Goal of Projects:
To determine if we will exceed our cost with the cash flows identified.
Task of Projects:
If we should purchase the project.
Payback Period:
How long it takes to get the initial cost back to a nominal sense.
Payback Advantages:
Easy to Understand and compute
Adjusts for uncertainty of later cash flows
Biased toward liquidity
Payback Disadvantages:
Ignores the time value of money
Requires an arbitrary cutoff point
Ignores cash flows beyond the cutoff date.
Biased against long-term projects, such as research and development, and new projects.
Discounted Payback Period:
How long it takes to get the initial cost back after you bring all of the cash flows to the present value, by the cut-off period.
Discounted Payback Advantages:
Includes time value of money.
Easy to understand
Biased toward liquidity.
Discounted Payback Disadvantages:
Requires an arbitrary cutoff point.
Ignores cashflows beyond the cutoff point.
Biased against long-term projects, such as RandD and new products.
Net Present Value:
The difference between the market value of a project and its cost.
(Adding number to the value of a company)
Net Present Value Advantages:
Considers all of the cash flows in the computation
Uses the time value of money
Provides the answer in dollar terms, which is easy to understand.
Usually provides a similar answer to the IRR computation.
Net Present Value Disadvantages:
Requires the use of time value of money, thus a bit more difficult to compute.
Projects that differ by orders of magnitude in cost are not obvious in the NPV final figure.
Profitability Index:
The PI measures the benefit per unit cost of a project, based on the time value of money. It is very useful in situations where you have multiple projects of hugely different costs and/ or limited capital (capital rationing)
Profitability Index Advantages:
Closely related to NPV, generally leading to identical decisions.
Easy to understand and communicate.
May be useful when available investment funds are limited.
Profitability Index Disadvantages:
May lead to incorrect decisions in comparisons of mutually exclusive investments.
Average Accounting Return (AAR):
A measure of the average accounting profit compared to some measure of average accounting value of a project.
Average Accounting Return Advantages:
Easy to calculate
Needed information will usually be available
Average Accounting Return Disadvantages:
Not a true rate of return: time value of money is ignored.
Uses an arbitrary benchmark cutoff rate
Based on accounting net income and book values, not cash flows and market values.
Internal Rate of Return (IRR)
The discount rate (or required return) that will bring all of the cash flows into present value time and total the exact value of the cost of the project (it is the return that will yield a NPV=0)
IRR Advantages:
Considers all of the cash flows in the computation
Uses the time value of money
If the IRR is high enough, you may not need to estimate a required return, which is often a difficult task
Usually provides a similar answer to the NPV computation.
IRR Disadvantages:
Uses the firm's required rate of return for comparison purposes
Usually high numbers can often occur when a significant amount of the projects cash flows occur early in the life of a project.
Mutually Exclusive Projects:
If you choose one, you cannot choose the other.
Three things we ask ourselves when determining undertaking a project:
Does the rule take into account or adjust for the time value of money?
Does the rule adjust for risk?
Does the rule provide information on whether or not we are creating value for the firm?
Goodwill Project:
Doesn't gain or lose money, purely to make the company look good.