3 - 4: NPV & Other Investment Rules∗

Dr. Bhanu Pratap Singh†

IIM Sirmaur, 2024

Learning Objectives
• NPV Method.
• Payback Period Method.
• Discounted Payback Period Method.
• Internal Rate of Return.
• Problem with IRR.
• Profitability Index.

Introduction
• Goal of Corporate Finance/Financial Management?
– Increasing the value of a company’s stock.

• How to achieve this Goal?

– By taking important Corporate Financial Decisions.
– Investment, Financing & Dividend Decisions.

• Investment Decisions
– How to tell whether a particular investment will achieve that purpose or not.
– With the help of various techniques: NPV, IRR etc.

NPV Method
• Example 5.1.
– The Alpha Corporation is considering investing in a riskless project costing $100.
– The project receives $107 in one year and has no other cash flows.
– The riskless discount rate on comparable riskless investments is 2%.
– The NPV of the project can easily be calculated as: $4.90 = −$100 + $107/1.02.
– NPV is Positive.
– npv(r = .02, cf = c(-100, 107))

• The Basic Investment Rule: The NPV Rule.

– Accept a project if the NPV is greater than zero.
– Reject a project if the NPV is less than zero.
∗ Reference: Corporate Finance, Ross, Westerfield, Jaffe & Jordan, Chapter 5
† bhanupratap.singh@iimsirmaur.ac.in

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NPV Method

Why does the NPV rule lead to good decisions?

• Accepting positive NPV projects benefits the stockholders.

– Consider two strategies.
– Use $100 to invest in the project. The $107 will be paid as dividend in one year.
– Forgo the project and pay the $100 as dividend today. Will become $102 in one year.

• The value of the firm rises by the NPV of the project.

– Imagine that the firm today has assets worth $V and has $100 of cash.
– If the firm forgoes the project, the value of the firm today would simply be: $V + $100.
– If the firm accepts the project, the firm will receive $107 in one year: $V + $107/1.02.
– The difference is $4.90, the NPV of the project.
– Value of the firm is merely the sum of the values of the different projects, divisions, or
other entities within the firm.
– This is called value additivity: Contribution of any project to a firm’s value is simply
the NPV of the project.

• The NPV rule uses the correct discount rate.

– Depending on the riskyness of the cashflows.

NPV Method

Key Attributes of NPV (which other investment criteria might not have)

• NPV uses cash flows (not accounting earnings).

– These cashflows can be used for various purposes.

• PV uses all the cash flows of the project.

– Other approaches may ignore cash flows beyond a particular date.

• NPV discounts the cash flows properly.

– Other approaches may ignore the time value of money.

Payback Period Method

• Consider the following cashflows.

• The firm receives $30,000 and $20,000 in the first two years, which add up to the original
investment.

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 • This means that the firm has recovered its investment within two years.

• In this case, two years is the payback period of the investment.

Payback Period Method

• The payback period rule is simple.

– A particular cutoff date, say two years, is selected.
– All projects that have payback periods of 2 years or less are accepted. Others, rejected.

Payback Period Method

Problems with the Payback Period

• Consider the following projects.

Payback Period Method

Problems with the Payback Period

• Timing of Cash Flows within the Payback Period.

– It does not consider the timing of the cash flows within the payback period.
– Larger cashflows in earlier years are preffered (higher PV).

• Payments after the Payback Period.

– It ignores all cash flows occurring after the payback period.
– Some valuable long-term projects are likely to be rejected.

• Arbitrary Standard for Payback Period.

– How the cutoff date is decided?

Discounted Payback Period Method

• Under this approach, the cash flows are first discounted.

• Then we ask how long it takes for the discounted cash flows to equal the initial investment.

• Example.
– Suppose that the discount rate is 10% and the cash flows are: -$100, $50, $50, $20.

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 – The payback period is 2 years.
– The discounted payback period is simply the payback period for these discounted cash
flows.
• Same major flaws as payback.
– Requires to choose an arbitrary cutoff period.
– Ignores all cash flows after that date.

• It may look like NPV, but just a poor compromise between the payback method and NPV.

Internal Rate of Return

• The basic rationale: It provides a single number summarizing the merits of a project.

• That number does not depend on the interest rate prevailing in the capital market.

• That is why it is called the internal rate of return.

– The number is internal or intrinsic to the project and depends on the cash flows of the
project.

Internal Rate of Return

• Consider the following cashflows.

• For these cash flows, IRR is the rate that causes the NPV of the project to be zero.

• N P V = −100 + 110/(1 + R)

• By setting, NPV = 0, we can solve for R.

– irr(cf = c(-100, 110))

Internal Rate of Return

• The implication is very simple.

– Accept the project if the IRR is greater than the discount rate.
– Reject the project if the IRR is less than the discount rate.

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Internal Rate of Return

• Cashflows for a complex project.

• Algebraically, IRR is the unknown in the following equation.

–
– irr(cf = c(-200, 100, 100, 100))

Internal Rate of Return

• It should be clear that the NPV is positive for discount rates below the IRR and negative
for discount rates above the IRR.

• If we accept projects like this one when the discount rate is less than the IRR, we will be
accepting positive NPV projects.

• Thus, the IRR rule coincides exactly with the NPV rule.
– But this does not happen for all types of projects.

Problem with IRR

• Independent Project.
– Whose acceptance or rejection is independent of the acceptance or rejection of other
projects.

• Mutually Exclusive Project.

– You can accept A or B or you can reject both of them, but you cannot accept both of
them.

Problem with IRR

2 Problems with both types of Projects

• Problem 1: Investing or Financing

• Consider the following projects.

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 •

Problem with IRR

2 Problems with both types of Projects

• Problem 1: Investing or Financing

• Project A is actually a substitute for lending: Investing type projects.

– Because the IRR is 30%, taking on Project A is tantamount to lending at 30%.
– The firm should accept Project A if the lending rate is below 30%.
– Conversely, the firm should reject Project A if the lending rate is above 30%.

• Project B is a substitute for borrowing: Financing type projects.

– Because the IRR is 30%, taking on Project B is equivalent to borrowing at%.
– If the firm can borrow from a bank at, say, only 25%, it should reject the project.
– However, if it can borrow at, say, 35%, it should accept the project.
– Thus Project B will be accepted if and only if the discount rate is above the IRR.

• Investing type projects are the norm.

• Because the IRR rule is reversed for financing type projects, be careful when using it with
this type of project.

Problem with IRR

2 Problems with both types of Projects

• Problem 2: Multiple rate of return.

• Suppose the cash flows from a project are: (-$100, $230, -$132).

• It is easy to verify that this project has two IRRs, 10% and 20%.

• In a case like this, the IRR does not make any sense. What IRR are we to use.

• In theory, a cash flow stream with K changes in sign can have up to K IRRs.

• Therefore, because Project C has two changes in sign, it can have as many as two IRRs.

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Problem with IRR

NPV Rule

• We should not be too worried about multiple rates of return.

• We can always fall back on the NPV rule.

• The NPV is 0 at both 10% and 20% and negative outside the range.

• Thus, the NPV rule tells us to accept the project if the appropriate discount rate is between
10 and 20%.

• The project should be rejected if the discount rate lies outside this range.

Problem with IRR

NPV Rule

Problem with IRR

Modified IRR

• Consider Project C again. (-100, 230, -132).

– Assume discount rate of 14%.
– The value of the last cash flow, -$132, as on Date 1 is: -132/1.14 = -115.79.
– After adjusting with 230, the adjusted cash flow at date 1 is 114.21.
– Now we have only two conventional cashflows: (-100, 114.21)
– The IRR of these two cash flows is 14.21%.
– Implying that the project should be accepted given our assumed discount rate of 14%.
– The same concept can be applied to multiple cashflows as well.

• However, it violates the “spirit” of the IRR approach.

• The basic rationale behind the IRR is that it provides a single number summarizing the
merits of a project.

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 • That number does not depend on the discount rate.

• By contrast, MIRR is clearly a function of the discount rate.

Problem with IRR

General Rules

• Note that the NPV criterion is the same for each of the three cases.

• In other words, NPV analysis is always appropriate.

Problem with IRR

Problems specific to Mutually Exclusive Projects

• The Scale Problem.

• Example.
– Opportunity 1: You give me $1 now and I’ll give you $1.50 back at the end of the class
period.
– Opportunity 2: You give me $10 and I’ll give you $11 back at the end of the class
period.
– Which one you choose?
– The correct answer is 2.

–
– One should choose the opportunity with the highest NPV.

Problem with IRR

Problems specific to Mutually Exclusive Projects

• Where does IRR go wrong?

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 – The problem with IRR is that it ignores issues of scale.
– Although Opportunity 1 has a greater IRR, the investment is much smaller.
– High return on Opportunity 1 is more than offset by a decent return on a much bigger
investment.

Problem with IRR

Problems specific to Mutually Exclusive Projects

• The Scale Problem.

• Example.
– Stanley Jaffe and Sherry Lansing have just purchased the rights to Corporate Finance:
The Motion Picture.
– They will produce this major motion picture on either a small budget or a big budget.
– Because of high risk, a 25% discount rate is considered appropriate.
– Sherry wants to adopt the large budget because the NPV is higher.
– Stanley wants to adopt the small budget because the IRR is higher. Who is right?

–
– Overall, the large budget option is correct. NPV is higher.
– But what additional arguments can be given?
– Incremental IRR?

Problem with IRR

Problems specific to Mutually Exclusive Projects

• The Scale Problem.

• Incremental IRR.
– Incremental cash flows from choosing the large budget instead of the small budget.

–
– Incremental IRR = 66.66%.

–
– Small-budget picture would be acceptable as an independent project: NPV is positive.

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Problem with IRR

Problems specific to Mutually Exclusive Projects

• Is is worth to invest an additional $15 million to make the large-budget picture?

• First, the NPV on the incremental investment is positive.

• Second, the incremental IRR of 66.67% is higher than the discount rate of 25%.

• For both reasons, the incremental investment can be justified.

Problem with IRR

Problems specific to Mutually Exclusive Projects

• The Scale Problem.

• Overall.
– Compare the NPVs of the two choices.
– Calculate the incremental NPV.
– Compare the incremental IRR to the discount rate.
– All three approaches always give the same decision.

• However, comparing IRR directly will give the conflicting results.

Problem with IRR

Problems specific to Mutually Exclusive Projects

• The Timing Problem.

• Example.
– Kaufold Corporation has two alternative uses for a warehouse.
– It can store toxic waste containers (Investment A) or electronic equipment (Investment
B).

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Problem with IRR

Problems specific to Mutually Exclusive Projects

Problem with IRR

Problems specific to Mutually Exclusive Projects

• The Timing Problem.

– Which investment to choose?

• [1] Compare NPVs of the two projects.

– If the discount rate is below 10.55%, we should choose Project B.
– If the rate is above 10.55%, we should choose Project A.

Problem with IRR

Problems specific to Mutually Exclusive Projects

• The Timing Problem.

– Which investment to choose?

• [2] Compare incremental IRR to discount rate.

–
– Incremental IRR is 10.55%.
– NPV on the incremental investment is 0 when the discount rate is 10.55%.
– Thus, if the discount rate is below 10.55%, Project B is preferred.
– If the discount rate is above 10.55%, Project A is preferred.
– NPVs of the two projects are equal when the discount rate is 10.55%: Crossover rate is
10.55%.

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Problem with IRR

Problems specific to Mutually Exclusive Projects

• Incremental IRR is also 10.55%.

– It is not a coincidence. This equality must always hold.
– The incremental IRR is the rate that causes the incremental cash flows to have zero
NPV.
– The incremental cash flows have zero NPV when the two projects have the same NPV.

Problem with IRR

Problems specific to Mutually Exclusive Projects

• The Timing Problem.

– Which investment to choose?

• [3] Calculate NPV on incremental cash flows.

– If the NPV is positive on the incremental flows, we should choose B.
– If the NPV is negative, we should choose A.

Profitability Index

• Represented as: PI = PV of Cashflows subsequent to initial investment/Initial Investment.

Profitability Index

Application of PI: Independent Projects

• The profitability index (PI) is greater than 1 whenever the NPV is positive.

• Thus, the PI decision rule is:

– Accept an Independent project if PI > 1.
– Reject if PI < 1.

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Profitability Index

Application of PI: Mutually Exclusive Projects

• For mutually exclusive projects, the profitability index suffers from the scale problem.

• However, it can be corrected using incremental analysis.

• Incremental cash flows after subtracting Project 2 from Project 1.

• Because the PI on the incremental cash flows is greater than 1.0, we should choose the bigger
project.

• This is the same decision we get with the NPV approach.

Profitability Index

Application of PI: Capital Rationing

• When the firm does not have enough capital to fund all positive NPV projects.
– This is the case of capital rationing.

• Imagine that the firm has a third project, as well as the first two.

Profitability Index

Application of PI: Capital Rationing

• Projects are independent, but the firm has only $20 million to invest.

• This forces the firm to choose either Project 1 or Projects 2 and 3.

– What should the firm do?

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Profitability Index

Application of PI: Capital Rationing

• Individually, Projects 2 and 3 have lower NPVs than Project 1.

– However, the sum of NPVs of Projects 2 and 3 is higher than the NPV of Project 1.
– Thus, common sense dictates that Projects 2 and 3 should be accepted.
– Hence, in the case of limited funds, we cannot rank projects according to their NPVs.
– Instead we should rank them according to the PI rule.

• However, the PI does not work if funds are also limited beyond the initial time period.
– For example, if heavy cash outflows elsewhere in the firm were to occur at Date 1,
Project 3, which also has a cash outflow at Date 1, might need to be rejected.
– In other words, the profitability index cannot handle capital rationing over multiple
time periods.

• In addition, indivisibilities may reduce the effectiveness of the PI rule.

– Imagine that $30 million is available for investment. Enough for Projects 1 and 2.
– The firm would be better served by accepting Projects 1 and 2.
– But, Projects 2 and 3 still have the highest profitability indexes.
– The key is that Projects 1 and 2 use up all of the $30 million.
– If Projects 2 and 3 are accepted, the remaining $10 million must be left in the bank.

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