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# Chapter 6 --Alternate Measures of Capital Investment Desirability - PowerPoint PPT Presentation

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

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Presentation Transcript

• 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

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

• 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