F402 Cheat Sheet

Unit 2: Capital Budgeting/Project Evaluation

I. Investment Decision Criteria 

A. Net present value (NPV)

This measure gives an estimate of the present value of a project, i.e. how much value a project creates if a firm undertakes it. Decision Rule: Accept if NPV > 0. If NPV of a project is $1 million, then the value of the firm should increase by $1 million when the project is announced (assuming markets are efficient... more on this in unit 3).

B. Payback Period How long until initial investment is recouped. Decision Rule: Accept project if payback period < some period of time. Problems: Ignores Time Value of Money. Ignores how much value is created.

C. Discounted Payback Period (DPP) How long until initial investment is recouped in present value terms. Decision Rule: Accept project if DPP < some period of time. This adjusts for the first problem with the payback period criteria, but it still doesn’t provide an estimate of how much value is created.

D. Average Accounting Return (AAR) (Average Net Income)÷(Average Book Value), where the averages are computed over the life of the project. Decision Rule: Accept if AAR is greater than some required ARR. Problem: Accounting Net Income does not equal Free Cash Flow; ignores time value (because is it as average over the life of the project.

E. Internal Rate of Return (IRR) The internal rate of return is the rate of return that, when used as the discount rate, sets the NPV of the project equal to 0. Decision rule: Accept if IRR > Cost of Capital/Required Return/Hurdle Rate. Problems: 1. If cash flows are not “normal” (normal cash flows: firm spends $ upfront to reap positive cash inflows in future periods) and the sign of the cash flows changes more than once (e.g. cash outflow followed by cash inflow followed by cash outflow), then there are multiple IRRs. 2. Comparing mutually exclusive projects. NPV is better at comparing mutually exclusive projects. Project A may offer higher IRR than Project B, but may have lower NPV at a firm’s actual cost of capital/required return.

F. Modified Internal Rate of Return (MIRR) The modified internal rate of return method adjusts cash flows to solve the first problem with the IRR by bringing all negative cash flows to time 0 by discounting them. Another method brings all positive cash flows to the end of the project by finding their future value. The third method brings all negative cash flows to time 0 by discounting them and all positive cash flows to the time at which the project ends by finding the future value. Problem: What discount rate should be used to discount negative cash flows and/or find the future value of positive cash flows? If discount rate to be used is the firm’s cost of capital for the project, then why not calculate project NPV?