Choosing the Appropriate Technique The advantages and disadvantages of each of the techniques for evaluat-

Choosing the Appropriate Technique The advantages and disadvantages of each of the techniques for evaluat-

ing investments are summarized in Exhibit 13.7. We see in this chart that the discounted cash flow techniques are preferred to the non-discounted cash flow techniques. The discounted cash flow techniques—NPV, PI, IRR, MIRR—are preferable because they consider (1) all cash flows, (2) the time value of money, and (3) the risk of future cash flows. The discounted cash flow techniques are also useful because we can apply objective deci- sion criteria—criteria we can actually use that tells us when a project increases wealth and when it does not.

We also see in Exhibit 13.7 that not all of the discounted cash flow techniques are right for every situation. There are questions we need to ask when evaluating an investment and the answers will determine which technique is the one to use for that investment:

■ Are the projects mutually exclusive or independent? ■ Are the projects subject to capital rationing? ■ Are the projects of the same risk? ■ Are the projects of the same scale of investment?

If projects are independent and not subject to capital rationing, we can evaluate them and determine the ones that maximize wealth based on any of the discounted cash flow techniques. If the projects are mutu- ally exclusive, have the same investment outlay, and have the same risk, we must use only the NPV or the MIRR techniques to determine the projects that maximize wealth. If projects are mutually exclusive and are of different risks or are of different scales, NPV is preferred over MIRR. If the capital budget is limited, we can use either the NPV or the PI. We must be careful, however, not to select projects on the basis of their NPV (that is, ranking on NPV and selecting the highest NPV projects), but rather how we can maximize the NPV of the total capital budget.

LONG-TERM INVESTMENT DECISIONS

EXHIBIT 13.7 Summary of Characteristics of the Evaluation Techniques

PAYBACK PERIOD

Advantages

Disadvantages

1. Simple to compute. 1. No concrete decision criteria to tell 2. Provides some information on

us whether an investment increases he risk of the investment.

the firm’s value. 3. Provides a crude measure of

2. Ignores cash flows beyond the liquidity.

payback period. 3. Ignores the time value of money. 4. Ignores the riskiness of future cash

flows.

DISCOUNTED PAYBACK PERIOD

Advantages

Disadvantages

1. Considers the time value of money. 1. No concrete decision criteria that 2. Considers the riskiness of the

tells us whether the investment cash flows involved in the payback.

increases the firm’s value. 2. Calls for a cost of capital. 3. Ignores cash flows beyond the

payback period.

NET PRESENT VALUE

Advantages

Disadvantages

1. Decision criteria that tells us 1. Requires a cost of capital for whether the investment will

calculation.

increase the firm’s value. 2. Expressed in terms of dollars, not as 2. Considers all cash flows.

a percentage. 3. Considers the time value of money. 4. Considers the riskiness of future

cash flows.

PROFITABILITY INDEX

Advantages

Disadvantages

1. Decision criteria that tells us 1. Requires a cost of capital for whether an investment increases

calculation.

the firm’s value. 2. May not give correct decision 2. Considers all cash flows.

when comparing mutually exclusive 3. Considers the time value of money.

projects.

4. Considers the riskiness of future cash flows. 5. Useful in ranking and selecting projects when capital is rationed.

Capital Budgeting Techniques

EXHIBIT 13.7

(Continued) INTERNAL RATE OF RETURN

Advantages

Disadvantages

1. Decision criteria that tells us 1. Requires a cost of capital for whether an investment increases

decision.

the firm’s value. 2. May not give value maximizing 2. Considers the time value of money.

decision when comparing 3. Considers all cash flows.

mutually exclusive projects. 4. Considers riskiness of future

3. May not give value maximizing cash flows.

decision when choosing projects with capital rationing.

MODIFIED INTERNAL RATE OF RETURN

Advantages

Disadvantages

1. Decision criteria that tells us 1. May not give value maximizing whether the investment increases

decision when comparing mutually the firm’s value.

exclusive projects with different 2. Considers the time value of money.

scales or different risk. 3. Considers all cash flows.

2. May not give value maximizing 4. Considers riskiness of future

decision when choosing projects cash flows.

with capital rationing.