Chapter 6

Net Present Value & Other

Investment Rules
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

1
Chapter Outline
6.1 Why Use Net Present Value?
6.2 The Payback Period Method
6.3 The Discounted Payback Period Method
6.4 The Internal Rate of Return
6.5 Problems with the IRR Approach
6.6 The Profitability Index
6.7 The Practice of Capital Budgeting

2
6.1 Why Use Net Present Value?
 Accepting positive NPV projects benefits shareholders.
 NPV uses cash flows
 NPV uses all the cash flows of the project
 NPV discounts the cash flows properly

3
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 discount rate
3. Estimate initial costs
 Minimum Acceptance Criteria: Accept if NPV > 0
 Ranking Criteria: Choose the highest NPV

4
Calculating NPV with Spreadsheets
 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.
 Add the initial investment after computing the NPV.

5
6.2 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

6
 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
 Advantages:
 Easy to understand
 Biased toward liquidity

7
6.3 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.

8
 6.4 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

9
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

10
 IRR: Example

Consider the following project:

$50 $100 $150

0 1 2 3
-$200

The internal rate of return for this project is 19.44%

Remember the approximation Formula for IRR
$50 $100 $150
NPV  0  200  ( i
U  i L ).NPVL 2

IRR  (1   )( NPV(1L NPV
i LIRR IRRU )) (1  IRR )3
11
 NPV Payoff Profile
If we graph NPV versus the discount rate, we can see the IRR
as the x-axis intercept.

0% $100.00 $150.00
4% $73.88
8% $51.11 $100.00
12% $31.13
16% $13.52 $50.00 IRR = 19.44%
NPV

20% ($2.08)
24% ($15.97) $0.00
28% ($28.38) -1% 9% 19% 29% 39%
32% ($39.51) ($50.00)
36% ($49.54)
40% ($58.60) ($100.00)
44% ($66.82) Discount rate

12
Calculating IRR with Spreadsheets
 You start with the same cash flows 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.

13
6.5 Problems with IRR
 Multiple IRRs
 Are We Borrowing or Lending
 Two (or more) mutually exclusive
projects
o The Scale Problem
o The Timing Problem

14
 Multiple IRRs
There are two IRRs for this project: Which one should we use
0 1 2 3

-$200 $200 $800 - $800 ?

NPV

80
60
40
100% = IRR2
20
0
-50% -20 0% 50% 100% 150% 200%
Discount rate
-40
-60 0% = IRR1
-80
-100

Number of IRRs is equivalent to the number of sign changes in the CFs 15

Modified IRR - MIRR
 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

16
 Modified IRR – An Example
 Assume a project with the following CFs: (R=15%)
Year CFs Year CFs MCFs FV(Cash Inflows)
0 -15,000 0 -15,000 -16315.0
1 4,000 1 4,000 0 6,996.03
2 5,000 2 5,000 0 7,604.38
3 -2,000 3 -2,000 0
4 7,000 4 7,000 0 8,050.00
5 7,000 5 7,000 29,650.40 7,000.00
MIRR= 12.69%

 Cash outflow year 3 (CFs<0) is discounted to the present using the borrowing rate.
 All cash inflows (CFs>0) are compounded to the last year using the investing rate.
 We assume borrowing and investment rates are equal to required return
 We compute MIRR using the following formula:

 MCF: Modified CFs MIRR  N MCFN

0
MCF
1
 Benefits: single answer and specific rates for borrowing and reinvestment
17
Mutually Exclusive vs. Independent
 Mutually Exclusive Projects: only ONE of several
potential projects can be chosen, e.g., acquiring an
accounting system.
 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

18
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?
Example: If you are given the choice between the two following investment
opportunities, which one would you chose? Why?
― AED1 dirham now and getting AED1.5 and hour later or
― AED10 and getting AED11 an hour later.

CF0 CF1 NPV @0% IRR

-1 1.5 0.5 50.0%
-10 11 1 10.0%
19
The Scale Problem
Example2: We have two projects, Small CF0 CF1
Small Budget -10 40
Budget and Large Budget. Which one Large Budget -25 65
should we chose?
CF0 CF1 NPV @25% IRR
Small Budget -10 40 22 300%
Large Budget -25 65 27 160%

We get conflicting results. How should we resolve them?

a. Compare NPVs (safest option, always): NPVLB>NPVSB
b. Calculate incremental CFs, then compute
i. Incremental NPV, if addition investment leads to added wealth, then invest in LB
ii.Incremental IRR and compare to discount rate, if incremental IRR> r, then
invest in LB

CF0 CF1 NPV @25% IRR

Incremental CFs -15 25 5 66.7% 20
The Timing Problem
Year CFA CFB 6,000

0 -10,000 -10,000 4,000

1 10,000 1,000 2,000

2 1,000 1,000 0
0% 10% 20% 30% 40% 50% 60%
3 1,000 12,000 -2,000
IRR 16.0% 12.9%
-4,000

-6,000
r NPVA NPVB NPVA NPVB
0% 2,000.0 4,000.0
10% 668.7 751.3 For A, Largest CF appears in year 1. For B,
15% 109.3 -484.1 largest CF appears in year 3, which explains
20% -393.5 -1,527.8 why B has higher NPV for lower r, while A has
25% -848.0 -2,416.0 higher NPV for higher r. Timing of CFs affects
30% -1,260.8 -3,177.1 NPV, hence their attractiveness.
35% -1,637.5 -3,833.3
40% -1,982.5 -4,402.3 The preferred project in this case depends
45% -2,299.8 -4,898.5 on the discount rate, not the IRR.
21
50% -2,592.6 -5,333.3
 The Timing Problem
$5,000.00 Project A
$4,000.00 Project B
$3,000.00
$2,000.00 10.55% = crossover rate
$1,000.00
NPV

$0.00
($1,000.00) 0% 10% 20% 30% 40%

($2,000.00)
($3,000.00)
($4,000.00)
($5,000.00) 12.94% = IRRB 16.04% = IRRA

Discount rate
22
Calculating the Crossover Rate
Compute the IRR for either project “A-B” or “B-A”
Year CFA CFB CFA - CFB CFB - CFA
0 -10,000 -10,000 0 0
1 10,000 1,000 9,000 -9,000
2 1,000 1,000 0 0
3 1,000 12,000 -11,000 11,000
IRR 16.0% 12.9% 10.55% 10.55%

3,000 10.55% = IRR

2,000
1,000
NPV

0
0% 5% 10% 15% 20%
-1,000
-2,000
-3,000
Discount rate
A-B B-A
23
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

24
 6.6 The Profitability Index (PI)

Total PV of Future Cash Flows

PI 
Initial Investent

 Minimum Acceptance Criteria:

 Accept if PI > 1

 Ranking Criteria:
 Select alternative with highest PI

25
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

26
6.7 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
either IRR or NPV.

27
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

28
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

29
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?
30
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 -66.64
100% 0.00 -81.25
120% -18.93 -92.52

31
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
32
Practice of Kl Budgeting

Table 6.4 Percentage of Firms who use Capital Budgeting Techniques

US UK
NetherlandsGermany France
Net present value 74.93 46.97 70 47.58 35.09
Internal rate of return 75.61 53.13 56 42.15 44.07
Accounting rate of return 20.29 38.1 25 32.17 16.07
Profitability index 11.87 15.87 8.16 16.07 37.74
Payback period 56.74 69.23 64.71 50 50.88
Discounted payback 29.45 25.4 25 30.51 11.32
Hurdle rate 56.94 26.98 41.67 28.81 3.85
Sensitivity analysis 51.54 42.86 36.73 28.07 10.42
Real options 26.56 29.03 34.69 44.04 53.06
Source: Brounen et al. (2004).

33
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

34
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

35
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?

36