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Discuss NPV decision rule; calculate payback period, IRR, profitability index

1) Your author offers four alternatives to the NPV rule. List and discuss these four alternatives.

2) When two mutually exclusive projects give conflicting acceptance indicators, how should the manager resolve the conflict?

3) Two projects have the expected cash flows shown below. The projects have similar risk characteristics and their cost of capital is 6 percent.

End of Year Project A Project B
Now (10,000,000) (8,000,000)
1 7,000,000 3,000,000
2 3,000,000 1,500,000
3 3,500,000 1,500,000
4 3,000,000 500,000

a) Calculate the payback period for each project.

b) Calculate the internal rate of return of each project. Which project should be accepted if they are independent? If they are mutually exclusive? (HINT - USE EXCELL)

c) Calculate the profitability index of each project. Which project should be accepted if they are independent? If they are mutually exclusive?

4) Why do many managers prefer to use the IRR rather than the NPV?

Solution Preview

See attached Excel file.

1) Your author offers four alternatives to the NPV rule. List and discuss these four alternatives.

The NPV Decision rule
In determining whether to accept or reject a particular projected, the NPV decision rule is
? Accept a project if its NPV > 0;
? Reject a project if its NPV < 0;
? Indifferent where NPV = 0.
Alternatives to the NPV rule
? Internal Rate of Return (IRR)

The internal rate of return, IRR, of a project is the rate of return which equates the net present value of the project's cash flows to zero; or equivalently the rate of return which equates the present value of inflows to the present value of cash outflows.

In determining whether to accept or reject a particular project, the IRR decision rule is
? Accept a project if IRR > rp
? Reject a project if IRR< rp
? Indifferent if IRR = rp
? For mutually exclusive projects accept the project with highest IRR if IRR > rp where rp is the required return on the project.

Payback Period
The payback period, PP, is the length of time it takes to recover the initial investment of the project. To apply the payback period criterion, it is necessary for management to establish a maximum acceptable payback value PP*. In practice, PP* is usually between 2 and 4 years. In determining whether to accept or reject a particular project, the payback period decision rule is:
? Accept if PP < PP*
? Reject if PP > PP*
? Indifferent where PP = PP*
? For mutually exclusive alternatives accept the project with the lowest PP if PP<PP*

Profitability Index
Another capital budgeting technique, the profitability index, is used when firms have only a limited supply of capital with which to invest in positive NPV ...

Solution Summary

With detailed narrative and accurate calculations, the problems are explained.

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