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CF
473.32
9
Winter 2014
Investment Criteria
ch 9
you may remember some of this
What’s a Good Idea?
assessing an investment option is market value > cost?
• value creation for firm in a rational market
• here’s an odd thing: You should act as if the market is rational. As a manager, responsible for the health of the firm, the
rationality of the market is not your first concern. What matters most is your duty to the firm.
» So you should do those things which, to the best of your knowledge, will create value for the firm.
» “to the best of your knowledge” “rationally”
NPV
Is market value > cost? How much value is created from undertaking
an investment?
sdd ts
t
d
t
ds r)(
FV
r)(
FV
r)(
FVPV
111 2
2
1
1
nt
ntt r)(
CF
r)(
CF
r)(
CFNPV
1...
11 2
2
1
1
given a required return (an r), solve for NPV
IRR
most important alternative to NPV
nt
ntt r)(
CF
r)(
CF
r)(
CFNPV
1...
11 2
2
1
1
set NPV = 0, solve for r
IRR disadvantages
1. mutually-exclusive
projects
2. non-conventional
cash flows may have
• multiple answers
• no answer
if cash flows sign changes >1• use NPV instead
-$8,000
-$4,000
$0
$4,000
25% 50%
NPV
nt
ntt r)(
CF
r)(
CF
r)(
CFNPV
1...
11 2
2
1
1
321 12.1
00.080,91
12.1
00.800,70
12.1
00.120,6300.000,165$
)()()(NPV
“A Project”
year CF NI
0 -$165,000
1 63,120 $13,620
2 70,800 3,300
3 91,080 29,100
given: r = 12%
solve for NPV
IRR
nt
ntt r)(
CF
r)(
CF
r)(
CFNPV
1...
11 2
2
1
1
year CF NI
0 -$165,000
1 63,120 $13,620
2 70,800 3,300
3 91,080 29,100
321 1
00.080,91
1
00.800,70
1
00.120,6300.000,165$0
r)(r)(r)(
given: NPV = 0
solve for r
IRR disadvantages
1. mutually-exclusive projects doesn’t compare together if IRR gives different answer than NPV
• trust NPV instead
What To Do?
primary NPV IRR
secondary payback
• useful for explanation
if payback-obsessed: # years arbitrary What about after?
What’s a Good Idea?
assessing an investment option is market value > cost? time value risk
comm
on
problems?
considers easy to
time value
risk
value creation
use
explain
NPV payback disc. payback AAR IRR profitability
Assessment Methods
Recommended