financial analysis

II. Alternative Decision Criteria

Payback Period, IRR, Profitability Index

NBA6060, Spring 2014

Hyunseob Kim

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Which investment decision criteria to use?

NBA6060, Spring 2014

Hyunseob Kim

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Potential interview question:
“What’s the difference between IRR and NPV?”

NBA6060, Spring 2014

Hyunseob Kim

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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

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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

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1. Payback Period
• The rule:
– How long until the sum of project cash flows is positive?

• Some examples:

NBA6060, Spring 2014

Hyunseob Kim

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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

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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

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