These lectures cover capital budgeting techniques such as net present value, payback, average accounting return, internal rate of return, discounted payback and profitability index
Net Present Value Computation | Corporate Finance
Payback Rule | Corporate Finance
Discounted Payback Rule | Corporate Finance
Average Accounting Rate of Return | Corporate Finance
Internal Rate of Return | Corporate Finance
Profitability index | Corporate Finance
Net present value is a measure of how much value is created or added today by undertaking an investment. Given our goal of creating value for the stockholders, the capital budgeting process can be viewed as a search for investments with positive net present values.
An investment is worth undertaking if it creates value for its owners. In the most general sense, we create value by identifying an investment worth more in the marketplace than it costs us to acquire. How can something be worth more than it costs? It’s a case of the whole being worth more than the cost of the parts.
The payback period is a kind of “break-even” measure. Because time value is ignored, you can think of the payback period as the length of time it takes to break even in an accounting sense, but not in an economic sense. The biggest drawback to the payback period rule is that it doesn’t ask the right question. The relevant issue is the impact an investment will have on the value of the stock, not how long it takes to recover the initial investment.
Nevertheless, because it is so simple, companies often use it as a screen for dealing with the myriad minor investment decisions they have to make. There is certainly nothing wrong with this practice. As with any simple rule of thumb, there will be some errors in using it; but it wouldn’t have survived all this time if it weren’t useful. Now that you understand the rule, you can be on the alert for circumstances under which it might lead to problems.
The average accounting return (AAR) is the average project earnings after taxes and depreciation, divided by the average book value of the investment during its life. Approach to making capital budgeting decisions involves the average accounting return(AAR).
The internal rate of return, universally known as the (IRR) is closely related to NPV. With the IRR, we try to find a single rate of return that summarizes the merits of a project. Furthermore, we want this rate to be an “internal” rate in the sense that it depends only on the cash flows of a particular investment, not on rates offered elsewhere.