AFM273 Chapter Notes - Chapter 6: Payback Period, Net Present Value
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Published on 17 Feb 2015
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Chapter 6:
•The difference b/w the cost of capital and IRR is max. amount of estimation error in the
cost of capital estimate that can exist without altering the original decision
NPV Rule
•Accept project when NPV is positive
Internal Rate of Return (IRR) Investment Rule
•The rate of IRR is when NPV = 0
•Take investment where IRR > cost of capital. Turn down investment where IRR < cost of
capital
•IRR rule works if all of project’s negative cash flows precede its positive cash flows
•Situations where IRR rule and NPV rule may be in conflict:
oUnconventional cash flows
oMultiple IRRs
•No IRR exists because the NPV is positive for all values of the discount rate. Thus, IRR
rule cannot be used
•IRR rule has shortcomings for making investment decisions. IRR measures the average
return of the investment and the sensitivity of the NPV to any estimation error in the cost
of capital
Payback Rule
•Payback period is the amount of time it takes to recover or pay back initial investment. If
payback period is less than pre-specified length of time, accept the project
Mutually Exclusive Projects
•When you must choose only one project among several possible projects, choice is
mutually exclusive
•NPV rule – select project with highest NPV
•IRR rule – select project with highest IRR may lead to mistakes
oWhen projects differ in their scale of investment, timing of their cash flows, or
riskiness, then their IRRs cannot be meaningfully compared
Differences in Scale
•If project’s size is doubled, its NPV will double. This is not the case with IRR because
IRR measure average return of investment. Thus, IRR rule cannot be used to compare
projects of different scales
Differences in Timing