ECON 435: Net Present Value & Other Investment Criteria

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ECON 435 > ECON 435: Net Present Value & Other Investment Criteria

Net Present Value

The Payback rule

• Payback period is amount of time until investment generates sufficient cash flow to repay initial investment & costs.
• NOTE: given this, good projects can have a NEGATIVE net present value

Discounted payback rule

• A much better rule, because returns are discounted to present
• Problems: You don't consider anything after payback period.

Average accounting return rule

• (Average net accounting income over the relevant period) / (average book value of investments required by project)
• Not economically meaningful. Based on book values & accounting incomes (bad)

Advantage

• Accounting data is widely available

Internal rate of return

• The IRR is the discount rate that makes the NPV=0. It's asking the quesiton - how high can I set the discount rate and still break even on the investment?

Discartes's rule of sign

• The number of IRRs=#of sign changes in cash flows, or is an even number less
  • See slide 18, 19, & 20

Also know crossover points

• NEVER USE IRR IF YOU HAVE A MULTIPLE PROJECT PROBLEM
  • See slide 21
• In this case, if your discount rate is less than the crossover point, it's advantageous to pick project A (see graph on slides). If it's after the discount rate, project B is advantageous.

Advantage of IRR

• Can comparing multiple projects, it may be simplier

Profitability index rule

• PI index = (PV of future cash flows) / (Initital investment cost)

Problem

• Does not consider investment size at all

All investment criteria, ranked

• See slides page 24 (last)
• Net present value
• Internal rate of return
• Profitability index

The "Monsters:"

• Payback criteria
  • Payback period
  • Discounted payback period
• Accounting criterion

Lecture slides

• See Chapter 9