Net Present Value and Other

Investment Rules
Chapter 5
Key Concepts and Skills
• Be able to compute payback and discounted
payback and understand their shortcomings
• Be able to compute the internal rate of return
and profitability index, understanding the
strengths and weaknesses of both approaches
• Be able to compute net present value and
understand why it is the best decision criterion
Chapter Outline
5.1 Why Use Net Present Value?
5.2 The Payback Period Method
5.3 The Discounted Payback Period
Method
5.4 The Internal Rate of Return
5.5 Problems with the IRR Approach
5.6 The Profitability Index
5.7 The Practice of Capital Budgeting
5.1 Why Use Net Present Value?
• Capital budgeting is the decision-making
process for accepting or rejecting projects.
• Mutually Exclusive Projects: only ONE of
several potential projects can be chosen
• RANK all alternatives, and select the best one.
• Independent Projects: accepting or rejecting
one project does not affect the decision of the
other projects.
• Must exceed a MINIMUM acceptance criteria
The Net Present Value
(NPV) Rule

• Net Present Value (NPV) = Total PV of future CF’s -

Initial Investment
• Estimating NPV:
1. Estimate future cash flows: how much? and when?
2. Estimate initial costs
3. Estimate discount rate
Minimum Acceptance Criteria: Accept if NPV > 0
Ranking Criteria: Choose the highest NPV
 The Net Present Value
(NPV) Rule
• Example:

• Both projects require an annual return of 14 percent. If

your decision is based on NPV, what is your best choice?
5.1 Why Use Net Present Value?
• Accepting positive NPV projects benefits
shareholders.
• The value of the firm rises by the NPV of the
project
üNPV uses cash flows
üNPV uses all the cash flows of the project
üNPV discounts the cash flows properly
• NPV has the attribute called value additivity. It
means that the value of the firm is merely the
sum of the values of the different projects,
divisions, or other entities within the firm.
5.2 The Payback Period
Method
• How long does it take the project to “pay back” its
initial investment?
• Payback Period = number of years to recover initial
costs
• Minimum Acceptance Criteria:
• Set by management
• Ranking Criteria:
• Set by management
5.2 The Payback Period
Method

• The payback period of the investment is two years.

• If the required payback period is more than two years. This
investment is accepted.
The Payback Period Method
• Disadvantages:
• Ignores the time value of money
• Ignores cash flows after the payback period
• Biased against long-term projects
• Requires an arbitrary acceptance criteria
• A project accepted based on the payback
criteria may not have a positive NPV
The Payback
Period Method
The Payback Period Method
• Advantages:
• Easy to understand
• Biased toward liquidity
5.3 The Discounted
Payback Period
• How long does it take the project to
“pay back” its initial investment, taking
the time value of money into account?
• Decision rule: Accept the project if it
pays back on a discounted basis within
the specified time.
• By the time you have discounted the
cash flows, you might as well calculate
the NPV.
5.4 The Internal Rate of
Return
• IRR: the discount rate that sets NPV to zero
• Minimum Acceptance Criteria:
• Accept if the IRR exceeds the required
return
• Ranking Criteria:
• Select alternative with the highest IRR
• Reinvestment assumption:
• All future cash flows are assumed to be
reinvested at the IRR
5.4 The Internal
Rate of Return

• IRR of the project is 23.37%.

• That number does not depend on the interest
rate prevailing in the capital market (internal)
Internal Rate of Return (IRR)
• Disadvantages:
• Does not distinguish between investing and
borrowing
• IRR may not exist, or there may be multiple
IRRs
• Problems with mutually exclusive investments

• Advantages:
• Easy to understand and communicate
 q Are We Borrowing or Lending
5.5 Problems with q Multiple IRRs
IRR q The Scale Problem
q The Timing Problem
Are We Borrowing or Lending?
• IRR does not distinguish between investing and
borrowing
Multiple IRRs
There are two IRRs for this
project:

Which IRR should we use?

Modified IRR
• Calculate the net present value of all cash
outflows using the borrowing rate.
• Calculate the net future value of all cash
inflows using the investing rate.
• Find the rate of return that equates these
values.
• Benefits: single answer and specific rates for
borrowing and reinvestment
The Scale Problem
• Would you rather make 100% or 50% on your
investments?
• What if the 100% return is on a $1 investment,
while the 50% return is on a $1,000
investment?
The Scale Problem
• Stanley Jaffe and Sherry Lansing have just purchased
the rights to Corporate Finance: The Motion
Picture. They will produce this major motion
picture on either a small budget or a big budget.
The Scale Problem
• Compare the NPVs of the two choices.
• Calculate the incremental NPV from
making the large-budget picture instead of
the small-budget picture
• Compare the incremental IRR to the
discount rate
The Timing Problem

• At the discount rate 10%, NPV B is higher

than NPV A but IRR A is higher than IRR
A.
The Timing Problem The cross-over
rate is the IRR of
project A-B
 NPV versus IRR
• NPV and IRR will generally give the same decision.
• Exceptions:
• Non-conventional cash flows – cash flow signs
change more than once
• Mutually exclusive projects
• Initial investments are substantially different
• Timing of cash flows is substantially different
5.6 The Profitability Index (PI)
• Minimum Acceptance Criteria: Ranking Criteria:
• Accept if PI > 1 Select alternative with highest PI
The Profitability Index
• Disadvantages:
• Problems with mutually exclusive investments
• Advantages:
• May be useful when available investment funds
are limited
• Easy to understand and communicate
• Correct decision when evaluating independent
projects
The Profitability Index

• Project 1,2,3 are indedendent and the company has only

$20 million to invest
5.7 The Practice of Capital Budgeting
• Varies by industry:
• Some firms may use payback, while others
choose an alternative approach.
• The most frequently used technique for large
corporations is either IRR or NPV.
Summary – Discounted Cash Flow
• Net present value
• Difference between market value and cost
• Accept the project if the NPV is positive
• Has no serious problems
• Preferred decision criterion
• Internal rate of return
• Discount rate that makes NPV = 0
• Take the project if the IRR is greater than the required return
• Same decision as NPV with conventional cash flows
• IRR is unreliable with non-conventional cash flows or mutually exclusive projects
• Profitability Index
• Benefit-cost ratio
• Take investment if PI > 1
• Cannot be used to rank mutually exclusive projects
• May be used to rank projects in the presence of capital rationing
Summary – Payback Criteria
• Payback period
• Length of time until initial investment is recovered
• Take the project if it pays back in some specified period
• Does not account for time value of money, and there is an
arbitrary cutoff period
• Discounted payback period
• Length of time until initial investment is recovered on a
discounted basis
• Take the project if it pays back in some specified period
• There is an arbitrary cutoff period
Quick Quiz
• Consider an investment that costs $100,000 and has
a cash inflow of $25,000 every year for 5 years. The
required return is 9%, and payback cutoff is 4 years.
• What is the payback period?
• What is the discounted payback period?
• What is the NPV?
• What is the IRR?
• Should we accept the project?
• What method should be the primary decision rule?
• When is the IRR rule unreliable?