financial analysis
II. Alternative Decision Criteria
Payback Period, IRR, Profitability Index
NBA6060, Spring 2014
Hyunseob Kim
1
Which investment decision criteria to use?
NBA6060, Spring 2014
Hyunseob Kim
2
1
Potential interview question:
“What’s the difference between IRR and NPV?”
NBA6060, Spring 2014
Hyunseob Kim
3
Alternatives to NPV rule
• The NPV rule leads to investment decisions in the shareholder’s best interest.
• But, alternative investment rules have been and still are used by businesses.
• Three common alternatives to the NPV rule:
1) Payback period
2) Internal rate of return (IRR)
3) Profitability index
NBA6060, Spring 2014
Hyunseob Kim
4
2
Alternatives to NPV rule: Test
• Which of the following rules may be useful when a firm is capital constrained? (that is, it cannot invest in all positive-NPV projects)
a) Payback period
b) Internal rate of return (IRR)
c) Profitability index
d) All of above
NBA6060, Spring 2014
Hyunseob Kim
5
1. Payback Period
• The rule:
– How long until the sum of project cash flows is positive?
• Some examples:
NBA6060, Spring 2014
Hyunseob Kim
6
3
1. Payback Period – pros and cons
• Major drawbacks: Ignores three important things
1) Risk of cash flows
2) Timing of cash flows within the payback period
3) All cash flows in excess of initial investment
• Also, cutoff for payback period is arbitrary.
• Then, why it might be useful?
– Since cash flows further away likely harder to forecast, may help distinguish between projects with similar NPV
– Easier to use for a large number of “small” investments.
NBA6060, Spring 2014
Hyunseob Kim
7
Small firms more likely to use payback criterion
Sales
Revenue
$5 billion
0%
10%
20%
30%
40%
50%
60%
70%
Percent of CFO's who always or almost always use payback method
Graham and Harvey (2001, JFE); US firms
NBA6060, Spring 2014
Hyunseob Kim
8
4
Payback Period, IRR, Profitability Index
NBA6060, Spring 2014
Hyunseob Kim
1
Which investment decision criteria to use?
NBA6060, Spring 2014
Hyunseob Kim
2
1
Potential interview question:
“What’s the difference between IRR and NPV?”
NBA6060, Spring 2014
Hyunseob Kim
3
Alternatives to NPV rule
• The NPV rule leads to investment decisions in the shareholder’s best interest.
• But, alternative investment rules have been and still are used by businesses.
• Three common alternatives to the NPV rule:
1) Payback period
2) Internal rate of return (IRR)
3) Profitability index
NBA6060, Spring 2014
Hyunseob Kim
4
2
Alternatives to NPV rule: Test
• Which of the following rules may be useful when a firm is capital constrained? (that is, it cannot invest in all positive-NPV projects)
a) Payback period
b) Internal rate of return (IRR)
c) Profitability index
d) All of above
NBA6060, Spring 2014
Hyunseob Kim
5
1. Payback Period
• The rule:
– How long until the sum of project cash flows is positive?
• Some examples:
NBA6060, Spring 2014
Hyunseob Kim
6
3
1. Payback Period – pros and cons
• Major drawbacks: Ignores three important things
1) Risk of cash flows
2) Timing of cash flows within the payback period
3) All cash flows in excess of initial investment
• Also, cutoff for payback period is arbitrary.
• Then, why it might be useful?
– Since cash flows further away likely harder to forecast, may help distinguish between projects with similar NPV
– Easier to use for a large number of “small” investments.
NBA6060, Spring 2014
Hyunseob Kim
7
Small firms more likely to use payback criterion
Sales
Revenue
$5 billion
0%
10%
20%
30%
40%
50%
60%
70%
Percent of CFO's who always or almost always use payback method
Graham and Harvey (2001, JFE); US firms
NBA6060, Spring 2014
Hyunseob Kim
8
4