Essentials of Corporate Finance

Chapter 8
Net Present Value and Other Investment
Criteria
Assoc. Professor Dr. Bora Aktan
University of Bahrain
Outline
Evaluating Investment Projects:
Capital Budgeting Techniques
Overview of Capital Budgeting
• Capital budgeting is the process of evaluating
and selecting long-term investments that are
consistent with the firm’s goal of maximizing
shareholder wealth.

• For example: Suppose your firm must decide whether to

purchase a new plastic molding machine for BD 125,000
Dinars. How do we decide?
- Will the machine be profitable?
- Will your firm earn a high rate of return on the
investment?
Overview of Capital Budgeting:
Steps in the Process
The capital budgeting process consists of 4
steps:

1. Proposal generation. Proposals for new investment

projects are made at all levels within a business
organization and are reviewed by finance personnel.
2. Review and analysis. Financial managers perform
formal review and analysis to assess the merits of
investment proposals
3. Decision making & Implementation Firms typically
delegate capital expenditure decision making on the
basis of dollar limits. Following approval, expenditures
are made and projects implemented. Expenditures for
a large project often occur in phases.
4. Follow-up. Results are monitored and actual costs
and benefits are compared with those that were
expected. Action may be required if actual outcomes
differ from projected ones.
Overview of Capital Budgeting: Basic
Terminology

Independent versus Mutually Exclusive

Projects

– Independent projects are projects whose cash

flows are unrelated to (or independent of) one
another; the acceptance of one does not
eliminate the others from further consideration.

– Mutually exclusive projects are projects that

compete with one another, so that the
acceptance of one eliminates from further
consideration all other projects that serve a
similar function.
Overview of Capital Budgeting: Basic
Terminology (cont.)

Unlimited Funds versus Capital Rationing

– Unlimited funds is the financial situation in

which a firm is able to accept all independent
projects that provide an acceptable return.

– Capital rationing is the financial situation in

which a firm has only a fixed number of dollars
available for capital expenditures, and numerous
projects compete for these dollars.
Overview of Capital Budgeting: Basic
Terminology (cont.)

Accept-Reject versus Ranking Approaches

– An accept–reject approach is the evaluation of

capital expenditure proposals to determine whether
they meet the firm’s minimum acceptance criterion.

– A ranking approach is the ranking of capital

expenditure projects on the basis of some
predetermined measure, such as the rate of return.
Capital Budgeting Techniques

Bahrain Ship Repairing & Engineering Company

(BASREC) is currently contemplating two projects:
Project A requires an initial investment of $42 million
USD project B an initial investment (outlay) of $45
million USD. The relevant operating cash flows for the
two projects are presented in Table-1 and depicted on
the Timelines in Figure-1.
https://www.bahrainbourse.org/livequotes
Table-1 Capital Expenditure Data for Bahrain
Ship Repairing & Engineering Company (000.-)
Payback Method

• The Payback (Period) Method is the amount of

time required for a firm to recover its initial
investment in a project, as calculated from cash
inflows.

• The length of the maximum acceptable payback

period is determined by management.

– If the payback period is less than the maximum

acceptable payback period, accept the project.

– If the payback period is greater than the maximum

acceptable payback period, reject the project.
Payback Method (cont.)
Payback Method:
Pros and Cons of Payback Analysis

• The payback method is widely used by large firms

to evaluate small projects and by small firms to
evaluate most projects.
• Its popularity results from its computational
simplicity and intuitive appeal.
• By measuring how quickly the firm recovers its
initial investment, the payback period also gives
implicit consideration to the timing of cash flows
and therefore to the time value of money.
• Because it can be viewed as a measure of risk
exposure, many firms use the payback period as a
decision criterion or as a supplement to other
decision techniques.
Payback Method:
Pros and Cons of Payback Analysis (cont.)

• The major weakness of the payback period is that

the appropriate payback period is merely a
subjectively determined number.
– It cannot be specified in light of the wealth maximization
goal because it is not based on discounting cash flows to
determine whether they add to the firm’s value.
• A second weakness is that this approach fails to
take fully into account the time factor in the value
of money.
• A third weakness of payback is its failure to
recognize cash flows that occur after the payback
period.
Payback Method

• The Discounted Payback (Period)

Method is the amount of time required for a
firm to recover its initial investment in a
project, as calculated from cash inflows.
• However, in this case the cashflows are
discounted.
• This process is a more accurate depiction of
the real payback period as future cash flows
are converted into present value.
• In this case (i%) is required. Normally known
as cost of capital.
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Payback Method

Year Project A Project B

Cash Flows PV of Cash Cash Flows PV of Cash
Flows Flows
(Discounted) (Discounted)
0 (Initial 42,000 42,000 45,000 45,000
Investment)
1 14,000 12,727 28,000 25,454
2 14,000 11,570 12,000 9,917
3 14,000 10,518 10,000 7,513
4 14,000 9,562 10,000 6,830
5 14,000 8,692 10,000 6,209

Copyright ©2015 Pearson Education, Inc. All rights reserved. 10-16

Focus on Practice

Limits on Payback Analysis

– While easy to compute and easy to understand,

the payback period simplicity brings with it some
drawbacks.

– Whatever the weaknesses of the payback period

method of evaluating capital projects, the
simplicity of the method does allow it to be used
in conjunction with other, more sophisticated
measures.
Net Present Value (NPV)
Net present value (NPV) is a sophisticated capital
budgeting technique; found by subtracting a project’s
initial investment from the present value of its cash
inflows discounted at a rate equal to the firm’s cost of
capital.

NPV = Present value of cash inflows – Initial

investment
Net Present Value (NPV) (cont.)

• Decision criteria:

– If the NPV is greater than $0, accept the project.

– If the NPV is less than $0, reject the project.

• If the NPV is greater than $0, the firm will earn a

return greater than its cost of capital. Such action
should increase the market value of the firm, and
therefore the wealth of its owners by an amount
equal to the NPV.
Net Present Value (NPV) (cont.)
Table-1 Capital Expenditure Data for Bahrain Ship
Repairing & Engineering Company (BASREC)

If the company has a 10% cost of capital, what is the

NPV of each project?
Figure-2: Calculation of NPVs for Bahrain Ship
Repairing & Engineering Company’s Capital
Expenditure Alternatives
Net Present Value (NPV) (cont.)
Financial calculator
Net Present Value (NPV) (cont.)
Excel spreadsheets
Profitability Index
For a project that has an initial cash outflow followed
by cash inflows, the profitability index (PI) is simply
equal to the present value of cash inflows divided by
the initial cash outflow:

When companies evaluate investment opportunities

using the PI, the decision rule they follow is to invest
in the project when the index is greater than 1.0.
Profitability Index (cont.)

We can refer back to Figure-2, which shows the

present value of cash inflows for projects A and B, to
calculate the PI for each of the company’s investment
options:

PIA = $53,071 ÷ $42,000 = 1.26

PIB = $55,924 ÷ $45,000 = 1.24

PVA = PI = 1 + (NPV / Initial

$53,071 Investment)
PVB =
 Internal Rate of Return (IRR)
• The Internal Rate of Return (IRR) is the discount rate
that equates the NPV of an investment opportunity with
$0 (because the present value of cash inflows equals the
initial investment); it is the rate of return that the firm
will earn if it invests in the project and receives the given
cash inflows.

• Consider the NPV equation again:

• Set the NPV to zero and simplify:

Internal Rate of Return (IRR)
Figure-3: Calculation of IRRs for Bahrain Ship Repairing & Engineering Company’s Capital
Expenditure Alternatives
Internal Rate of Return (IRR):
Financial Calculator
Internal Rate of Return (IRR):
Excel Spreadsheets
Internal Rate of Return (IRR):
Mathematical Formula

Copyright ©2015 Pearson Education, Inc. All rights reserved. 10-31

Internal Rate of Return (IRR):
Trial & Error Method
Internal Rate of Return (IRR):
Calculating the IRR (cont.)
Internal Rate of Return (IRR):
Calculating the IRR (cont.)

• It is interesting to note in the preceding example that

the IRR suggests that project B, which has an IRR of
21.7%, is preferable to project A, which has an IRR of
19.9%.

• This conflicts with the NPV rankings obtained in an

earlier example.

• Such conflicts are not unusual.

• There is no guarantee that NPV and IRR will rank

projects in the same order. However, both methods
should reach the same conclusion about the
acceptability or non-acceptability of projects.
Comparing Results

Technique A B Superior

PBP 3 years 2.5 years B

NPV $11,071 $10,924 A

PI 1.26 1.24 A

IRR 19.9% 21.7% B

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Comparing NPV and IRR Techniques:
Conflicting Rankings

• Conflicting rankings are conflicts in the ranking

given a project by NPV and IRR, resulting from
differences in the magnitude and timing of cash
flows.
• One underlying cause of conflicting rankings is the
implicit assumption concerning the reinvestment of
intermediate cash inflows—cash inflows received
prior to the termination of the project.
• NPV assumes intermediate cash flows are
reinvested at the cost of capital, while IRR assumes
that they are reinvested at the IRR.
Comparing NPV and IRR Techniques:
Which Approach is Better?

On a purely theoretical basis, NPV is the better

approach because:
– NPV measures how much wealth a project creates (or
destroys if the NPV is negative) for shareholders.
– Certain mathematical properties may cause a project to
have multiple IRRs—more than one IRR resulting from a
capital budgeting project with a nonconventional cash flow
pattern; the maximum number of IRRs for a project is equal
to the number of sign changes in its cash flows.
Despite its theoretical superiority, however, financial
managers prefer to use the IRR approach just as often
as the NPV method because of the preference for
rates of return.
What Methods Do Companies
Really Use?

Evaluation Criteria Used by Companies

Special Issues:
Comparing Evaluation Techniques

49
Special Issues:
Comparing Evaluation Techniques
Chapter Summary
o There are alternative approaches to evaluating
capital investment projects. These approaches
include the net present value, the internal rate
of return, the modified internal rate of return,
the profitability index, the payback period, and
the discounted payback period.

o The net present value method requires the

calculation of the value added from the project,
which is the difference between the present
value of the cash inflows from a project and the
present value of the project’s cash outflows,
where all cash flows are discounted at the
project’s cost of capital. A positive net present
value indicates that the investment is expected
to enhance the value of the company.
 Chapter Summary
o The internal rate of return is the yield on the project, which we
derive by solving for the discount rate resulting in a zero net
present value.
• In many cases, a project with an internal rate of return greater than the
project’s cost of capital is attractive because the project earns more than
what the supplier of capital requires considering the project’s risk.

o One of the drawbacks of the internal rate of return is that the

reinvestment assumption applied to cash flows is the internal
rate of return. We can use the modified internal rate of return,
with its more realistic reinvestment rate assumption, to
overcome this problem. In addition, we should not use the
internal rate of return when deciding among mutually exclusive
projects or evaluating projects with different initial investments.

o Another drawback of the internal rate of return is that the

internal rate of return should not be used when the sign of the
cash flow changes more than once during the life of the project.
 Chapter Summary
o The profitability index is related to the net present value;
instead of the difference between the present value of the
inflows and outflows, the profitability index is the ratio of these
two present values.

o The payback period and the discounted payback period are

measures of how long it takes to recover a project’s cash outlay
in cash inflows and discounted cash inflows, respectively.

o The net present value method is the preferred method because

it is consistent with the maximization of shareholder wealth and
is not complicated by issues that may cause the internal rate of
return to provide misleading results, with respect to mutually
exclusive projects, mathematical issues, and an aggressive
reinvestment rate.

o If capital is rationed—that is, there is a limit on the capital

budget—the focus should be in selecting projects that best
enhance shareholder wealth, which means selecting the set of
projects that provides the greatest sum of net present values
with a sum of initial investments that fit within the budget.
CFA Problems
1- Given the following cash flows for a capital
project, calculate the NPV and IRR. The required
rate of return is 8 percent.

Year
0 1 2 3 4 5

CASH FLOW –50,000 15,000 15,000 20,000 10,000 5,000

NPV

IRR
a. $1,905

10.9%
b. $1,905
2- Given the following cash flows for a capital
project, calculate its payback period and discounted
payback period. The required rate of return is 8
percent.

Year
0 1 2 3 4 5

CASH FLOW –50,000 15,000 15,000 20,000 10,000 5,000

The discounted payback period is

a. 0.16 years longer than the payback
period.
b. 0.80 years longer than the payback
period.
c. 1.01 years longer than the payback
period.
3-An investment of $100 generates after-tax cash
flows of $40 in Year 1, $80 in Year 2, and $120 in
Year 3. The required rate of return is 20 percent.
The net present value is closest to

a. $42.22
b. $58.33
c. $68.52
d. $98.95
4- An investment of $150,000 is expected to
generate an after-tax cash flow of $100,000 in one
year and another $120,000 in two years. The cost of
capital is 10 percent. What is the internal rate of
return?
a. 28.19
percent
b. 28.39
percent
c. 28.59
percent
d. 28.79
percent