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