What is NPV
Net present value - present value of future cash flows minus initial investment
When to accept or reject projects based on NPV
Accept if NPV > 0
Reject if NPV < 0
What does a positive NPV mean
The project increases firm value
Why is NPV the best method
- uses all cash flows
- accounts for time value of money (discounts cash flows properly)
- measures value created
What type of data does NPV use
Cash flows
NOT accounting earnings
Why are earnings not used in NPV
Because they don’t reflect actual cash movement
What is Operating Cash Flow (OCF)
Cash generated from normal business operations
What is included in OCF
- revenues
- operating costs
- taxes
What is not included in OCF
- depreciation (non-cash)
- interest (financing cost)
What is the payback period
Time it takes to recover initial investment
Main problem with payback method
- ignores time value of money
- ignores cash flows after payback
Advantages of payback method
Simple and measures liquidity
What is discounted payback, and decision rule
Payback period using discounted cash flows.
Accept project if it pays back on a discounted basis within specified time.
Problem with discounted payback
- Still ignores cash flows after payback period
- biased against long-term projects
- requires an arbitrary acceptance criteria
What is IRR
Internal rate of return
Discount rate that makes NVP = 0
IRR decision rule, when to accept
Accept if IRR >= required return
Reject if IRR < required return
Advantage of IRR
Easy to understand (percentage return)
Disadvantages of IRR
- doesn’t distinguish between investing and borrowing
- IRR may not exist or may be multiple IRR
- problems with mutually exclusive investments
What happens if no IRR exists
Cannot use IRR, so need to rely on NPV
What is the scale problem (IRR)
Higher IRR doesn’t always mean high value (NPV might be bigger for other project)
What is the timing problem (IRR)
When projects have different cash-flow timing patterns
Project w earlier cash inflows usually has a higher IRR.
Project w later, larger inflows may have lower IRR but higher NPV.
Conflict: IRR favors project w quick payback, NPV recognized larger long-term value
Decision rule for mutually exclusive projects
Choose the project with the highest NPV
What are independent projects
Projects that don’t affect each other
Decision rule for independent projects
Accept all with NPV > 0
