignores the time value of money. It is a useless method. ARR Average Cash Flow Average Amount Invested =