1. L3 Ch5 During class, we learn four investment rules including payback period, internal rate of return, profitability index, and net present value. (15 marks) a. State the criterion for accepting or rejecting independent projects under each rule. Briefly discuss the potential shortcomings of each rule. b. What are some of the difficulties that might come up in actual applications of the various investment rules? Elaborate. C. Which one would be the best investment rule to implement in actual applications? Explain. Net Present Value (NPV) Rule = * Net Present Value (NPV) = PV of cash inflow - PV of cash outflow (usually investment at time 0) How to estimate NPV? Estimate Future Net Cash Flow (both size and timing) Estimate Discount Rate Estimate Initial Cash Outflow 1. 2. 3. 5.2 Payback Period Method Basic question: How long does it take the project to pay back its initial investment? * Payback Period the number of periods needed to recover initial cost. * Usual rule * The shorter the period, the better it is. * Minimum Acceptance Criterion * set by management Ranking Criterion * set by management * 2 5.4 Internal Rate of Return (IRR) Rule What is IRR? * It is a discount rate that makes that NPV of the project to be zero. * Minimum Acceptance Criteria * Accept a project if its IRR exceeds the required return * Ranking Criterion * Select alternative with the highest IRR Reinvestment assumption * All future cash flows are assumed to be reinvested at the IRR * IRR has a lot of problems, but it is easy to understand and communicate. 5.6 The Profitability Index (PI) Total PV of CFs subsequent to initial investment PI= Initial Investment * Minimum Acceptance Criteria: * Accept if PI > 1 * Ranking Criteria: * Select alternative with highest PI 1. L3 Ch5 During class, we learn four investment rules including payback period, internal rate of return, profitability index, and net present value. (15 marks) a. State the criterion for accepting or rejecting independent projects under each rule. Briefly discuss the potential shortcomings of each rule. b. What are some of the difficulties that might come up in actual applications of the various investment rules? Elaborate. C. Which one would be the best investment rule to implement in actual applications? Explain. Net Present Value (NPV) Rule = * Net Present Value (NPV) = PV of cash inflow - PV of cash outflow (usually investment at time 0) How to estimate NPV? Estimate Future Net Cash Flow (both size and timing) Estimate Discount Rate Estimate Initial Cash Outflow 1. 2. 3. 5.2 Payback Period Method Basic question: How long does it take the project to pay back its initial investment? * Payback Period the number of periods needed to recover initial cost. * Usual rule * The shorter the period, the better it is. * Minimum Acceptance Criterion * set by management Ranking Criterion * set by management * 2 5.4 Internal Rate of Return (IRR) Rule What is IRR? * It is a discount rate that makes that NPV of the project to be zero. * Minimum Acceptance Criteria * Accept a project if its IRR exceeds the required return * Ranking Criterion * Select alternative with the highest IRR Reinvestment assumption * All future cash flows are assumed to be reinvested at the IRR * IRR has a lot of problems, but it is easy to understand and communicate. 5.6 The Profitability Index (PI) Total PV of CFs subsequent to initial investment PI= Initial Investment * Minimum Acceptance Criteria: * Accept if PI > 1 * Ranking Criteria: * Select alternative with highest PI
