Chapter 3 - Time value of Money applications

Chapter 3: Time Value of Money Applications II. PROJECT APPRAISAL RULES 1. Payback Period 2. Net Present Value 3. Internal Rate of Return 4. Net Present Value versus Internal Rate of Return 1. Payback Period Payback Period = number of years to recover initial costs Computation Estimate the cash flows Subtract the future cash flows from the initial cost until the initial investment has been recovered Decision Rule – Accept if the payback period is less than some preset limit Computing Payback for the Project Project A: Initial cost: 165000 Cash flow return: Year 1: 63120; Year 2: 70800; Year 3: 91080 Assume we will accept the project if it pays back within two years. Year 1: 165,000 – 63,120 = 101,880 still to recover Year 2: 101,880 – 70,800 = 31,080 still to recover Year 3: 31,080 – 91,080 = -60,000 project pays back in year 3 Do we accept or reject the project? Computing Payback for the Project Consider Capital budgeting project B which yields the following cash flows: Year CF 0 1 2 3 4 5 -1000 500 400 200 200 100 Calculate the pay back period? Advantages and Disadvantages Advantages Easy to understand Adjusts for uncertainty of later cash flows Disadvantages Ignores the time value of money Ignores cash flows beyond the cutoff date 2. Net Present Value Net Present Value - Present value of cash flows minus initial investments. Opportunity Cost of Capital - Expected rate of return given up by investing in a project