Orientation and Chapter 9 Lecture

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Please familiarize yourself with five different types of project evaluations which are: (1) accounting rate
of return; (2) conventional and discounted payback (3) net present value (4) internal rate of return; (5)
profitability index.

The final exam will cover only new chapters after the midterm exam. There will be 50 multiple choice
questions, and ten of them will be from this chapter.

The ten questions will be related to the following:

Relationship between each key parameter and net present value e.g., required return, cash inflow

Advantage and disadvantage of each of the 5 investment measurements (NPV, IRR, Profitability index,
Average accounting return, Payback)

Key criteria to determine what would be good or bad measurements

Calculations using the five investment measurements

Understand IRR concepts

NPV analysis of mutually exclusive projects

Power Point Slide

Slide 3

This is a capital budgeting decision. What assets should we buy? We need to ask ourselves the following
three questions when evaluating decision criteria:
• Does the decision rule adjust for the time value of money?
• Does the decision rule adjust for risk?
• Does the decision rule provide information on whether we are creating value for the firm?

Slide 4

This example will be used for each of the decision rules so that you can compare the different rules and
see that conflicts can arise. This illustrates the importance of recognizing which decision rules provide
the best information for making decisions that will increase shareholder value.

Slide 5

We learn how to estimate the required return in chapter 13. We will do a deep dive how to estimate
the cash flows next week in chapter 10.

Net present value is the difference between the market value of a project and its cost. To quantify how
much value is created from undertaking an investment, we need to follow three steps. The first step is
to estimate the expected future cash flows. The second step is to estimate the required return for
projects of this risk level. The third step is to find the present value of the cash flows and subtract the
initial investment.

Slide 6

If the NPV is positive, accept the project. A positive NPV means that the project is expected to add value
to the firm and will therefore increase the wealth of the owners. Since our goal is to increase owner
wealth, NPV is a direct measure of how well this project will meet our goal.

Slide 7

The calculator used for the illustration is the Texas Instruments BA-II plus. The basic procedure is the
same, you start with the year 0 cash flow and then enter the cash flows in order. You toggle between
the different cash flows by using the up and down arrows in the top row. F01, F02, etc. are used to set
the frequency of a cash flow occurrence. Many of the calculators only require you to use that if the
frequency is something other than 1. Using the BAII Plus, press CF. The screen displays CFo=0.0000. If
there is already data entered into the Cash Flow functions memory, you can clear this by pressing 2nd
and CE/C. Enter -165,000 and press ENTER. Press the down arrow once until the screen displays CO1.
Enter 63,120 and press ENTER. Press the down arrow twice until the screen displays CO2. Enter 70,800
and press ENTER. Press the down arrow twice until the screen displays CO3. Enter 91,080 and press
ENTER. Then press NPV – you should see I=0.0000. Enter 12 and press enter. Then press the up arrow
key once – the calculator should display NPV=0.0000. Press CPT and the calculator should display the
answer.

Slide 8
Let’s apply the three decision criteria test. Does the NPV rule account for the time value of money?
Does the NPV rule account for the risk of the cash flows? Does the NPV rule provide an indication about
the increase in value? Should we consider the NPV rule for our primary decision criteria?
The answer to all of these questions is yes. I would like to point out that if you get a very large NPV in
real life then you should go back and look at your cash flow estimation again. In competitive markets,
extremely high NPVs should be rare.

Slide 9

Click on the Excel icon to go to an embedded Excel worksheet that has the cash flows along with the
right and wrong way to compute NPV.

Slide 10

Payback period is the length of time the accumulated cash flows, equals or exceeds the original
investment.

Payback period rule is that investment is acceptable if it’s calculated payback is less than some pre-
specified (subjective) number of years.

Because a project is financially sound, some it does not mean that it will be implemented. it also has to
be ethically sound. The question of ethical appropriateness is less frequently discussed in the context of
capital budgeting than that of financial appropriateness. That said, you should always keep in mind
about ethical appropriateness in real life.

Slide 11

The payback period is year 3 if you assume that the cash flows occur at the end of the year as we do
with all of the other decision rules. If the preset limit is 3 years, then the project just meets the preset
limit. That said this is like having net present value of “0” that it does not add value or destroy value if
you decide to go ahead with the project.

Let’s analyze the rule. There is no discounting involved. Payback does not consider risk differences. You
need to determine the cutoff point which is subjective, and there is bias for short-term investments. The
answer to all of these questions is no.

Teaching the payback rule seems to put one in a delicate situation - as the text indicates, the rule is a
flawed indicator of project desirability, at best. And yet, surveys continue to suggest that it is widely
used by practitioners. How does one explain this apparent discrepancy between theory and practice?

While the payback rule is widely used in practice, it is not often the only measure of desirability used;
rather, it is typically used in conjunction with one of the other "better" (i.e., DCF) rules. The payback
technique is particularly useful in comparing mutually exclusive projects. Given two similar projects, the
one which returns the initial investment sooner is likely to be (though certainly not always) the better
project. Payback is useful for screening out internal corporate maneuvering. Many overoptimistic
project managers will overestimate their future cash flows to increase their project’s chance of being
accepted. These overoptimistic forecasts are often called “hockey stick” forecasts for the shape of the
sales chart.

Let’s redeem qualities of the rule. Payback is simple to use (mostly by ignoring long-term). Bias for short-
term promotes liquidity. Can take into account the riskiness of later cash flows simply by ignoring them
all together. Interestingly enough, the payback period technique is used quite heavily in determining
the viability of certain investment projects in the health care industry. Why? Consider the nature of this
industry: the technology is rapidly changing, some of the equipment (e.g., magnetic resonance imaging -
MRI - machines) tends to be expensive, and the industry itself is increasingly competitive. What this
means is that, in many cases, an equipment purchase is complicated by the fact that, while the machine
may be able to perform its function for 6 years, new and improved equipment (as yet unknown) is likely
to supersede it long before that. In the face of such uncertainty, many hospital administrators then
focus on how long it will take to recoup the initial outlay, in addition to the NPV and IRR of the
equipment.

Disadvantages are ignoring time value of money and cash flow beyond payback period. And also biased
against long-term projects. The payback period can be interpreted as a naive form of discounting if we
consider the class of investments with level cash flows over arbitrarily long lives. Since the present value
of a perpetuity is the payment divided by the discount rate, a payback period cut-off can be seen to
imply a certain discount rate.

Slide 14

Discounted payback rule is that an investment is acceptable if its discounted payback is less than some
pre-specified number of years.

Slide 15

Try the question on Slide 15. Payback is somewhere in year 3 while the cut off period is 2 years.
Therefore, we reject the project based on discounted payback measurements.

Slide 16

Discounted payback is better than conventional payback given that discounted payback factor in the
time value of money and risk. However, it’s still a subjective measurement so we cannot consider the
discounted payback rule for our primary decision criteria.

Slide 17

Advantages are that all those of the simple payback rule, plus, the time value of money is taken into
account. If a project pays back on a discounted basis, it must have a positive NPV.

Disadvantages are that although the second advantage listed above suggests that there is a link between
the discounted payback period and firm value, the link is an indirect one - it is not generally possible to
arbitrarily specify a target payback period for all projects and be ensured of maximizing firm value.
The discounted payback period is the length of time until accumulated discounted cash flows equals or
exceeds the initial investment. Use of this technique entails all the work of NPV, but its decision rule is
arbitrary. Redeeming features of this approach are that (1) the time value of money is accounted for,
and (2) if the project pays back on a discounted basis, it has a positive NPV.
Slide 18

The average accounting return (AAR) equals: (measure of accounting profit)/(measure of average
accounting value). In other words, it is essentially a benefit/cost ratio that produces a pseudo rate of
return. However, because of the accounting conventions involved, the lack of risk adjustment, and the
use of profits rather than cash flows, it isn't clear what is being measured.

Since it involves accounting figures rather than cash flows, it is not comparable to returns in capital
markets. It treats money in all periods as having the same value. There is no objective way to find the
cut-off rate. The text gives the following specific definition: ARR = Average net income/Average book
value.

Decision rule is that a project is acceptable if its AAR return exceeds a target return.

Surveys indicate that few large firms employ the payback period and/or the AAR methods exclusively;
rather, these techniques are used in conjunction with one or more of the DCF techniques. On the other
hand, anecdotal evidence suggests that many smaller firms rely more heavily on non-DCF approaches.
Reasons for this include: (1) small firms don't have direct access to the capital markets (and therefore
find it more difficult to estimate discount rates based on funds costs); (2) the AAR is the project-level
equivalent to the ROA measure used for analyzing firm profitability (ROA is discussed in Chapter 3); and,
(3) some small-firm decision-makers may be less aware of DCF approaches than their large-firm
counterparts.

Slide 19

Try this question. You may ask where I came up with the 25%. I want to point out that this is one of the
drawbacks of this rule. There is no good theory for determining what the return should be. We generally
just use some rule of thumb.

Slide 20

The answer to all of these questions is no. In fact, this rule is even worse than the payback rule in that it
doesn’t even use cash flows for the analysis. It uses net income and book value.

Slide 21

Advantages and disadvantages are listed on Slide 21 which summarizes what we discussed.

Slide 22

Internal rate of return (IRR) is the rate that makes the present value of the future cash flows equal to the
initial cost or investment. In other words, the discount rate that gives a project a $0 NPV. The IRR rule is
very important. Management, and individuals in general, often have a much better feel for percent
returns and the value that is created, than they do for dollar increases. A dollar increase doesn’t seem to
provide as much information if we don’t know what the initial expenditure was. As a result, this is the
most important alternative to NPV. It is often used in practice and is intuitively appealing. It is based
entirely on the estimated cash flows and is independent of interest rates found elsewhere.
Finding the IRR for a project is an identical process to determining the YTM for a bond.

Slide 23

IRR rule is that investment is acceptable if and only if the required return is less than the IRR.

Slide 24

Many of the financial calculators will compute the IRR as soon as it is pressed; others require that you
press compute. The instructions are again using the Texas Instruments BAII Plus. Enter the cash flows as
described for the NPV example. Press IRR and then press CPT. The answer of 16.1322 should display on
the calculator’s screen.

Slide 25

Net present value profile—plot of an investment's NPV at various discount rates.

70,000
60,000
50,000
40,000
30,000
NPV

20,000
10,000
0
0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22
-10,000
-20,000
Discount Rate

Slide 26

Click on the icon for a spreadsheet template for calculating IRR.

Slide 27

The answer to all of these questions is yes, although it is not always as obvious. The IRR rule accounts for
time value because it is finding the rate of return that equates all of the cash flows on a time value basis.
The IRR rule accounts for the risk of the cash flows because you compare it to the required return, which
is determined by the risk of the project. The IRR rule provides an indication of value because we will
always increase value if we can earn a return greater than our required return. We should consider the
IRR rule as our primary decision criteria, but as we will see, it has some problems that the NPV does not
have. That is why we end up choosing the NPV as our ultimate decision rule.

Slide 28

Advantages are listed on Slide 28. A same comment that I shared with you on NPV that if you get a very
large IRR then you should go back and look at your cash flow estimation again. In competitive markets,
extremely high IRRs should be rare.

Slide 29

For NPV and IRR comparison, if a project's cash flows are conventional (costs are paid early and benefits
are received over the life), and if the project is independent (meaning the decision to take it does not
affect any other project), then NPV and IRR will give the same accept or reject signal.

Problems with the IRR are related to unconventional cash flows, multiple rates of return, and mutually
exclusive investment decisions.

For unconventional cash flows, if the cash flows are of loan type, meaning money in at first and cash out
later, the IRR is really a borrowing rate and lower is better. The IRR is sometimes called the IBR (internal
borrowing rate) in this case.

Multiple IRRs can be possible if cash flows alternate back and forth between positive and negative (in
and out), whereas NPV rule still works just fine.

IRR does not work for mutually exclusive investment decisions that if taking one project means another
is not taken, the projects are mutually exclusive. The one with the highest IRR may not be the one with
the highest NPV.

Slide 30

When the cash flows change sign more than once, there is more than one IRR. When you solve for the
IRR, you are solving for the root of an equation. When you cross the x-axis more than once, there will
be more than one return that solves the equation. If you have more than one IRR, which one do you use
to make your decision? This can be a daunting task.

Slide 31

NPV = 132,000 / 1.15 + 100,000 / (1.15)2 – 150,000 / (1.15)3 – 90,000 = 1,769.54

If you compute the IRR on the calculator, you get 10.11% because it is the first one that you come to.
So, if you just blindly use the calculator without recognizing the uneven cash flows, NPV would say to
accept and IRR would say to reject.
Slide 32

You should accept the project if the required return is between 10.11% and 42.66%. The MIRR (Modified
IRR) function in MS Excel addresses the multiple IRR problem. It takes the cash flows, finance rate
(interest rate to be paid for negative cash flows), and reinvestment rate (interest rate that would be
earned on positive cash flows) as inputs and returns a single value. Modified IRR is covered in Appendix
A.

$4,000.00

$2,000.00

$0.00
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55
($2,000.00)
NPV

($4,000.00)

($6,000.00)

($8,000.00)

($10,000.00)
Discount Rate

Slide 33

With this example of non-conventional cash flows, just using a calculator without plotting the NPV
profile would lead to rejection of the project. But the profile shows that the project should be accepted
if the required rate of return is 15%.

Slide 34

Mutually exclusive projects are that if you choose one, you can’t choose the other. An example is that
you can choose to attend graduate school next year at either Harvard or Stanford, but not both.
Intuitively you would use the following decision rules: NPV – choose the project with the higher NPV; IRR
– choose the project with the higher IRR.

Slide 35

As long as we do not have limited capital, we should choose project A. You may argue that you should
choose B because then you can invest the additional $100 in another good project, say C. The point is
that if we do not have limited capital, we can invest in A and C and still be better off. If we have limited
capital, then we will need to examine what combinations of projects with A provide the highest NPV and
what combinations of projects with B provide the highest NPV. You then go with the set that will create
the most value. If you have limited capital and a large number of mutually exclusive projects, then you
will want to set up a computer program to determine the best combination of projects within the
budget constraints.
The important point is that we DO NOT use IRR to choose between projects regardless of whether or not
we have limited capital.

Slide 36

If the required return is less than the crossover point of 11.8%, then you should choose A. If the required
return is greater than the crossover point of 11.8%, then you should choose B

Slide 37

NPV directly measures the increase in value to the firm. Whenever there is a conflict between NPV and
another decision rule, you should always use NPV. IRR is unreliable innon-conventional cash flows, and
mutually exclusive projects

Slide 38

Profitability index (PI) (or benefit/cost ratio) is the present value of the future cash flows divided by the
initial investment. If a project has a positive NPV, then the PI will be greater than 1. It is common
practice among large firms to employ a discounted cash flow technique such as IRR or NPV along with
payback period or average accounting return. It is suggested that this is one way to resolve the
considerable uncertainty over future events that surrounds estimating the NPV.

Slide 39

Advantages of PI are that it is closely related to NPV, generally leading to identical decisions, easy to
understand and communicate, and may be useful when available investment funds are limited

Disadvantages of PI are that it may lead to incorrect decisions in comparisons of mutually exclusive
investments.

Slide 40
NPV and IRR are the most commonly used primary investment criteria. Payback is a commonly used
secondary investment criteria. Capital budgeting techniques vary with industry. Firms that are better
able to estimate cash flows precisely are more likely to use NPV. These methods should be used with
considerable judgment and thought. There may be more risk than we have considered or we may want
to pay additional attention to our cash flow estimations. Sensitivity and scenario analysis can be used to
help us evaluate our cash flows. The fact that payback is commonly used as a secondary criteria may be
because short paybacks allow firms to have funds sooner to invest in other projects without going to the
capital markets.

Slide 41

Capital rationing occurs when a firm or division has limited resources. Soft rationing – the limited
resources are temporary, often self-imposed. Hard rationing is that additional capital cannot be raised,
due to financial distress or pre-existing contractual agreements. The profitability index is a useful tool
when faced with capital rationing.