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Chapter 6 --Alternate Measures of Capital Investment DesirabilityPowerPoint Presentation

Chapter 6 --Alternate Measures of Capital Investment Desirability

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Chapter 6 --Alternate Measures of Capital Investment Desirability

- Goals for this chapter:
- Know how to calculate the following measures of investment desirability:
- Net present value
- Profitability index Modified profitability index
- Internal rate of return Modified internal rate of return
- Payback period Present value payback

- Strengths and weaknesses of various methods
- Know the reasons for multiple measures and when each would be appropriately used in reality

- Know how to calculate the following measures of investment desirability:

Calculating a Net Present Value Desirability

- Steps to calculate the net present value:
- Step 1 -- Lay out the years and cash flows
- Step 2 -- Discount back to present with the NPV function
- Step 3 -- Net the result of step 2 with the initial outlay

Calculating a Profitability Index Desirability

- Steps to calculate the profitability index:
- Step 1 -- Calculate the net present value
- Step 2 -- Use the formula in the book to calculate the PI
- PI = 1 + NPV/ Initial outlay (always positive)

What Does the Profitability Index Measure? Desirability

- The wealth created per dollar of initial outlay
- The margin of safety or margin for error

When Would You Use the DesirabilityProfitability Index?

- As a very crude short cut when your firm is facing capital rationing
- Capital rationing may exist when the firm is not large enough or profitable enough to raise money in the capital markets
- This is not uncommon for small, new or rapidly growing businesses

- You must still watch for size differentials
- Might use this when you cannot see all your projects at one time (which is often the case)

The Modified Profitability Index Desirability

- Steps to calculate the Modified Profitability Index:
- Calculate the NPV
- Start at the rightmost negative number
- Discount the amount in step 2 back one year by dividing by the 1+ the interest rate
- Net step three with that year’s cash flow
- If negative, continue steps 3 and 4
- If positive, stop, this is a self financing project and MPI = PI
- When arriving at 0 you have the additional investment
- Add the additional investment to the initial outlay to get the initial commitment
- Use the formula MPI = 1 + NPV / Initial commitment (always positive)

Strengths of the Modified DesirabilityProfitability Index

- Strengths of the modified profitability index over the profitability index
- It tells you the up front initial commitment needed to finish the project
- You can use this to:
- Ask the regulators for rate hikes or commitments
- Raise the appropriate amount of money up front rather than at many points in the future. (negative signal and costly)

Calculating the Internal DesirabilityRate of Return

- Steps to calculate the internal rate of return:
- Lay out the years and cash flows
- Discount back to present with
- the IRR function on the calculator as described in earlier chapters
- Must use the goal seek tool (under the tools menu) on the computer if you have mid-year cash flows

Weaknesses of the DesirabilityInternal Rate of Return

- Weaknesses of the internal rate of return:
- It assumes that new projects will come along in future years that will pay at least the internal rate of return (reinvestment rate assumption
- It ignores the size of the project

Calculating the Modified DesirabilityInternal Rate of Return

- Steps to calculate the modified internal rate of return:
- Begin with year 1 and grow to the end of the project by multiplying by 1 plus the discount rate raised to the remaining years
- Do this for all remaining cash flows
- Sum the terminal values
- Fill the intermediate years with zeros
- Use the IRR function to solve for the modified IRR

Strengths of the Modified DesirabilityInternal Rate of Return

- Strengths of the modified internal rate of return:
- It eliminates the reinvestment rate assumption
- There appears to be many cases where companies in the US are generating more cash than worthwhile projects. In this case, the MIRR may give a better indication of the return from the project
- MIRR is a worst case scenario which assumes that excess cash is used to retire debt and equity. By definition this action earns the cost of money

Calculating a Payback Period Desirability

- Steps to calculating the payback period:
- Lay out your years and cash flow
- Accumulate the cash flows
- Identify where the accumulation goes from negative to positive
- Use the year on the left
- Use the result in step 4 and add the amount needed divided by the amount received

Strengths and Weaknesses of the Payback Period Method Desirability

- Weaknesses of the payback method:
- It ignores the time value of money
- It ignores all cash flows after the payback period
- It ignores risk

- Strengths of the payback method:
- It is a measure of liquidity
- It can be used as a short cut in industries where the product life is very short

Calculating the Present Value Payback Period Desirability

- Steps to calculate the present value payback
- Lay out the years and cash flows
- Bring the cash flows back to present by dividing by (1 + discount rate) raised to the number of years
- Accumulate the cash flows
- the accumulation should equal the NPV in the last year

- Identify where the accumulation goes from negative to positive
- Use the year on the left
- Use the result in step 4 and add the amount needed divided by the present value amount received

The Accounting Rate of Return Desirability

- Calculating the accounting rate of return
- There are many different ways to calculate an accounting rate of return
- All of these methods ignore the time value of money

Reasons for Multiple Measures Desirability

- Different measures for different circumstances
- Multiple measure allow members of the committee to use the measures with which they are comfortable
- Multiple measures may provide better information

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