Corporate Finance

Investment Decisions Rules

Philipp Krüger
Course objectives
• How to apply the NPV rules?

• What is the Internal Rate of Return (IRR)? How to apply it?

• Understanding the Payback Rule

• Using the investment decision rules for choosing the best

alternative between projects

• How to select a project if we have some resource constraints?

What is the Profitability Index?

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Overview
• NPV and stand-alone projects
• The internal rate of return rule
• The payback rule
• Choosing between projects
• Project selection with resource constraints

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NPV decision rule
• NPV decision rule states that:
– When making an investment decision, take the alternative with the
highest NPV. Choosing this alternative is equivalent to receiving its
NPV in cash today.

• In the case of stand-alone projects, we must choose between

accepting or rejecting the project.
• As such, the NPV rule says we should compare the project’s
NPV to zero and accept if its NPV is positive.
• What if the NPV is equal to 0?

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NPV decision rule
• Consider a take-it-or-leave-it investment decision involving a
single, stand-alone project for Frederik’s Feed and Farm (FFF).
• The project costs $250 million and is expected to generate
cash flows of $35 million per year, starting at the end of the
first year and lasting forever.
• The NPV of the project is calculated as:
NPV = -250 + 35/r
• The NPV depends on the discount rate r.

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NPV decision rule
• If FFF’s cost of capital is 10%, the NPV is $100 million and they
should undertake the investment.

NPV = 0: very important. discount rate is called the Internal rate of return.

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Internal rate of return
• Take any investment where the internal rate of return (IRR)
exceeds the cost of capital. Turn down any investment whose
IRR is less than the cost of capital.
• The IRR investment rule will give the same answer as the NPV
rule in many, but not all, situations.
• In general, the IRR rule works for a stand-alone project if all of
the project’s negative cash flows precede its positive cash
flows.
• In other cases, the IRR rule may disagree with the NPV rule
and thus be incorrect.
IRR gives bad decision

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Internal rate of return
• Delayed investments:
– Assume that Mr. Star has just retired as the CEO of a successful
company. A major publisher has offered you a book deal. The
publisher will pay you CHF 1 million upfront if you agree to write a
book about your experiences. You estimate that it will take three years
to write the book. The time you spend writing will cause you to give up
speaking engagements amounting to CHF 500,000 per year. You
estimate your opportunity cost to be 10%.

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Internal rate of return
• Multiple IRRs:
– Suppose Mr. Star informs the publisher that it needs to sweeten the
deal before he will accept it. The publisher offers CHF 550,000
advance and CHF 1,000,000 in four years when the book is published.

– Should he accept or reject the new offer?

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Internal rate of return
• Nonexistent IRRs:
– Finally, Star is able to get the publisher to increase his advance to CHF
750,000, in addition to the CHF 1 million when the book is published in
four years. With these cash flows, no IRR exists; there is no discount
rate that makes NPV equal to zero.

• While the IRR rule has shortcomings for making investment

decisions, the IRR itself remains useful. IRR measures the
average return of the investment and the sensitivity of the
NPV to any estimation error in the cost of capital.

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Internal rate of return

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Internal rate of return
• While the IRR rule works for project A, it fails for each of the
other projects.

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Internal rate of return

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Payback rule
• The payback period is the amount of time it takes to recover
or pay back the initial investment. If the payback period is less
than a pre-specified length of time, you accept the project.
Otherwise, you reject the project.

• The payback rule is used by many companies because of its

simplicity.

• However, the payback rule has several drawbacks.

– Ignores the project’s cost of capital and time value of money.
– Ignores cash flows after the payback period.
– Relies on an ad hoc decision criterion.

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Payback rule

0 1 2 3 Payback NPV @20%

Investment A -1000 500 400 600 2 1/6 years 42
Investment B -1000 500 500 100 2 years -178

• Based on the payback rule, you would chose project B.

• Based on the NPV rule, you would chose project A.

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Mutually exclusive projects
• When you must choose only one project among several
possible projects, the choice is mutually exclusive.
• NPV rule: Select the project with the highest NPV.
• IRR rule: Selecting the project with the highest IRR may lead
to mistakes.
• In particular, when projects differ in their scale of investment,
the timing of their cash flows, or their riskiness, then their
IRRs cannot be meaningfully compared.

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Mutually exclusive projects

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Mutually exclusive projects

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Mutually exclusive projects
• If a project’s size is doubled, its NPV will double. This is not
the case with IRR. Thus, the IRR cannot be used to compare
projects of different scales.

• Consider two of the projects from the previous example:

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Mutually exclusive projects
• Another problem with the IRR is that it can be affected by
changing the timing of the cash flows, even then the scale is
the same.

– IRR is a return, but the dollar value of earning a given return - and
therefore its NPV – depends on how long the return is earned.

• Consider again the coffee shop and the music store

investment in the previous example. Both have the same
initial scale and the same horizon. The coffee shop has a
lower IRR, but a higher NPV because of its higher growth rate.

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Mutually exclusive projects
• An IRR that is attractive for a safe project need not be
attractive for a riskier project.

• Consider the investment in the electronics store from the

previous example. The IRR is higher than those of the other
investment opportunities, yet the NPV is the lowest.

• The higher cost of capital means a higher IRR is necessary to

make the project attractive.

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Mutually exclusive projects
• Incremental IRR investment rule:

– Apply the IRR rule to the difference between the cash flows of the two
mutually exclusive alternatives (the increment to the cash flows of one
investment over the other).

• The incremental IRR tells us the discount rate at which it

becomes profitable to switch from one project to the other.

• Then, rather than compare the projects, we can evaluate the

decision to switch from one to the other using the IRR rule.

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Mutually exclusive projects

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Mutually exclusive projects

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Mutually exclusive projects

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Mutually exclusive projects
• Shortcomings of the incremental IRR rule:

– The incremental IRR may not exist.

– Multiple incremental IRRs could exist.

– The fact that the IRR exceeds the cost of capital for both projects does
not imply that either project has a positive NPV.

– When individual projects have different costs of capital, it is not

obvious which cost of capital the incremental IRR should be compared
to.

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Project selection
• In principle, the firm should take on all positive NPV
investments it can identify.

• In practice, there are often limitations on the number of

projects the firm can undertake.

• Often, this limitation is due to resource constraints.

• In such situations, the firm must choose the best set of

investments it can make given the resources it has available.

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Profitability index
• We can compute a profitability index to identify the optimal
combination of projects to undertake.

Profitability index = Value created / Resource Consumed

• Suppose you have a budget of $100 million.

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Profitability index

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Profitability index

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Profitability index
• Shortcomings of the profitability index:

– In some situations, the profitability index does not give an accurate

answer.

– With multiple resource constraints, the profitability index can break

down completely.

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