Capital Budgeting Decision Rules: What Real Investments Should Firms Make?
Capital Budgeting Decision Rules: What Real Investments Should Firms Make?
Capital Budgeting Decision Rules: What Real Investments Should Firms Make?
Rules
What real investments should
firms make?
NPV
IRR
Profitability Index
Payback Period
NPV Analysis
Lockheed Tri-Star
Revenues (1970-1977)
2
3
4
(1.10) (1.10) (1.10) (1.10) (1.10)5
70
70
70
70
420
6
7
8
9
(1.10) (1.10) (1.10) (1.10) (1.10)10
$584 Million
400
$12.00
$700
-$12
400
$11.75
$800
$42
500
$11.00
$1,600
$441
2
3
4
5
(1.10) (1.10)
(1.10) (1.10)
(1.10)
70
420
6
7
(1.10)
(1.10)
$18 Million
-$1,000
1
$400
2
$400
3
$400
Rate NPV
0
$200
10
-$5.3
20
-$157.4
At r = 9.7%,
NPV = 0
Multiple IRRs
$230
-$132
Project
NPV @
0%
$2000
$4000
A
B
NPV @ NPV@
10%
15%
$669
$109
$751
-$484
IRR
16.04%
12.94%
Profitability Index
PI
t
CF
/(
1
r
)
t
t 1
CF0
Example:
Project
CF0
CF1
NPV @ 10%
PI
A -$1,000
$1,500
$364
1.36
B -$10,000 $13,000
$1,818
1.18
Since you can only take one and not both the NPV rule
says B, the PI rule would suggest A. Which is right?
Average Accounting
Return
AAR
Problems