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Learning Objectives
Understand the difference between normal and non-normal
cash flow streams.
Understand the difference between mutually exclusive and
independent projects.
Calculate and use the major capital budgeting decision
criteria, which are the 1) payback period, 2) discounted
payback period, 3) Net Present Value (NPV), 4) Internal Rate
of Return (IRR), and 5) Modified IRR (MIRR) for mutually
exclusive and independent projects.
Discuss the strengths and weaknesses of each method.
Understand and interpret the NPV profile.
Calculate and understand the importance of the crossover
point.
Discuss the conflict between NPV and IRR when evaluating
mutually exclusive projects.
Understand why NPV is superior to IRR and MIRR.
Understand the multiple IRRs problem.
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AB1201: Financial
Management
3
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
4
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
5
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
An Illustrative Example
Here are the projects expected after-tax cash
flows (in thousands of dollars):
0 1 2 3
| | | |
Project L -100 10 60 80
Project S -100 70 50 20
Cost of capital = 10% for both projects
Which project(s) should we take up? How
should we analyse them?
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Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
7
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
8
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
0 1 2 3
| | | |
Project L -100 10 60 80
Project S -100 70 50 20
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Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
10
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
Calculating Payback
CFt -100 10 60 80
Mutually exclusive
Cumulative Choose the one with shorter
payback!
Independent
Subjective benchmark has to be
PaybackL = used. E.g. Only projects with
PaybackS = payback of less than three years
are accepted.
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Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
Strengths
Easy to calculate and understand.
Provides an indication of a projects risk and liquidity.
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Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
0 10% 1 2 3
CFt -100 10 60 80
PV of CFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79
Disc PaybackL =
Disc PaybackS =
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Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
Lessons Learnt 1
Normal cash flows versus non-normal cash flows.
Independent versus mutually exclusive projects.
Payback period is the number of years it takes to
recover projects initial investment.
To calculate the payback period, we cumulate the cash
flows.
Discounted payback period builds on the payback period
method by cumulating the discounted cash flows.
Decision criteria:
Independent projects: A subjective payback benchmark needs
to be used. Projects are accepted only if payback < benchmark.
Mutually exclusive projects: Choose the one with shorter
payback.
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Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
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Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
Initial Investment
Cost of capital
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Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
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Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
0 1 2 3
| | | |
Project S -100 70 50 20
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Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
19
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
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Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
NPV Profiles
A graphical representation of project
NPVs at various different costs of capital.
0 $50 $40
5 33 29
10 19 20
15 7 12
20 (4) 5
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Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
.
60
. .
50
40
30 . .
.. . ..
20 Crossover Point = 8.7%
10 S
0
5 10 15
. L 20 23.6
Discount Rate (%)
-10
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Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
Lessons Learnt 2
N
CFt
NPV
t 0 ( 1 r ) t
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Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
Payback
Discounted payback
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Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
25
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
26
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
0 1 2 3
| | | |
Project S -100 70 50 20
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Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
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Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
.
60
. .
50
40
30 . . Crossover Point
= 8.7%
.. . ..
20
10 S
0
5 10 15
. L 20 23.6
Discount Rate (%)
-10
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Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
30
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
31
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
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Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
Box titled Why NPV is better than IRR. Adapted from Essentials of Financial
Management (p. 414), by Brigham, Houston, Hsu, Kong, and Bany-Ariffin, 2013,
Singapore: Cengage Learning.
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Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
Lessons Learnt 3 N
CFt
0
IRR is the discount rate that forces NPV = 0 t 0 ( 1 IRR ) t
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Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
35
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
36
Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
Calculating MIRR
0 10% 1 2 3
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Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
N
COFt CIF (1 r ) N t
t 0 (1 r ) t
t 0
( 1 MIRR ) N
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Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
0 1 2 3
| | | |
Project S -100 70 50 20
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Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
0 1 2
10%
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Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
IRR2 = 400%
450
0 Discount rate
100 400
IRR1 = 25%
-800
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Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
0 1 2
10%
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Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
Lessons Learnt 4
MIRR is a modified version of the IRR where
intermediate cash flows are assumed to be
reinvested at the cost of capital.
More realistic reinvestment assumption than IRR.
MIRR avoids the multiple IRRs problem.
Decision criteria is similar to IRR
NPV, IRR, and MIRR leads to same accept/reject
decision when choosing independent projects.
When choosing mutually exclusive projects, conflicts
can still arise between NPV and MIRR.
NPV is superior to MIRR.
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Introduction > Normal vs. Non-normal CFs > Independent vs. mutually exclusive projects > Payback period > Discounted
payback period > Calculating NPV > NPV profiles > IRR > NPV vs. IRR > MIRR > Multiple IRRs > Conclusion
Payback
Discounted payback
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List of Images (1 of 2)
Slide no. Title of image/Source Author/Website License/Terms of use
3 IPhone at Macworld (rear view) blakeburris CC BY 2.0
http://www.flickr.com/photos/blake https://www.flickr.com/phot http://creativecommons.org/licenses/
4tx/352328190 os/blake4tx/ by/2.0/deed.en
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