Corporate Finance: Theory &

Practice
Investment Rules

Prof. Marta Degl’Innocenti

Capital Budgeting
• Capital budgeting is the process in which a business
determines whether long-run assets (tangible and non-
tangible) are worth pursuing.
• Every firm faces a large number of possible investments in
real assets. One of the concerns of the financial manager is
the type of assets to invest in.
• There are many options to each investment but each option
is usually mutually exclusive.
• For example, a UK textile firm may be looking to open a factory
abroad and they have to choose between a factory in India or
China or Egypt. If they pick India then China and Egypt are out
of contention.
• It is the job of the financial group and manager to find out
which one of the option is the most profitable and productive. 46
NPV method
• Terminology

The discounting factor, also know as the

Opportunity Cost of Capital, is the Expected What if it is lower
than the interest
rate of return given up by investing in a
rate?
project.

Net Present Value - Present value of cash flows

minus initial investments.

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NPV method (Cont’d)
• The NPV decision rule implies that we should:
• Accept positive-NPV projects; accepting them is equivalent to
receiving their NPV in cash today, and
• Reject negative-NPV projects; accepting them would reduce
the value of the firm, whereas rejecting them has no cost
(NPV = 0).

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NPV method (Cont’d)
• NPV takes into consideration the time value of money or cash
flows by means of present value (PV).
• Steps towards Estimation of NPV:
• (1) Estimate or forecast the opportunity cost of capital and
expected future cash flow from the investment.
• (2) Estimate the PV of the cash inflows and outflows of the
investments at a certain discount rate.
• (3) Compare the estimated NPVs from the different
investments.

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NPV method (Cont’d)
• How to calculate NPV?
Let:
C0 = Initial cash outflow or cost of investment
Ct = cash inflow at time t
r = Required rate of return or the discounting interest rate
C1 C2 Ct
so we have, NPV  C0   
(1  r )1 (1  r ) 2 (1  r )t

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Using the NPV rule: Example
A take-it-or-leave-it decision:
A fertiliser company can create a new environmentally friendly
fertiliser at a large savings over the company’s existing fertiliser.
The fertiliser will require a new factory that can be built at a cost of
$81.6 million. Estimated return on the new fertiliser will be $28
million after the first year, and last four years. If the company’s cost
of capital is 10%, should they undertake the investment?

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Using the NPV rule: Example
A take-it-or-leave-it decision:
A fertiliser company can create a new environmentally friendly
fertiliser at a large savings over the company’s existing fertiliser.
The fertiliser will require a new factory that can be built at a cost of
$81.6 million. Estimated return on the new fertiliser will be $28
million after the first year, and last four years. If the company’s cost
of capital is 10%, should they undertake the investment?
C0 = 81.6, Ct = 28, r = 10%
C1 C2 Ct
NPV  C0    
(1  r )1 (1  r ) 2 (1  r )t
28 28 28 28
 81.6   2
 3
 4
=7.16
1  10% (1  10%) (1  10%) (1  10%)
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Using the NPV rule: Example 2
A firm takes on a new investment that pays off $2,000 per year for
the first 2 years and then $3,000 for the third year. The cost of the
investment is $5,000 paid today. What is the NPV of the
investment at 10% interest rate per year?

C 0 = 5,000, r = 10%
2, 000 2, 000 3, 000
NPV  5, 000   2
 3
=725.01
1  10% (1  10%) (1  10%)

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NPV: Choosing among mutually exclusive projects
• Between two or more projects, the one with the highest NPV
is picked.
Example: Consider two projects, assuming a 10% opportunity
cost of capital. Which project should be selected?

Cash Flows
Project NPV
C0 C1 C2
Project 1 - $1,000 $700 $500 $49.59
Project 2 - $1,000 $500 $700 $33.06

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Alternative Decision Rules
• The Most Popular Decision Rules Used by CFOs

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Payback Rule
• Payback is the length of time a project takes to recover the
initial investment.
• The opportunity that pays back the initial investment quickly
is the best idea.
• A project is accepted if the calculated payback period is less
than some required period of time.
• This required period of time is pre set by the firm.
• Usually small localised firms apply the payback rule.

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Payback Rule: Simple example
• Initial Cost of Investment = $1000
Year Cash Inflow
• Required payback period = 3 years
• Payback period is somewhere 1 $200
between 2 and 3 years. End of
year 2 = $700 is recovered and
2 $500
thus $300 more is needed.
• Cash inflow during the 3rd year is
3 $500
$500 and thus, 300/500 = 3/5 or
0.60. Payback period is equal to
2.6 years. 4 $100

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Disadvantages of Payback Rule
• No discounting, so the time value money is ignored. $1 five
years in the future is considered the same as it is today.
• Cash flows after the cut off period are ignored. This could be
misleading.
• What if project A has payback period of 4 years and project B
has payback period of 3 years but has smaller (than project A)
cash inflows after the 3rd year?
• No risk factor. The payback period is calculated the same
way for a risky and a safe project.
• Not necessarily consistent with the goal of corporation.

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Disadvantages of Payback Rule: Example

Example: The three projects below are available. The company

accepts all projects with a 2 year or less payback period. Show
how this will impact your decision.

Cash Flows
NPV
Project Payback (@ 10%)
C0 C1 C2 C3 Period $49.59
1.6 years
Project 1 - $1,000 $700 $500 $33.06
1.7 years
Project 2 - $1,000 $500 $700 $558.98
1.7 years
Project 3 -$1,000 $500 $700 $700

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Cut off period: Exercise
• What is the payback period on each of the following
projects?

Project Payback
A 3 years
B 2 years
C 3 years
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Cut off period: Exercise (cont’d)
• Given that you wish to use the payback rule with a cutoff
period of 2 years, which projects would you accept?

• If you use a cutoff period of 3 years, which projects would

you accept?

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Cut off period: Exercise (cont’d)
• If the opportunity cost of capital is 10%, which projects have
positive NPVs?

$1,000 $1,000 $3,000

NPVA  $5,000   2
 3
 $1,010.52
1.10 (1.10) (1.10)
$1,000 $2,000 $3,000
NPVB  $1,000     $3,378.12
(1.10) 2 (1.10) 3 (1.10) 4
$1,000 $1,000 $3,000 $5,000
NPVC  $5,000      $2,405.55
1.10 (1.10) 2 (1.10) 3 (1.10) 4
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Discounted Payback Rule
• Discounted payback rule solves the problem of time value of
money. The first disadvantage described above is solved.
• The rule is:
• The length of time required for an investment’s discounted cash
inflows to equal or exceed the initial cost of the investment.

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Discounted Payback Rule: Example
Year Cash Flow Discounted Cash Flow
1 $100 100/(1.1)=$90.91
2 $100 100/(1.1)2 = $82.64
3 $100 100/(1.1)3 = $75.13
4 $100 100/(1.1)4 = $68.30
• Initial cost of investment = $200
• Discount rate = 10% per year
• Payback period using normal cash inflow = 2 years
• Payback period using discounted cash inflows = 2-3 years.

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NPV & Internal Rate of Return (IRR)
Cash flow C0 C1 C2 C3
Project - $375K $25K $25K $475K

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IRR: Example
• IRR is the discount rate (interest rate) that will equate the PV
of expected cash outflows to the PV of the cash inflows.
• IRR makes the NPV of an investment equal to zero.

C1 C2 Ct
NPV  C0  1
 2
 t
0
(1  IRR ) (1  IRR) (1  IRR)
C1 C2 Ct
 C0  1
 2

(1  IRR ) (1  IRR) (1  IRR )t
• The firm should be equally willing to accept or reject the
project if the discount rate is IRR.

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IRR rules

• If the discount rate is lower than the IRR, accept the project.
• If the discount rate is greater than the IRR, reject.

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IRR: Example
• Initial cost of investment = $800
Year Cash Inflow
• What is the IRR? Since we do
not have a discount rate or cost
of capital, we apply the trial 1 $300
and error method.
2 $300

3 $300

4 $150

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IRR: Example (cont’d)
• Starting with discount rate = 10%

• Since NPV at 10% is a positive we need to apply larger

discount rate, say 14%.
• NPV at 14% is equal to -14.70. We need to apply slightly
lower rate, say 13%.
• NPV at 13% is equal to 0.34. This is close enough. Of course,
a more accurate IRR can be achieved with more trial and
error. Financial calculators and spreadsheets can perform this
function easily.

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Exercise
If you insulate your office for £10,000, you will save £1,000 a
year in heating expenses. These savings will last forever.
a. What is the NPV of the investment when the cost of capital
is 8%? 10%?
b. What is the IRR of the investment?
c. What is the payback period on this investment?
a. The present value of the savings is £1,000/r.
r = 0.08, so PV = £12,500 and NPV = –£10,000 + £12,500 = £2,500
r = 0.10, so PV = £10,000 and NPV = –£10,000 + £10,000 = £0

b. IRR = 0.10 = 10%

At this discount rate, NPV = £0.

c. Payback period = 10 years 70

Weakness in IRR
• Can we just rely on the IRR to make investment decision?
• Pitfall 1a: Mutually Exclusive Projects with same lives
• In mutually exclusive projects, IRR ignores the scale of investment. It provides
a rate of return in percentage but ignores the size of the return in pounds
(dollars).
• It may give a higher rate of return on smaller size investment as compared to
a larger size investment but does not consider the larger size of return from
the larger investment.

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Weakness in IRR: Example 2

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Weakness in IRR: Example 2

Calculating the incremental IRR:

25 million
15 million  0
1  IRR
IRR  66.67%
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Weakness in IRR
• IRR Pitfall 1b: Mutually Exclusive Projects
• In mutually exclusive projects with different lives the IRR does not take timing
of the cash flows into consideration.
• Projects with larger cash inflows at a later stage will provide lower IRR than
projects with larger cash inflows at an earlier stage.
• But, the NPV will be higher for the project with larger cash inflows at a later
stage than the project with the cash inflows at an earlier stage.

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Weakness in IRR
• IRR Pitfall 1b: Mutually Exclusive Projects

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Weakness in IRR
• IRR Pitfall 2 - Lending or Borrowing?

150
NPVH @10%  100   36.36
(1  10%)
150
NPVI @10%  100   36.36
(1  10%)
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Lending or borrowing: Example 2
Consider this project with an IRR of 13.1%. Should you accept
or reject the project if the discount rate is 12%?

• This is a “borrowing-type” project with a

positive cash flow followed by negative
cash flows. A high IRR in such cases is not
attractive: You don’t want to borrow at a
high interest rate.

60 60
NPV  100   2
 1.40
(1  12%) (1  12%)

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IRR Vs. NPV: Non-conventional projects
• A stocks or bonds are conventional investment. You buy the security
(initial cash outlay) and then dividend payment or interest payments
are the expected future positive cash inflows.
• A non-conventional project has cash flow pattern that are much
different from the conventional. In some cases, the initial cash flow
may be positive and the expected future cash flows may be negative.
• For example, pension firms or insurance firms receive the initial investment
amount from clients and then in the future make regular payments to clients.
• If the cash flow changes sign, multiple IRR will happen.

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Non-conventional project example
• Consider the following cash flows (millions):
C0 C1 C2 C3 C4 C5
-$210 +$125 +$125 +$175 +$175 -$400

Calculate the NPV of the project if the discount rate is

1) 3%
2) 25%

125 125 175 175 400

NPV1  210   2
 3
 4
 5
0
1.03 1.03 1.03 1.03 1.03
125 125 175 175 400
NPV2  210   2
 3
 4
 5
0
1.25 1.25 1.25 1.25 1.25

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Non-conventional project example

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Bottom Line on IRR
• The Bottom Line on IRR
• Picking the investment opportunity with the largest IRR
can lead to a mistake.
• In general, it is dangerous to use the IRR in choosing
between projects.
• Try to rely more on NPV.

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Other Investment Criteria: Profitability Index

NPV
Profitability Index 
Initial Investment

Cash Flows
Profitability
NPV Index
Project C0 C1 C2 (@10%) .0496
Project 1 - £1,000 £700 £500 £49.59
.0331
Project 2 - £1,000 £500 £700 £33.06
When funds are limited, start from the project with the
highest profitability index

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Putting It All Together

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Putting It All Together

Ignores the time value of

money; No risk factor

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Reading

• Corporate Finance (11th ed.), Chapter 4, 5 6 and 7.

• Principles of Corporate Finance (12th ed.), Chapter 5 & 6.