Discounted payback period Length of time until the sum of discounted cash flows is equal to initial costAddresses the fact that payback period ignores TMVDiscounted Payback Rule:Accept a project if its discounted payback period is less than some prespecified number of years (“cutoff point”)61•Less commonly used than payback period even though it fixe the problem (ignoring time value) of payback period. •If you already calculate the discounted value of cash flows. Why don’t you use NPV instead of the discounted payback period

Discounted payback problemProject A has the following cash flows and discounted cash flows. Find A’s discounted payback period.Verify that discounted payback period = 2.194 years (2.194 yrs= 2 yrs+ (9000-2727-4949)/6762Year0123Cash flow-9000 3000 6000 9000Discounted cash flow 2727 4959 6762622727+4959=7686(<9000)=>1314(=9000-7686) more needed

Average accounting return (AAR)AAR= An investment’s average net income / average book value of investmentAAR Rule:Accept a project if its average accounting return exceeds a target average accounting return63

Example- AAR64ARR is not comparable to returns offered in financial marketA project has an initial cost of $32,000 and a 3-year life. The company uses straight-line depreciation to a book value of zero over the life of the project. The projected net income from the project is $1,200, $2,300, and $1,800 a year for the next 3 years, respectively. What is the average accounting return?T=0BV of investment=32000T=1BV=32000-13667=21333T=2BV=32000-13667*2=10667T=3BV=32000-13667*3=0Annual depreciation= (32000-0)/3=13667AAR(120023001800) /3(3200021333106670) / 411.04%

AAR advantages & disadvantagesAdvantagesDisadvantagesEasy to calculateIgnores time value of moneyNeeded information will usually be availableRequires an arbitrary benchmark cutoff rateBased on accounting (book) values, not cash flows and market values65

Question - ARRWhich of the following are considered weaknesses in the average accounting return method of project analysis?I. exclusion of time value of money considerationsII. need of a cutoff rateIII. easily obtainable information for computationIV. based on accounting valuesA.I onlyB.I and IV onlyC.II and III onlyD.I, II, and IV onlyE.I, II, III, and IV66

Practice of capital budgeting In 1999, Duke University professors John Graham and Campbell Harvey conducted a survey of U.S. CFOsResults from the 392 CFOs who responded:Capital budgeting rulePercentage of CFOs always or almost always usingInternal rate of return76Net present value75Payback period57Discounted payback period29Accounting rate of return20Profitability index12Source: Graham and Harvey, “The theory and practice of corporate finance: Evidence from the field” Journal of Financial Economics, 2001, v60 pp.187-24467

Why use rules other than NPV?Uncertaintyabout the future means the NPV we compute is only an estimateManagers use other rules to assess whether estimated NPV is reliableExample:Estimated NPV positive, short payback and very high AAR => all positive signals, NPV is probably rightIf long payback, low AAR => conflicting signals, reconsider the project68