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Chapter 6 --Alternate Measures of Capital Investment Desirability Goals for this chapter: Know how to calculate the following measures of investment desirability: Net present value Profitability index Internal rate of return Payback period Strengths Modified profitability index Modified internal rate of return Present value payback and weaknesses of various methods Know the reasons for multiple measures and when each would be appropriately used in reality Calculating a Net Present Value Steps to calculate the net present value: Step 1 -- Lay out the years and cash flows Step 2 -- Discount back to present with the NPV function Step 3 -- Net the result of step 2 with the initial outlay Calculating a Profitability Index Steps to calculate the profitability index: Step 1 -- Calculate the net present value Step 2 -- Use the formula in the book to calculate the PI PI = 1 + NPV/ Initial outlay (always positive) What Does the Profitability Index Measure? The wealth created per dollar of initial outlay The margin of safety or margin for error When Would You Use the Profitability Index? As a very crude short cut when your firm is facing capital rationing Capital rationing may exist when the firm is not large enough or profitable enough to raise money in the capital markets This is not uncommon for small, new or rapidly growing businesses You must still watch for size differentials Might use this when you cannot see all your projects at one time (which is often the case) The Modified Profitability Index Steps to calculate the Modified Profitability Index: Calculate the NPV Start at the rightmost negative number Discount the amount in step 2 back one year by dividing by the 1+ the interest rate Net step three with that year’s cash flow If negative, continue steps 3 and 4 If positive, stop, this is a self financing project and MPI = PI When arriving at 0 you have the additional investment Add the additional investment to the initial outlay to get the initial commitment Use the formula MPI = 1 + NPV / Initial commitment (always positive) Strengths of the Modified Profitability Index Strengths of the modified profitability index over the profitability index It tells you the up front initial commitment needed to finish the project You can use this to: Ask the regulators for rate hikes or commitments Raise the appropriate amount of money up front rather than at many points in the future. (negative signal and costly) Calculating the Internal Rate of Return Steps to calculate the internal rate of return: Lay out the years and cash flows Discount back to present with the IRR function on the calculator as described in earlier chapters Must use the goal seek tool (under the tools menu) on the computer if you have mid-year cash flows Weaknesses of the Internal Rate of Return Weaknesses of the internal rate of return: It assumes that new projects will come along in future years that will pay at least the internal rate of return (reinvestment rate assumption It ignores the size of the project Calculating the Modified Internal Rate of Return Steps to calculate the modified internal rate of return: Begin with year 1 and grow to the end of the project by multiplying by 1 plus the discount rate raised to the remaining years Do this for all remaining cash flows Sum the terminal values Fill the intermediate years with zeros Use the IRR function to solve for the modified IRR Strengths of the Modified Internal Rate of Return Strengths It of the modified internal rate of return: eliminates the reinvestment rate assumption There appears to be many cases where companies in the US are generating more cash than worthwhile projects. In this case, the MIRR may give a better indication of the return from the project MIRR is a worst case scenario which assumes that excess cash is used to retire debt and equity. By definition this action earns the cost of money Calculating a Payback Period Steps to calculating the payback period: Lay out your years and cash flow Accumulate the cash flows Identify where the accumulation goes from negative to positive Use the year on the left Use the result in step 4 and add the amount needed divided by the amount received Strengths and Weaknesses of the Payback Period Method Weaknesses of the payback method: It ignores the time value of money It ignores all cash flows after the payback period It ignores risk Strengths of the payback method: It is a measure of liquidity It can be used as a short cut in industries where the product life is very short Calculating the Present Value Payback Period Steps to calculate the present value payback Lay out the years and cash flows Bring the cash flows back to present by dividing by (1 + discount rate) raised to the number of years Accumulate the cash flows the accumulation should equal the NPV in the last year Identify where the accumulation goes from negative to positive Use the year on the left Use the result in step 4 and add the amount needed divided by the present value amount received The Accounting Rate of Return Calculating the accounting rate of return There are many different ways to calculate an accounting rate of return All of these methods ignore the time value of money Reasons for Multiple Measures Different measures for different circumstances Multiple measure allow members of the committee to use the measures with which they are comfortable Multiple measures may provide better information