Investment Rules

Ningyue Liu (刘宁悦)

Beijing Institute of Technology
Email:[email protected]
 1Why Use Net Present Value?

2The Payback Period Method

3The Discounted Payback Period Method

4 The Average Accounting Return Method

5 The Internal Rate of Return

6 The Profitability Index

 Learning Objectives
• LO1 The reasons why the net present value criterion is the
best way to evaluate proposed investments;
• LO2 The payback rule and some of its shortcomings;
• LO3 The discounted payback rule and some of its
shortcomings;
• LO4 Average accounting return and some of the problems
with them;
• LO5 The internal rate of return criterion and its strengths
and weaknesses;
• LO6 The profitability index and its relation to net present
value.
 1 Net Present Value and Its Rules

• Net Present Value (NPV) =

Total PV of future project CF’s less the Initial Investment
• Estimating NPV:
1. Estimate future cash flows: how much? and when?
2. Estimate discount rate
3. Estimate initial costs
• Minimum Acceptance Criteria: Accept if NPV > 0
• Ranking Criteria: Choose the highest NPV
 Net Present Value: Example
• Suppose Big Deal Co. has an opportunity to make an
investment of $100,000 that will return $33,000 in year 1,
$38,000 in year 2, $43,000 in year 3, $48,000 in year 4, and
$53,000 in year 5. If the company’s required return is 12%
should they make the investment?

Answer:
Cash PV of
Year Flow Cash Flow
0 $ (100,000) $ (100,000) YES! The NPV is
1 $ 33,000 $ 29,464 greater than $0.
2 $ 38,000 $ 30,293 Therefore, the
3 $ 43,000 $ 30,607
4 $ 48,000 $ 30,505 investment does return
5 $ 53,000 $ 30,074 at least the required
rate of return.
Net Present Value $ 50,943
 Why Use Net Present Value?
• Accepting positive NPV projects benefits
shareholders.
✓NPV uses cash flows
✓NPV uses all relevant cash flows of the project
✓NPV discounts the cash flows properly
• Reinvestment assumption: the NPV rule assumes
that all cash flows can be reinvested at the discount
rate.
 Questions
• What is the net present value rule?
• If we say an investment has an NPV of
$1,000, what exactly do we mean?
 1Why Use Net Present Value?

2The Payback Period Method

3The Discounted Payback Period Method

4 The Average Accounting Return Method

5 The Internal Rate of Return

6 The Profitability Index

 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; a predetermined time period
• Ranking Criteria:
– Set by management; often the shortest payback
period is preferred
 Example: Payback Method
• Consider a project with an investment of $50,000 and
cash inflows in years 1,2, & 3 of $30,000, $20,000,
$10,000

• The timeline above clearly illustrates that payback in this

situation is 2 years. The first two years of return =
$50,000 which exactly “pays back” the initial investment
 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
• Advantages:
– Easy to understand
– Managerial control
– Quick cash recovery
 Questions
• In words, what is the payback period? The
payback period rule?
• Why do we say that the payback period is,
in a sense, an accounting break-even
measure?
 1Why Use Net Present Value?

2The Payback Period Method

3The Discounted Payback Period Method

4 The Average Accounting Return Method

5 The Internal Rate of Return

6 The Profitability Index

 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.
 Example: Discounted Payback Method
• Suppose Big Deal Co. has an opportunity to make an
investment of $100,000 that will return $33,000 in year 1,
$38,000 in year 2, $43,000 in year 3, $48,000 in year 4, and
$53,000 in year 5. If the company’s required return is 12%
and predetermined payback period is 3 years should they
make the investment?
Cash PV of Cumulative
Year Flow Cash Flow PV of Cash Flows Answer: NO! At the
0 $ (100,000) $ (100,000) $ (100,000) end of three years the
1 $ 33,000 $ 29,464 $ (70,536) project has still not
2 $ 38,000 $ 30,293 $ (40,242)
broken even or “ paid
3 $ 43,000 $ 30,607 $ (9,636)
4 $ 48,000 $ 30,505 $ 20,869 back”. Therefore, it
5 $ 53,000 $ 30,074 $ 50,943 must be rejected.
 The Discounted Payback Period
• Disadvantages:
– Ignores cash flows after the payback period
– Biased against long-term projects
– Requires an arbitrary acceptance criteria
• Advantages:
– Simplicity?
• A poor compromise between the payback
method and NPV
 Questions
• In words, what is the discounted payback
period? Why do we say it is, in a sense, a
financial or economic break-even measure?
• What advantage(s) does the discounted
payback have over the ordinary payback?
 1Why Use Net Present Value?

2The Payback Period Method

3The Discounted Payback Period Method

4 The Average Accounting Return Method

5 The Internal Rate of Return

6 The Profitability Index

 4 Average Accounting Return

Average Net Income

AAR =
Average Book Value of Investment

• Another attractive, but fatally flawed,

approach
• Ranking Criteria and Minimum Acceptance
Criteria set by management
Example: Average Accounting Return
 Average Accounting Return
• Disadvantages:
–Ignores the time value of money
–Uses an arbitrary benchmark cutoff rate
–Based on book values, not cash flows and market
values
• Advantages:
–The accounting information is usually available
–Easy to calculate
 Questions
• What is an average accounting rate of
return (AAR)?
• What are the weaknesses of the AAR rule?
 1Why Use Net Present Value?

2The Payback Period Method

3The Discounted Payback Period Method

4 The Average Accounting Return Method

5 The Internal Rate of Return

6 The Profitability Index

 5 The Internal Rate of Return

• IRR: the discount rate that sets NPV to zero

• Minimum Acceptance Criteria:
– Accept if the IRR is greater the discount rate
• Ranking Criteria:
– Select alternative with the highest IRR
• Reinvestment assumption:
– All future cash flows assumed reinvested at the
IRR
 Example: IRR
Consider the following project:
$50 $100 $150

0 1 2 3
-$200
The internal rate of return for this project is 19.44%

$ 50 $ 100 $ 150
NPV = 0 = − 200 + + +
(1 + IRR ) (1 + IRR ) (1 + IRR ) 3
2
 NPV Payoff Profile
If we graph NPV versus the discount rate, we can see the IRR
as the x-axis intercept.
0% $100.00 $120.00
4% $73.88 $100.00
8% $51.11 $80.00
12% $31.13 $60.00
16% $13.52 $40.00 IRR = 19.44%
NPV

20% ($2.08) $20.00

24% ($15.97) $0.00
28% ($28.38) ($20.00)
-1% 9% 19% 29% 39%
32% ($39.51) ($40.00)
36% ($49.54) ($60.00)
40% ($58.60)
($80.00)
44% ($66.82)
Discount rate
 The Internal Rate of Return (IRR)
• Advantages:
–IRR does not depend on the discount rate (the
interest rate prevailing in the capital market).
–Easy to understand and communicate

• Disadvantages:
–Does not distinguish between investing and
financing
–There may be multiple IRRs
–Problems with mutually exclusive investments: the
scale and timing problem
 Problems with IRR

❑ Investing or Financing?
❑ Multiple IRRs
❑ The Scale Problem
❑ The Timing Problem
 Independent vs
Mutually Exclusive Projects
• Independent Projects: accepting or rejecting
one project does not affect the decision of the
other projects.
– Must exceed a MINIMUM acceptance criteria

• Mutually Exclusive Projects: only ONE of

several potential projects can be chosen.
– RANK all alternatives, and select the best one.
Example
 Investing or Financing?
• Investing type project (Project A): Lending
• Minimum Acceptance Criteria:
– Accept if the IRR is greater than the discount rate

• Financing type project (Project B): Borrowing

• Minimum Acceptance Criteria:
– Accept if the IRR is less than the discount rate
 Multiple IRRs

• (-$100, $230, -$132)

• Initial investment, profits and further investment
• The cash flows of Project C exhibit two changes of
signs
• In theory, a cash flow stream with K changes in
sign can have up to K sensible IRR.
• IRR simply cannot be used for Project C.
 Modified IRR (MIRR)
• Discount and combine cash flows until only one change
in sign remains.
➢Project C: with a discount rate of 14%, the value of the last cash
flow is
➢-$132/1.14=-$115.79
➢The “adjusted” cash flow at date 1 is $114.21 (=$230-$115.79)
➢The cash flow is (-$100, $114.21)
➢The IRR rule can now be applied.

• Advantage: single answer and specific rates

• Disadvantage: use the discount rate
General Rules
 The Scale Problem

• Opportunity 1 or 2?

• Small or large project?

 The Incremental IRR

• Incremental IRR
• 0=-$15+$25/(1+IRR)
• IRR=66.67%>25%
• NPV of incremental cash flows:
• -$15+$25/1.25=$5
 The Scale Problem
• One of three ways:
• 1. Compare the NPVs of the two projects;
• 2. Calculate the incremental NPV from making the
large project instead of the small one;
• 3. Compare the incremental IRR to the discount
rate.
• All three approaches always give the same
decision. However, we must not compare the
IRRs of the two projects.
The Timing Problem
 The Timing Problem

• One of three methods:

• 1. Compare the NPVs of the Two Projects;
• 2. Compare the Incremental IRR to the Discount
Rate;
• 3. Calculate the NPV on the Incremental Cash
Flows.
• The same decision is reached according to three
methods. However, we should not compare the
IRR of two projects.
 NPV vs. 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
 Questions
• Under what circumstances will the IRR and
NPV rules lead to the same accept-reject
decisions? When might they conflict?
• What is the modified internal rate of
return?
 1Why Use Net Present Value?

2The Payback Period Method

3The Discounted Payback Period Method

4 The Average Accounting Return Method

5 The Internal Rate of Return

6 The Profitability Index

 6 The Profitability Index (PI)
• PI=Total PV of Future Cash Flows/Initial
Investment

• Minimum Acceptance Criteria:

– Accept if PI > 1

• Ranking Criteria:
– Select alternative with highest PI
 Example: The Profitability Index

• Project 1
• $70.5=$70/1.12+$10/(1.12)2
• 3.53=$70.5/$20
 The Profitability Index
• Disadvantages:
–Problems with mutually exclusive investments: the
scale problem
–The incremental analysis
 The Profitability Index
• Advantages:
–May be useful when available investment funds are
limited: capital rationing

– The firm has only $20 million to invest.

– Project 1 or Projects 2 + 3
– Added NPVs or PI rule (the dollar return) but not rank by NPVs
– Select Projects 2 + 3
 The Profitability Index
• When the firm has $30 million to invest, it
would be better served by accepting projects
1 and 2 because projects 1 and 2 use up all of
the $30 million, while projects 2 and 3 have a
combined initial investment of only $20
million (=$10+$10).
 Questions
• What does the profitability index measure?
• How would you state the profitability index
rule?
 The Practice of Capital Budgeting
• Varies by industry:
– Some firms use payback, others use accounting rate of return.
• The most frequently used technique for large corporations is
IRR or NPV.
 Example of Investment Rules
Compute the IRR, NPV, PI, and payback period
for the following two projects. Assume the
required return is 10%.
Year Project A Project B
0 -$200 -$150
1 $200 $50
2 $800 $100
3 -$800 $150
 Example of Investment Rules

Project A Project B
CF0 -$200.00 -$150.00
PV0 of CF1-3 $241.92 $240.80

NPV = $41.92 $90.80

IRR = 0%, 100% 36.19%
PI = 1.2096 1.6053
 Example of Investment Rules
Payback Period:
Project A Project B
Time CF Cum. CF CF Cum. CF
0 -200 -200 -150 -150
1 200 0 50 -100
2 800 800 100 0
3 -800 0 150 150

Payback period for project B = 2 years.

Payback period for project A = 1 or 3 years?
 NPV and IRR Relationship

Discount rate NPV for A NPV for B

-10% -87.52 234.77
0% 0.00 150.00
20% 59.26 47.92
40% 59.48 -8.60
60% 42.19 -43.07
80% 20.85 -65.64
100% 0.00 -81.25
120% -18.93 -92.52
 NPV Profiles
$400
NPV

$300
IRR 1(A) IRR (B) IRR 2(A)
$200

$100

$0
-15% 0% 15% 30% 45% 70% 100% 130% 160% 190%
($100)

($200)
Project A
Discount rates
Cross-over Rate Project B
 Summary
• Net present value
– NPV=Total PV of future project CF’s less the Initial Investment
– Minimum Acceptance Criteria: Accept if NPV > 0
– Ranking Criteria: Choose the highest NPV

• The Payback Period Method

– Length of time until initial investment is recovered

• The Discounted Payback Period Method

– Length of time until initial investment is recovered on a
discounted basis
 Summary
• The Average Accounting Return Method
Average Net Income
AAR =
Average Book Value of Investment

• The Internal Rate of Return

– IRR: the discount rate that sets NPV to zero
– Minimum Acceptance Criteria: Accept if the IRR is greater the
discount rate
– Ranking Criteria: Select alternative with the highest IRR
• The Profitability Index
– PI=Total PV of Future Cash Flows/Initial Investment
– Minimum Acceptance Criteria: Accept if PI > 1
– Ranking Criteria: Select alternative with highest PI
 Summary-Discounted Cash Flow
• Net present value
– Difference between present 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
– Doesn’t 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
 Summary-Accounting Criteria
• Average Accounting Return
– Measure of accounting profit relative to book value
– Similar to return on assets measure
– Take the investment if the AAR exceeds some specified
return level
– Ignores the time value of money
– Uses an arbitrary benchmark cutoff rate
– Based on book values, not cash flows and market values