Difference Between Profitability Index and Net Present Value

Document Sample
Difference Between Profitability Index and Net Present Value Powered By Docstoc
					                                                                  Capital Budgeting Techniques
                                                              •   Net Present Value
                                                              •   The Payback Rule
                   Chapter 8                                  •   The Average Accounting Return
                                                              •   The Internal Rate of Return
         Net Present Value and Other                          •   The Profitability Index
              Investment Criteria

           Net Present Value                                            NPV Decision Rule
• The difference between the market value of a                • If the NPV is positive, accept the
  project and its cost                                          project
• How much value is created from undertaking an               • A positive NPV means that the project is
  investment?                                                   expected to add value to the firm and will
  – The first step is to estimate the expected future cash      therefore increase the wealth of the
    flows.                                                      owners.
  – The second step is to estimate the required return for
    projects of this risk level.
                                                              • Since our goal is to increase owner
  – The third step is to find the present value of the cash
                                                                wealth, NPV is a direct measure of how
    flows and subtract the initial investment.                  well this project will meet our goal.

              Payback Period                                  Decision Criteria Test - Payback
• How long does it take to get the initial cost               • Does the payback rule account for the
  back in a nominal sense?                                      time value of money?
• Computation                                                 • Does the payback rule account for the risk
  – Estimate the cash flows                                     of the cash flows?
  – Subtract the future cash flows from the initial
    cost until the initial investment has been                • Does the payback rule provide an
    recovered                                                   indication about the increase in value?
• Decision Rule – Accept if the payback                       • Should we consider the payback rule for
  period is less than some preset limit                         our primary decision criteria?
Advantages and Disadvantages of
                                                              Average Accounting Return
• Advantages                  • Disadvantages              • There are many different definitions for
  – Easy to understand          – Ignores the time value     average accounting return
  – Adjusts for uncertainty       of money
    of later cash flows         – Requires an arbitrary    • The one used in the book is:
  – Biased towards                cutoff point               – Average net income / average book value
    liquidity                   – Ignores cash flows         – Note that the average book value depends on
                                  beyond the cutoff date       how the asset is depreciated.
                                – Biased against long-
                                  term projects, such as   • Need to have a target cutoff rate
                                  research and
                                  development, and new
                                                           • Decision Rule: Accept the project if the
                                  projects                   AAR is greater than a preset rate.

                                                           Advantages and Disadvantages of
   Decision Criteria Test - AAR
• Does the AAR rule account for the time                   • Advantages             • Disadvantages
  value of money?                                            – Easy to calculate      – Not a true rate of
                                                             – Needed information       return; time value of
• Does the AAR rule account for the risk of                    will usually be          money is ignored
  the cash flows?                                              available              – Uses an arbitrary
                                                                                        benchmark cutoff rate
• Does the AAR rule provide an indication
                                                                                      – Based on accounting
  about the increase in value?                                                          net income and book
• Should we consider the AAR rule for our                                               values, not cash flows
                                                                                        and market values
  primary decision criteria?

       Internal Rate of Return                             IRR – Definition and Decision Rule
• This is the most important alternative to                • Definition: IRR is the return that makes the
  NPV                                                        NPV = 0
• It is often used in practice and is intuitively          • Decision Rule: Accept the project if the
  appealing                                                  IRR is greater than the required return
• It is based entirely on the estimated cash
  flows and is independent of interest rates
  found elsewhere
   Decision Criteria Test - IRR                                   Advantages of IRR
• Does the IRR rule account for the time                 • Knowing a return is intuitively appealing
  value of money?                                        • It is a simple way to communicate the
• Does the IRR rule account for the risk of                value of a project to someone who doesn’t
  the cash flows?                                          know all the estimation details
• Does the IRR rule provide an indication                • If the IRR is high enough, you may not
  about the increase in value?                             need to estimate a required return, which
• Should we consider the IRR rule for our                  is often a difficult task
  primary decision criteria?

                                                           IRR and Nonconventional Cash
                 NPV vs. IRR
• NPV and IRR will generally give us the                 • When the cash flows change signs more
  same decision                                            than once, there is more than one IRR
• Exceptions                                             • When you solve for IRR, you are solving
                                                           for the root of an equation and when you
  – Non-conventional cash flows – cash flow
                                                           cross the x-axis more than once, there will
    signs change more than once
                                                           be more than one return that solves the
  – Mutually exclusive projects                            equation
     • Initial investments are substantially different
     • Timing of cash flows is substantially different
                                                         • If you have more than one IRR, which one
                                                           do you use to make your decision?

     IRR and Mutually Exclusive
                                                         Conflicts Between NPV and IRR
• Mutually exclusive projects                            • NPV directly measures the increase in
  – If you choose one, you can’t choose the other          value to the firm
  – Example: You can choose to attend graduate           • Whenever there is a conflict between NPV
    school next year at either Ole Miss or Mississippi
                                                           and another decision rule, you should
    State, but not both
                                                           always use NPV
• Intuitively, you would use the following
  decision rules:                                        • IRR is unreliable in the following situations
  – NPV – choose the project with the higher NPV           – Non-conventional cash flows
  – IRR – choose the project with the higher IRR           – Mutually exclusive projects
                                                  Advantages and Disadvantages of
           Profitability Index
                                                         Profitability Index
• Measures the benefit per unit cost, based       • Advantages                 • Disadvantages
  on the time value of money                        – Closely related to         – May lead to incorrect
                                                      NPV, generally leading       decisions in
• A profitability index of 1.1 implies that for       to identical decisions       comparisons of
  every $1 of investment, we create an              – Easy to understand           mutually exclusive
                                                      and communicate              investments
  additional $0.10 in value
                                                    – May be useful when
• This measure can be very useful in                  available investment
  situations in which there is limited capital        funds are limited

  Capital Budgeting In Practice
• We should consider several investment
  criteria when making decisions
• NPV and IRR are the most commonly
  used primary investment criteria
• Payback is a commonly used secondary
  investment criteria

Description: Difference Between Profitability Index and Net Present Value document sample