Lecture 2: Investment Decisions Rules

Corporate Finance
Outline

Investment decision rules

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

2
NPV and Stand-Alone Projects
• Consider a take-it-or-leave-it investment
decision involving a single, stand-alone
project for Fredrick’s Feed and Farm
(FFF).
– The project costs $250 million and is
expected to generate cash flows of $105
million per year for the next 3 years, starting
at the end of the first year.

3
NPV Rule
• The NPV of the project is calculated as:
!"(!$%)!"
• 𝑁𝑃𝑉 = −250 + 105
%

• The NPV is dependent on the discount rate.

• Assuming the discount rate is 5%, then
NPV=35.94. The project would “create value”.

4
The Internal Rate of Return Rule
• The internal rate of return (IRR) is the discount rate
that equates the PV of a project’s net cash flows
with its initial cash outlay.
– IRR is the discount rate (or rate of return) at which the
net present value is zero.
)
𝐶𝐹'
𝑁𝑃𝑉 = , '
− 𝐶𝐹* = 0
(1 + 𝑟)
'(!
• The IRR is compared to the required rate of
return (k).
• If IRR > k, the project should be accepted.
• IRR measures the average return of the investment
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IRR Calculation
• In the previous example, we have the following
equation
1 − (1 + 𝑟)!"
𝑁𝑃𝑉 = −250 + 105 =0
𝑟
• Can be calculated using a financial calculator or
MS Excel (not examinable)
• Can be calculated manually using the trial and
error method! (not required for exams)

6
 Linking NPV with IRR
NPV

NPV=0
35.94

r
5%

IRR=12.24%

• As IRR of 12.24% is greater than the required rate of return, which is 5%,
FFF should accept this project.

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Applying the IRR Rule
• IRR rule agrees with the NPV rule most of the
time, because
– They are both originated from the discounted cash
flow (DCF) methods, which involve the process of
discounting a series of future net cash flows to their
present values.
• They may not agree with each other when
– The investment is delayed;
– There are multiple IRRs;
– There does not exist an IRR.
• When the rules conflict, follow the NPV.
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Applying the IRR Rule (cont'd)
• Delayed Investments
– Assume you have just retired as the CEO of a
successful company. A major publisher has
offered you a book deal. The publisher will
pay you $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
$500,000 per year. You estimate your
opportunity cost to be 10%.
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Applying the IRR Rule (cont'd)
• Delayed Investments
– Should you accept the deal?
!"(!$%)!"
• 1,000,000 − 500,000 =0
%
• IRR=23.38% using a financial calculator or Excel

– The IRR is greater than the cost of capital

(10%). Thus, the IRR rule indicates you
should accept the deal.

10
Applying the IRR Rule (cont'd)
• Delayed Investments
– Should you accept the deal?

1 − 1.1!"
1,000,000 − 500,000 = −243,426
0.1
– Since the NPV is negative, the NPV rule
indicates you should reject the deal.

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Applying The IRR Rule (cont'd)
• Delayed Investments
– When the benefits of an investment occur before
the costs, the NPV is an increasing function of the
discount rate.
– Then the IRR rule and the NPV rule will give you
exactly the opposite recommendations.

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Applying the IRR Rule (cont'd)
• Multiple IRRs
– Suppose Star informs the publisher that it
needs to sweeten the deal before he will
accept it. The publisher offers $550,000 in
advance and $1,000,000 in four years when
the book is published.
– Should he accept or reject the new offer?

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Applying the IRR Rule (cont'd)
• Multiple IRRs
– The cash flows would now look like:

– The NPV is calculated as:

+**,*** +**,*** +**,*** !,***,***
– 𝑁𝑃𝑉 = 550,000 − − − +
!$% !$% # !$% " !$% $

14
Applying the IRR Rule (cont'd)
• Multiple IRRs
– By setting the NPV equal to zero and solving
for r, we find the IRR. In this case, there are
two IRRs: 7.164% and 33.673%. Because
there is more than one IRR, the IRR rule
cannot be applied.
– When cash flows of a project change sign
more than once, there will be multiple IRRs

15
NPV of Star’s Book Deal with Royalties

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Applying the IRR Rule (cont'd)
• Nonexistent IRR
– Finally, Star is able to get the publisher to increase
his advance to $750,000, in addition to the $1 million
when the book is published in four years.
– The NPV is calculated as:
+**,*** +**,*** +**,*** !,***,***
– 𝑁𝑃𝑉 = 750,000 − − − +
!$% !$% # !$% " !$% $

– With these cash flows, no IRR exists; there is no

discount rate that makes NPV equal to zero.

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 NPV of Star’s Final Offer

• No IRR exists because the NPV is positive for all values of the discount rate.
Thus the IRR rule cannot be used.

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The Payback Rule
• The payback period is 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.

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Example of Payback Rule
Q: Fredrick’s Feed and Farm (FFF) requires an initial
investment of $250 million for an equipment, and it will
generate $35 million per year for the next 10 years.
Assume FFF requires a payback period of 8 years, will
FFF purchase this equipment?

A: Payback period=$250/$35=7.14*
So FFF should purchase this equipment

*There is no need to round it up to 8 years because the cash flow

is continuous

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The Payback Rule (cont’d)
• Pitfalls:
– Ignores the project’s cost of capital (r) and
time value of money.
– Ignores cash flows after the payback period.

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Choosing Between Projects
• 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.
22
Example Problem
A venture capitalist is considering investing in several
projects. You have researched several possibilities for her
and come up with the following cash flow estimates.
Which investment should you recommend for the venture
capitalist to choose?

Initial First-Year Growth Cost of

Project
Investment Cash Flow Rate Capital
Dating App $250,000 $55,000 4% 7%
Green Energy $350,000 $75,000 4% 8%
Water Purification $400,000 $120,000 5% 8%

“Smart” Clothes $500,000 $125,000 8% 12%

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Example Solution
Assuming each business lasts indefinitely, we can compute
the present value of the cash flows from each as a constant
growth perpetuity. The NPV of each project is
$55, 000
NPV (Dating App) = - $250, 000 + = $1,583,333
7% - 4%
$75, 000
NPV (Green Energy) = -$350, 000 + = $1,525, 000
8% - 4%
$120, 000
NPV (Water Purification) = -$400, 000 + = $2, 600, 000
8% - 5%
$125, 000
NPV ("Smart" Clothes) = -$500, 000 + = $2, 625, 000
12% - 8%

All of the alternatives have a positive NPV. But, because we

can only choose one, the clothing store is the best.

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Example Problem
A small commercial property is for sale near your
university. Given its location, you believe a student –
oriented business would be very successful there. You
have researched several possibilities and come up with the
following cash flow estimates (including the cost of
purchasing the property). Which investment should you
choose?
Initial First-Year Cash
Project Growth Rate Cost of Capital
Investment Flow
Book store $300,000 $63,000 3.0% 8%
Coffee shop $400,000 $80,000 3.0% 8%
Music store $400,000 $104,000 0.0% 8%
Electronic store $400,000 $100,000 3.0% 11%

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Example Solution
Assuming each business lasts indefinitely, we can compute
the present value of the cash flows from each as a constant
growth perpetuity. The N P V of each project is
63, 000
NPV (Book Store) = -300, 000 + = $960, 000
8% - 3%
80, 000
NPV (Coffe Shop) = -400, 000 + = $1, 200, 000
8% - 3%
104, 000
NPV (Music Store) = -400, 000 + = $900, 000
8%
100, 000
NPV (Electronic Store) = -400, 000 + = $850, 000
11% - 3%

Thus, all of the alternatives have a positive N P V. But,

because we can only choose one, the coffee shop is the
best alternative.
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IRR Pitfalls: Differences in Scale

• If a project’s size is doubled, its N P V will double. This is

not the case with IR R.

• Thus, the IR R rule cannot be used to compare projects

of different scales.

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IRR Pitfalls: Differences in Scale
– Consider two of the projects from the example

Bookstore Coffee Shop

Initial Investment $300,000 $400,000
Cash FlowYear 1 $63,000 $80,000
Annual Growth Rate 3% 3%
Cost of Capital 8% 8%
IRR 24% 23%
NPV $960,000 $1,200,000

– Which one do you choose?

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IRR Pitfalls: Differences in Scale

• NPV of bookstore < NPV of coffee shop, but IRR of

bookstore > IRR of coffee shop
• Because the investment in the coffee shop ($400,000) is
larger than the initial investment in the bookstore, the $
return from the coffee shop is higher than that from the
bookstore. The % return from the coffee shop is not
necessarily higher than that from the bookstore.
• Then we should follow the NPV rule. In another word,
the coffee shop project “creates” more values.

29
IRR Pitfalls: Timing of Cash Flows
– Another problem with the I R R is that it can be
affected by changing the timing of the cash
flows, even when the scale is the same.
• IRR is a return, but the dollar value of earning a given
return depends on how long the return is realized.
– Consider again the coffee shop and the music
store investment.
– Both have the same initial scale and the same
horizon.
– The coffee shop has a lower I R R, but a
higher N P V because of its higher growth rate.
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IRR Pitfalls: Differences in Risk

• 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
Example.
• The IRR is higher than those of the other investment
opportunities, yet the N P V is the lowest.
• The higher cost of capital means a higher IRR is
necessary to make the project attractive.

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Incremental IRR
• 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)
– Incremental IRR > cost of capital, switch from
one project to the other

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Example

33
Example (cont’d)

IRRA=23.4%
IRRB=36.3%
Incremental IRR=20%

34
Example (cont’d)

35
Project with different lives

• EAV rule
• The constant chain of replacement in
perpetuity method
• The lowest common multiple method

36
Example
• Imagine a situation where a firm is considering acquiring
one of two new machines which are both adequate at
producing its product. The required rate of return is 10%
p.a.. Details of the two machines are tabulated below:

Machine NPV n (years)

A $2,000 5

B $3,000 10

37
Comparing Projects With Different Lives
Under the constant chain of replacement assumption,
each project is assumed to be replaced with an identical
project at the end of its economic life until project chains
are of equal length and a valid comparison between them
can be made.

Methods of achieving this include:

– the lowest common multiple method;
– the equivalent annual value (EAV) method;
– and the constant chain of replacement in perpetuity
method.

38
Lowest Common Multiple (LCM) Method
• Also assume projects can be constantly replaced.
• In the previous example where Project A has a life of
5 years and Project B has a life of 10 years,
– The LCM in this case is 10. That is, replacing Project A
at the end of year 5, and then both options will have a
life of 10 years.
– Based on the above, we can compare the NPV of the
two options:
2,000
𝑁𝑃𝑉- = 2,000 + +
= 3,241.84
1.1
𝑁𝑃𝑉. = 3,000
– Take Project A!

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Equivalent Annual Value (EAV) Method
• Same assumption – constant replacement
• EAV method involves calculating the annual
cash flow of an annuity which has the same life
and NPV as the project.
NPV
EAV =
é1 - (1 + k ) - n ù
ê k ú
ë û
• The decision rule is to choose the one with the
highest EAV.

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Example (EAV)
• Calculate the EAV for both Projects A and
B in the previous example.
2,000
𝐸𝐴𝑉# = !$ = 527.59
1 − 1.1
0.1
3,000
𝐸𝐴𝑉% = !&' = 488.24
1 − 1.1
0.1
• Take Project A!

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Constant Chain of Replacement in
Perpetuity Method
• Constant chain of replacement in perpetuity method is a
variant of the EAV approach, which will provide the same
project ranking as the EAV does. This method assumes that
both chains continue indefinitely. Under this approach:
– The lengths of the chains are the same (i.e. infinity);
– If the NPV of each replacement project is $N and the life of each project
is n years, then the constant chain of replacement is the same as
receiving $N at 0, n, 2n, etc; and,
– Therefore, the NPV of the chain comprises $N at 0 plus a perpetuity of
$N payable every n years
é (1 + k )n ù
NPV¥ = NPV0 ê ú
ë (1 + k ) n
- 1 û

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EAV vs. Constant Chain of Replacement

• The relationship between the last two methods,

EAV and the constant chain of replacement, is
fairly simple (k = cost of capital of the project):
EAV
NPV¥ =
k
\ EAV = kNPV¥

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Example (EAV & Constant Chain of
Replacement)
• Chocolate Heaven Ltd needs to replace its chocolate equipment. Two
machines, A and B, are both adequate at completing the required tasks.
Forecasted cash flows for each machine are provided below. The required
rate of return is10% p.a. for both machines. Which machine would you
recommend to Chocolate Heaven? Show which option is preferable using
both the EAV and the constant chain of replacement methods.

A B
Estimated life 3 years 6 years
Investment Cost 13000 22000
Net Cash Inflows 7600 9600
Sale Price at end of project 1000 4000

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Example (EAV)
• Using this information, we can calculate the NPV for
each project:

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Example (EAV)
• We can then calculate the EAV for each project as
follows:

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Example (NPV∞)
• Finally, we can also use the NPV figures above to calculate the NPV
to infinity for each project:

• Based on the preceding results, we can see that, irrespective of the

method employed to adjust for different lives, Machine B is
preferable to Machine A.

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Summary
• Issues associated with the IRR rule
– Delayed investments
– Multiple IRR
– Nonexistent IRR
– Investments of different scales
– Investments with different cost of capital
• Payback Rule
– Easy to calculate and adopt
– No consideration of time value of money
• NPV is the most reliable method
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