Chapter 08

Net Present Value and

Other Investment Criteria
授課老師：陳瓊蓉老師
 牛刀小試:溫故

1. The Chip Dip Co. has 15,500 shares of stock

outstanding, grants one vote per share, and uses
straight voting. How many shares must you
control to guarantee that you will be elected to the
firm's board of directors if there are three open
seats?
A. 5,167 shares
B. 5,134 shares
C. 3,876 shares
D. 7,751 shares
E. 7,134 shares
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 Key Concepts and Skills
Understand the payback rule and
its shortcomings

Understand accounting rates of return

and their problems

Understand the internal rate of return and

its strengths and weaknesses

Understand the net present value rule

and why it is the best decision criteria
 Chapter Outline
Net Present Value (淨現值)

The Payback Rule (回收期間法)

The Average Accounting Return (平均會計報酬率法)

The Internal Rate of Return (內部報酬率)

The Profitability Index

The Practice of Capital Budgeting (資本預算)

 英文專有名詞(1)
ØNet present value (NPV): The difference between an
investment’s market value and its cost.

ØPayback period rule: The amount of time required for an

investment to generate cash flows sufficient to recover its
initial cost.

ØAverage accounting return(AAR): An investment’s average

net income divided by its average book value.

ØInternal rate of return(IRR): The discount rate that makes

the NPV of an investment zero.
 英文專有名詞(2)
ØMutually exclusive investment decisions: A situation where
taking one investment prevents the taking of another.

ØProfitability index(PI): The present value of an

investment’s future cash flows divided by its initial cost.
Also, benefit-cost ratio.
 Good Decision Criteria
We need to ask ourselves the following
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?
 Project Example Information
You are looking at a new project and you have
estimated the following cash flows:

Year 0: CF = -165,000

Year 1: CF = 63,120; NI = 13,620

Year 2: CF = 70,800; NI = 3,300

Year 3: CF = 91,080; NI = 29,100

Average Book Value = 72,000

Your required return for assets of this risk is 12%.

 Net Present Value (淨現值)
The difference between the market value
of a project and its cost

How much value is created from undertaking

an investment?

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.
 NPV Decision Rule
(NPV決策準則)

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.
 Computing NPV for the Project

Using the formulas:

NPV = 63,120/(1.12) + 70,800/(1.12)2 +

91,080/(1.12)3 – 165,000 = 12,627.41

Using the calculator:

CF0 = -165,000; C01 = 63,120; F01 = 1; C02 = 70,800;

F02 = 1; C03 = 91,080; F03 = 1; NPV; I = 12; CPT
NPV = 12,627.41

Do we accept or reject the project?

 Decision Criteria Test - NPV
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?
 Calculating NPVs with
a Spreadsheet
Spreadsheets are an excellent way to compute NPVs,
especially when you have to compute the cash flows
as well.

Using the NPV function

The first component is the required return entered as a decimal

The second component is the range of cash flows beginning

with year 1

Subtract the initial investment after computing the NPV

 Quiz-NPV
For the following cash flows, what is the NPV at
a discount rate of zero percent? What if the
discount rate is 10 percent?

Year Cash Flow

0 -2,200

1 640

2 800

3 1,900
 Payback Period (回收期間法)
How long does it take to get the initial cost
back in a nominal sense?

Computation

Estimate the cash flows

Subtract the future cash flows from the initial cost until the
initial investment has been recovered

Decision Rule – Accept if the payback period

is less than some preset limit
 Computing Payback For The Project

Assume we will accept the project if it pays

back within two years.
Year 1: 165,000 – 63,120 = 101,880 still to recover

Year 2: 101,880 – 70,800 = 31,080 still to recover

Year 3: 31,080 – 91,080 = -60,000 project pays back during year 3

Payback = 2 years + 31,080/91,080 = 2.34 years

Do we accept or reject the project?

 Decision Criteria Test -
Payback
Does the payback rule account for
the time value of money?

Does the payback rule account for

the risk of the cash flows?

Does the payback rule provide an indication

about the increase in value?

Should we consider the payback rule for

our primary decision criteria?
 Advantages and Disadvantages
of Payback (回收期間法)

Advantages (優點) Disadvantages (缺點)

Easy to understand Ignores the time value of money

Adjusts for uncertainty of Requires an arbitrary cutoff point

later cash flows
Ignores cash flows beyond
Biased towards liquidity the cutoff date

Biased against long-term projects,

such as research and development,
and new projects
Example-Payback period

Year A B
0 -100 -$200
1 30 40
2 40 20
3 50 10
4 60 130
 Quiz -Payback period
Calculate the payback period for the following
project? If the required paypack period is 2
years, what is your decision for this project?

Year Cash Flow

0 -2,200

1 640

2 800

3 1,900
 Average Accounting Return
(會計報酬率法)
There are many different definitions for
average accounting return

The one used in the book is:

Average net income / average book value

Note that the average book value depends on how

the asset is depreciated.

Need to have a target cutoff rate

Decision Rule: Accept the project if the AAR

is greater than a preset rate.
 Computing AAR For The Project

Assume we require an average accounting

return of 25%

Average Net Income:

(13,620 + 3,300 + 29,100) / 3 = 15,340

AAR = 15,340 / 72,000 = .213 = 21.3%

Do we accept or reject the project?

 Decision Criteria Test - AAR
Does the AAR rule account for the time value of money?

Does the AAR rule account for the risk of the cash flows?

Does the AAR rule provide an indication about

the increase in value?

Should we consider the AAR rule for

our primary decision criteria?
 Advantages and Disadvantages
of AAR (平均會計報酬率法)

Advantages (優點) Disadvantages (缺點)

Easy to calculate Not a true rate of return;

time value of money is
Needed information will ignored
usually be available Uses an arbitrary benchmark
cutoff rate

Based on accounting net

income and book values, not
cash flows and market values
 Quiz-ARR
You are looking at a three-year project
with a projected net income of $1,000 in
Year 1, $2,000 in Year 2, and $4,000 in
Year 3. The cost is $9,000, which will be
depreciated straight line to zero over the
three-year life of the project. What is the
average accounting return? If target
AAR=30%, what is your decision for this
investment project?
 Internal Rate of Return
(內部報酬率法)

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
 IRR –
Definition and Decision Rule

Definition: IRR is the return that

makes the NPV = 0

Decision Rule: Accept the project if the

IRR is greater than the required return
 Computing IRR For The Project

If you do not have a financial calculator,

then this becomes a trial-and-error process

Calculator

Enter the cash flows as you did with NPV

Press IRR and then CPT

IRR = 16.13% > 12% required return

Do we accept or reject the project?

 NPV Profile For The Project
IRR = 16.13%
70,000
60,000
50,000
40,000
30,000
NPV

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

Does the IRR rule account for the time value of money?

Does the IRR rule account for the risk of the cash flows?

Does the IRR rule provide an indication about

the increase in value?

Should we consider the IRR rule for

our primary decision criteria?
 Advantages of IRR
(內部報酬率法)

Knowing a return is intuitively appealing

It is a simple way to communicate the value of

a project to someone who doesn’t know all the
estimation details

If the IRR is high enough, you may not need to

estimate a required return, which is often a
difficult task
 Summary of Decisions For
The Project

Summary
Net Present Value Accept

Payback Period Reject

Average Accounting Return Reject

Internal Rate of Return Accept

 Calculating IRRs With
A Spreadsheet

You start with the cash flows the same

as you did for the NPV

You use the IRR function

You first enter your range of cash flows,

beginning with the initial cash flow

You can enter a guess, but it is not necessary

The default format is a whole percent – you will normally

want to increase the decimal places to at least two
 Quiz-IRR
A firm evaluates all of its projects by applying
the IRR rule. If the required return is 18
percent, should the firm accept the following
project?

Year Cash Flow

0 -2,200
1 640
2 800
3 1,900
 NPV vs. IRR
NPV and IRR will generally give us
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

 IRR and Nonconventional
Cash Flows
When the cash flows change signs more than
once, there is more than one IRR

When you solve for IRR, you are solving for the
root of an equation and 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?
 Another Example –
Nonconventional Cash Flows
Suppose an investment will cost $90,000 initially
and will generate the following cash flows:

Year 1: 132,000

Year 2: 100,000

Year 3: -150,000

The required return is 15%.

Should we accept or reject the project?

 NPV Profile
IRR = 10.11% and 42.66%
$4,000.00
$2,000.00

$0.00
($2,000.00)
NPV

($4,000.00)
($6,000.00)

($8,000.00)
($10,000.00)
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55
Discount Rate
 Summary of Decision Rules
The NPV is positive at a required return of
15%, so you should Accept

If you use the financial calculator, you would get an

IRR of 10.11% which would tell you to Reject

You need to recognize that there are non-

conventional cash flows and look at the NPV profile
 IRR and Mutually Exclusive Projects

Mutually exclusive projects

If you choose one, you can’t choose the other

Example: 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

 Example With Mutually
Exclusive Projects

Period Project A Project B The required return

0 -500 -400 for both projects is

1 325 325
10%.

2 325 200 Which project

IRR 19.43% 22.17% should you accept
NPV 64.05 60.74 and why?
 NPV Profiles
IRR for A = 19.43%
$160.00
$140.00
IRR for B = 22.17%
$120.00 Crossover Point = 11.8%
$100.00
$80.00
A
NPV

$60.00
B
$40.00
$20.00
$0.00
($20.00)
($40.00)
0 0.05 0.1 0.15 0.2 0.25 0.3
Discount Rate
 Conflicts Between NPV and IRR

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 in the following situations

Non-conventional cash flows

Mutually exclusive projects

 Profitability Index (獲利率指數)

Measures the benefit per unit cost, based on

the time value of money

A profitability index of 1.1 implies that for

every $1 of investment, we create an additional
$0.10 in value

This measure can be very useful in situations

in which we have limited capital
 Advantages and Disadvantages
of Profitability Index1

Advantages (優點) Disadvantages (缺點)

Closely related to NPV, May lead to incorrect

generally leading to decisions in comparisons
identical decisions of mutually exclusive
investments
Easy to understand and
communicate

May be useful when

Available investment funds
are limited
 Capital Budgeting In Practice

We should consider several investment

criteria when making decisions

NPV and IRR are the most commonly

used primary investment criteria

Payback is a commonly used secondary

investment criteria
Table 8.5 Capital budgeting in practice
 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 required
payback is 4 years.
What is the payback period?

What is the NPV?

What is the IRR?

Should we accept the project?

What decision rule should be the primary decision method?

When is the IRR rule unreliable?
 本章架構－
Capital Budgeting Decision
Methods Formula Criteria (Accept)
1. Payback period Payback = CF0 - CF1 - CF2…… Payback < required payback
(payback) -CF t < 0

2. Average Accounting Average Net Income

AAR = AAR > target AAR
Return (AAR) Average Book Value

* 3. Internal Rate
of Return (IRR)
n
Σ
t=0
CFt
(1+IRR) t =0 IRR > Required return

* 4. Net Present Value n

CFt
( NPV )
NPV = Σ
t=0 (1+K)t
NPV > 0

Note
1.
* are the most commonly used methods .
2. Any conflict between NPV and another decision rule , use NPV .
 本章作業

1,3,4,5,7,10,13,15,16,17, 21

作業不需繳交，
但在期末考範圍內。
 QUIZ
1 Which capital investment evaluation technique is
described by the following characteristics? (1) Easy
to understand and communicate; (2) May result in
multiple answers; (3) May lead to incorrect
decisions when applied to mutually exclusive
investments.

a. NPV b. IRR c. AAR

d. Payback period e. Profitability index