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The method that recognizes the time value of monew by discounting the after-tax cash flows over life of a project, given the company's minimum rate of return is
NET PRESENT VALUE METHOD
ROI return on investment =
- = net income/ invested capitalOR Profit Margin (Return on Sale) x Investment TurnoverDisadvantage
- - may lead to rejecting projects that yield positive cash flows.
When do you accept NPV?
Investment should be made if NPV >0.If company has unlimited funds- NPV > or =0.
- 1)find Change in Market Value
- 2) Probability factor X Change in value = Cost of investment
Accounting rate of return =
= (Annual savings - Depreciation)/ Req. investment
4 steps to caculate NPV
- 1. Compute after tax cash flow= Pre-tax cash flow x (1- tax rate)
- 2. Add depreciation benefit = Depreciation x tax rate
- 3. Multiply result by appropriate present value of annuity.
- 4 Subtract initial Cash outflow (Investment)
NPV vs IRR methods
NPV - highlights amounts, more conservative, assumes reinvestment @ hurdle rateIRR - focuses decision makers on %, more agressive, assumes reinvestment @ IRR, less reliable.
Profitability index =
PROJECT Profitability index =
- PV of CF / Investment
- PV of CF - Investment
- NPV/ Investment
Profitability index =
(PV of cash flows) / Initial investmentIf Profitability index > 1 --> NPV > 0It provides the means to rank capital projects w/ different amounts of investment
As Interest Rate get higher, the PV FACTOR for the same number of periods becomes ___________
smaller.Smaller FVFactor - HIGHER % RATE
When do you accept IRR?
when IRR>hurdle (targeted RRR) rate Regect when IRR< or = hurdle (targeted) rateIRR> RRR when NPV =0
Pay Back period (present value factor) =
= Net incremental investment/ Net annual cash flowsNo concideration of time
What Does Present Value Interest Factor Of Annuity - PVIFA Mean?
A factor which can be used to calculate the present value of a series of annuities. The initial deposit, earning interest at the periodic rate (r), perfectly finances a series of (N) consecutive dollar withdrawals. PVIFA is also a variable used when calculating the present value of an ordinary annuity (is an annuity whose payments are made at the end of each period). PVIFA = [- (1 + r)^-N]/r
The payback period serves as a fair approximation of ?
of the annity factor value used in estimaiting the IRR
If the discount rate is increased, the PV of the future cash flows will ________
The discounted payback period id the length of the time required
for discounted cash flows to recover the cost of the investment.Investment= PVF yr.1 x CF yr1+PVFyr2 x CFyr.2...
Return on investment ROI ?
- Income/ Invested Capital
- ORReturn on Sales (Profit Margin)x Capital Turnover= Net income/Sales x Sales/Invested capital
- Disadvantage - may lead to rejecting projects that yield positive cash flows.
What Does Present Value Interest Factor - PVIF Mean?
Using the PVIF works best when you are attempting to discount one value in the future.
accounting rate of return (ARR)
- = (Net Cash flow - Depr.) / investment- Does not consider the time value of money, It focuses on income and not CFlowDefinition 1Straight-line' method of estimating average returns from an investment, it uses accrual based financial statements instead of compounded or discounted cash flows. Also called book value method, financial statement method, or simple rate of return.Definition
- 2Ratio that expresses the earnings before interest and taxes (EBIT) as a percentage of the capital employed at the end of an accounting period.
Compute after tax cash flow
= Pre-tax cash flow x (1- tax rate)
The profitability index is also known as
the excess present value index. it is a variation of NPV
Net Present Value =
- = the PV of an investment's future net cash flows minus the initial investment.If positive, the investment should be made (unless an even better investment exists), otherwise it should not.
- - the method that recognizes the time value of money by discounting the after
- - tax cash flows over the live of a project, given the company's minimum desired rate of return.
NPV is superior to IRR because
it is flexible enough to consistently handle either uneven cash flows or inconsistent rates of return for each year of the project.
What Does Internal Rate Of Return - IRR Mean?
The discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero.=> PV factor x cash inflows = cash investment, solve for PV factor
Popular methods of capital budgeting include
net present value (NPV), internal rate of return (IRR), discounted cash flow (DCF) and payback period.