Chapter 5

Net Present Value and 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

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 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

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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

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 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.

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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

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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

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 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

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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

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 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%
$50 $100 $150
NPV  0  200   2 
(1  IRR) (1  IRR) (1  IRR) 3

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NPV Payoff Profile
If we graph NPV versus the discount rate, we can see the IRR
as the x-axis intercept.
0% $100.00
4% $73.88 $150.00
8% $51.11
12% $31.13 $100.00
16% $13.52 IRR = 19.44%
20% ($2.08) $50.00
NPV

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

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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.
 Thedefault format is a whole percent – you will normally
want to increase the decimal places to at least two.

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Problems with IRR

 Multiple IRRs
 Are We Borrowing or Lending
 The Scale Problem
 The Timing Problem

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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

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 Multiple IRRs
There are two IRRs for this project:
$200 $800
Which one
should we use?
0 1 2 3
- $800
-$200
N PV

$100.00

100% = IRR2
$50.00

$0.00
-50% 0% 50% 100% 150% 200%
($50.00) Discount rate

0% = IRR1
($100.00)

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Modified IRR

 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

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Modified IRR

 The modified internal rate of return (MIRR) is

a financial measure of an investment's attractiveness.[It
is used in capital budgeting to rank alternative
investments of equal size. As the name implies, MIRR is a
modification of the internal rate of return (IRR) and as
such aims to resolve some problems with the IRR.

 where n is the number of equal periods at the end of

which the cash flows occur (not the number of cash
flows), PV is present value (at the beginning of the first
period), FV is future value (at the end of the last period).

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 MIRR (One possibility as per



Project A Cashflows
100,230, - 132
book)
 What are the IRRs?
 10% and 20%
 What is MIRR? How to find total number of IRRs from cashflows? :
Looking at the changes in cash flow signs

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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?

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The Timing Problem

$10,000 $1,000 $1,000

Project A
0 1 2 3
-$10,000

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

Discount rate

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Cross Over Rate

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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

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 The Profitability Index (PI)

Total PV of Future Cash Flow s

PI 
Initial Investent
 Minimum Acceptance Criteria:
 Accept if PI > 1

 Ranking Criteria:
 Select alternative with highest PI

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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

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The Practice of Capital Budgeting

 Varies by industry:
 Some firms may use payback, while others choose an alternative approach.

 The most frequently used technique for large corporations is

either IRR or NPV.

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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
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 PRACTICE QUESTIONS
1. Suppose you are offered $7,000 today but must make the
following payments:

a. What is the IRR of this offer?

b. If the appropriate discount rate is 10 percent, should you accept
this offer?
c. If the appropriate discount rate is 20 percent, should you accept
this offer?
d. What is the NPV of the offer if the appropriate discount rate is
10 percent? 20 percent?
e. Are the decisions under the NPV rule in part (d) consistent with
those of the IRR rule?

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 PRACTICE QUESTIONS
2. Consider the following cash flows on two mutually exclusive
projects for the Bahamas Recreation Corporation (BRC). Both
projects require an annual return of 14 percent.

As a financial analyst for BRC, you are asked the following questions:
a. If your decision rule is to accept the project with the greater IRR,
which project should you choose?
b. Because you are fully aware of the IRR rule’s scale problem, you
calculate the incremental IRR for the cash flows. Based on your
computation, which project should you choose?
c. To be prudent, you compute the NPV for both projects. Which
project should you choose? Is it consistent with the incremental IRR
rule?

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 PRACTICE QUESTIONS
3. Consider the following cash flows of two mutually exclusive
projects for Tokyo Rubber Company. Assume the discount rate for
Tokyo Rubber Company is 10 percent.

a. Based on the payback period, which project should be taken?

b. Based on the NPV, which project should be taken?
c. Based on the IRR, which project should be taken?
d. Based on this analysis, is incremental IRR analysis necessary? If
yes, please conduct the analysis.

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