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

Modified profitability index

Modified internal rate of return
Present value payback

Strengths 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 years 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

of the modified internal rate of return:

It 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