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Lecture 5 Econ 134A

October 13, 2005. 2. Outline of Today's Lecture. Ch6: Alternative Investment RulesCh7: NPV and Capital Budgeting. October 13, 2005. 3. Chapter 6: Alternative Investment Rules. In Ch4 and 5, we looked at how to use the NPV rule to evaluate any investment opportunity. (i.e. accept if NPV>0)Advanta

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Lecture 5 Econ 134A

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    1. Lecture 5 Econ 134A Lecturer: Xiaojuan (Grace)Hu Date: Oct. 13, 2005

    2. October 13, 2005 2 Outline of Today’s Lecture Ch6: Alternative Investment Rules Ch7: NPV and Capital Budgeting

    3. October 13, 2005 3 Chapter 6: Alternative Investment Rules In Ch4 and 5, we looked at how to use the NPV rule to evaluate any investment opportunity. (i.e. accept if NPV>0) Advantages of the NPV rule. Incorporates the time value of money; Uses cash flows and all the cash flows; NPVs are additive.

    4. October 13, 2005 4 Alternative Investment Rules The Payback Period Method The Discounted Payback Period Method The Internal Rate of Return Method (IRR)

    5. October 13, 2005 5 The Payback Period Method Idea: Choose among investment projects according to which project pays for itself the fastest. Payback period: The time it takes to recover the initial investment. Payback period rule: A particular cutoff date, say, 2 years, is selected. All investment projects that have payback periods of 2 years or less are accepted. The rest are rejected.

    6. October 13, 2005 6 Example 1 Assume that the cutoff date is 2 years. Which project to choose? Both project have the same payback period. Any problems with the Payback Period Method?

    7. October 13, 2005 7 The Problems with the Payback Period Method Problem 1: Ignores all cash flows occurring after the project has paid for itself. (NPV rule considers ALL cash flows.) Problem 2: Treats cash flows that occur before the payback period equally. In other words, it ignores the time value of money, since the cash flows are not discounted. (NPV rule discounts cash flows properly.) Problem 3: No guide for what the payback period should be.

    8. October 13, 2005 8 The Discounted Payback Period Method We first discount all cash flows. Then, we ask how long it takes for the discounted cash flows to recover the initial investment.

    9. October 13, 2005 9 Example 2

    10. October 13, 2005 10 Problems still remain Problem 1: We still ignore all (discounted) cash flows occurring after the initial investment of the project is recovered. Problem 2: Again, how do we decide what the required payback period should be?

    11. October 13, 2005 11 The Internal Rate of Return (IRR) Definition: The IRR is simply the discount rate that equates a project’s NPV to zero. The IRR is defined exclusively in terms of an asset’s cost and its cash flows. It is independent of market rates.

    12. October 13, 2005 12 IRR Rule Assumes we have an initial cash outflow followed by cash inflows in the future. (investing case) Accept the project if the discount rate is below the IRR. If there are several projects, choose the one with the highest internal rate of return.

    13. October 13, 2005 13 Example 3 A project with an initial investment of $4,000 and cash flows at time 1,2 of $2,000 and $4,000 respectively.

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