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METHODS OF EVALUATING CAPITAL INVESTMENTS

Non-discounted cash flow methods

* Payback period

* Payback reciprocal

* Payback bail-out period

* Accounting rate of return

Discounted cash flow methods

* Net present value

* Present value index (profitability index)

* Annualized net present value or Equivalent annual annuity

* Present value/discounted payback

* Internal rate of return

* Modified internal rate of return

Methods that consider risk

* Breakeven Cash Inflow

* Risk-Adjusted Discount Rates

* Certainty Equivalents

* Simulation ...view middle of the document...

Payback reciprocal – determines the portion or percentage of the net investment that is recovered in one year.

1 Ave. Free Cash Flows

= Payback period Net Investment

- a project with an infinite life would have an IRR equal to its payback

reciprocal.

* when a project’s life is at least twice the payback period and the

annual free cash flows are approximately equal, the payback reciprocal may be used to estimate the IRR

C. Payback bailout period – measures the length of time where the accumulated annual free cash inflows and the salvage value for the period is, at least equal to the net investment.

= Net Investment – (Cumulative CFAT last year + Salvage value this year)

CFAT this year

D. Accounting rate of return (also called the book value method, unadjusted rate of return method, simple rate of return method, or return on investment method)

* measures the rate of return on the net investment (based on net income)

Decision rule: Accept if ARR > required rate of return

Reject if ARR < required rate of return

1. Based on initial investment

= Average Annual Net Income After Tax

Initial or Net Investment

2. Based on average investment

= Average Annual Net Income After Tax

Net Investment + Salvage Value

2

Advantages:

1. easily understood

2. used as a rough preliminary screening device of investment proposals

Disadvantages:

1. ignores the time value of money

2. ignores the timing component of cash inflows

3. averaging may yield inaccurate answers

4. utilizes concepts of capital and net income primarily designed for the purpose of financial statement preparation and may not be relevant for the evaluation of investment proposals

II. Discounted cash flow techniques:

Advantages:

1. more reliable because it considers the time value of money

2. cash flows over the entire life of the project is considered

3. more objective and relevant because it focuses on cash flows

Disadvantages:

1. not easily understood

2. more complex and difficult to apply

3. requires detailed long-term forecasts of incremental cash flows

4. requires pre-determination of cost of capital

A. Net present value (NPV) – the excess of the present value of cash inflows over the present value of the net investment.

Present value of cash flows + Terminal cash flows

Less: Net Investment

Net Present Value

Decision rule: Accept if NPV > 0

Reject if NPV < 0

B. Present value index (profitability/desirability index or benefit-cost ratio)

- ratio of the present value of cash inflows to the present value of the net investment

* useful in evaluating projects of different sizes

Present value of free cash flows + Terminal cash flows

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