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assets. Long-term decisions; involving large expenditures. Replacement of fixed assets and modernization of plants.
What is the difference between normal and nonnormal cash flow streams?
Normal cash flow stream Cost (negative CF) followed by a series of positive cash inflows. One change of signs. Non-normal cash flow stream Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine, etc.
Variable Costs Fixed Costs Depreciation Interest Tax = Profit After Tax flows = Profit After Tax + Depreciation
Cash
EVALUATION CRITERIA
NON-DISCOUNTED CASH FLOW CRITERIA DISCOUNTED CASH FLOW CRITERIA
Accounting Rate of Return (ARR) Payback Period (PB) Discounted Payback Period
Net Present Value (NPV) Profitability Index (PI) Internal Rate of Return (IRR)
rate of return or simple rate of return is the ratio of the estimated accounting profit of a project to its average investment. It is an investment appraisal technique.
ARR =
Calculation of ARR
Initial Investment Year Profit After Tax 1 0 2 450 3 1800 4 2250 5 6750 50000
Weaknesses
number of years required to recover a projects cost, or How long does it take to get our money back? Calculated by adding projects cash inflows to its cost until the cumulative cash flow for the project turns positive.
Payback Period is 3 years and part of 4th year. The fraction of fourth year is calculated as 7750/12250 = 0.63. The Payback period in this case is 3.63 years
Provides an indication of a projects risk and liquidity. Easy to calculate and understand.
Weaknesses
Ignores the time value of money. Ignores CFs occurring after the payback period.
number of years required to recover a projects discounted cash flows. Calculated by adding projects discounted cash inflows to its cost until the cumulative cash flow for the project turns positive.
0.909 18180 0.826 8631.7 0.751 8861.8 0.683 8366.75 0.621 10401.75
Payback Period is 4 years and part of 5th year. The fraction of fifth year is calculated as 5959.75/10401.75 = 0.57. The Payback period in this case is 4.57 years
Provides an indication of a projects risk and liquidity. Easy to calculate and understand. Takes into account time value of money.
Weaknesses
Does not have much meaning. Ignores CFs occurring after the payback period.
CFt NPV t t 0 ( 1 k )
Calculating NPV
Year 0
1 2 3 4 5
PV @ 10%
0.909
PV -50000
18180
0.826
0.751 0.683 0.621
8631.7
8861.8 8366.75 10401.75 4442
NPV
Strengths:
It will give the correct decision advice assuming a perfect capital market. It will also give correct ranking for mutually exclusive projects. NPV gives an absolute value. NPV allows for the time value for the cash flows.
Weaknesses:
It is very difficult to identify the correct discount rate. NPV as method of investment appraisal requires the decision criteria to be specified before the appraisal can be undertaken.
Calculating PI
Year 0 1 2 3 4 5 PI Cash Flows PV @ 10% PV -50000 -50000 0.909 18180 20000 0.826 8631.7 10450 0.751 8861.8 11800 0.683 8366.75 12250 0.621 10401.75 16750 1.08884
Strengths:
It will give the correct decision advice assuming a perfect capital market. It will also give correct ranking for mutually exclusive projects. PI allows for the time value for the cash flows.
Weaknesses:
It is very difficult to identify the correct discount rate. It gives same information as NPV and does not add anything extra.
IRR is the discount rate that forces PV of inflows equal to cost, and the NPV = 0:
CFt 0 t ( 1 IRR ) t 0
n
IRR > WACC, the projects rate of return is greater than its costs. There is some return left over to boost stockholders returns.
projects are independent, accept both projects, as both IRR > k = 10%. If projects are mutually exclusive, accept 2, because IRR2 > IRR1.
Calculating IRR
Year 0 1 2 3 4 5 IRR Cash Flows -50000 20000 10450 11800 12250 16750 13.57%
It shows returns on original money invested IRR allows for the time value for the cash flows.
Weaknesses:
It does not give correct answer in case of alternating negative and positive cash flows.
projects are independent, the two methods always lead to the same accept/reject decisions. If projects are mutually exclusive
IRR and NPV may give conflicting results In case of any conflict, go with NPV method.
While the internal rate of return (IRR) assumes the cash flows from a project are reinvested at the IRR, the modified IRR assumes that positive cash flows are reinvested at the firm's cost of capital, and the initial outlays are financed at the firm's financing cost. Therefore, MIRR more accurately reflects the cost and profitability of a project. MIRR = n FV (Future Cash Flows. Reinvestment Rate) n PV (Negative Cash Flows. Finance Rate) -1
correctly assumes reinvestment at opportunity cost = WACC. MIRR also avoids the problem of multiple IRRs. Managers like rate of return comparisons, and MIRR is better for this than IRR.