Corporate Finance

Fifth Edition

Chapter 7
Investment Decision Rules

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Chapter Outline
7.1 NPV and Stand-Alone Projects
7.2 The Internal Rate of Return Rule
7.3 The Payback Rule
7.4 Choosing between Projects
7.5 Project Selection with Resource Constraints

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Learning Objectives (1 of 2)
• Define net present value, payback period, internal rate of
return, profitability index, and incremental IRR.
• Describe decision rules for each of the tools in objective 1,
for both stand-alone and mutually exclusive projects.
• Given cash flows, compute the NPV, payback period,
internal rate of return, and profitability index for a given
project, and the incremental IRR for a pair of projects.

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Learning Objectives (2 of 2)
• Compare each of the capital budgeting tools above, and
tell why NPV always gives the correct decision.
• Discuss the reasons IRR can give a flawed decision.
• Describe situations in which profitability index cannot be
used to make a decision.

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7.1 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 $35 million per year, starting at
the end of the first year and lasting forever.

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Applying the NPV Rule
• The NPV of the project is calculated as:
35
NPV =  250 +
r
– The NPV is dependent on the discount rate.

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Figure 7.1 NPV of Fredrick’s Fertilizer
Project

If FFF’s cost of capital is 10%, the NPV is $100 million, and

they should undertake the investment
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Alternative Rules Versus the NPV Rule
• Sometimes alternative investment rules may give the same
answer as the NPV rule, but at other times they may
disagree.
– When the rules conflict, the NPV decision rule
should be followed.

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7.2 The Internal Rate of Return Rule (1 of 2)

• Internal Rate of Return (IRR) Investment Rule

– Take any investment where the IRR exceeds the cost
of capital
– Turn down any investment whose IRR is less than the
cost of capital

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7.2 The Internal Rate of Return Rule (2 of 2)

• 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 Figure 7.1, whenever the cost of capital is below the
IRR of 14%, the project has a positive NPV, and you
should undertake the investment.

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Applying the IRR Rule (1 of 10)
• In other cases, the IRR rule may disagree with the NPV
rule and thus be incorrect.
– Situations where the IRR rule and NPV rule may be in
conflict:
 Delayed Investments
 Nonexistent IRR
 Multiple IRRs

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Pitfall 1: Delayed Investments (1 of 3)
• 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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Pitfall 1: Delayed Investments (2 of 3)
• Should you accept the deal?
– Calculate the IRR
Blank NPER RATE PV PMT FV Excel Formula
Given 3 Blank 1,000,000 −500,000 0 Blank
Solve for 1 Blank 23.38% Blank Blank Blank =RATE(3,500000,1
000000,0)

– The IRR is greater than the cost of capital

– Thus, the IRR rule indicates you should accept the deal

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Pitfall 1: Delayed Investments (4 of 3)
• Should you accept the deal?

500, 000 500, 000 500, 000

NPV  1, 000, 000   2
 3
 $243, 426
1.1 1.1 1.1

• Since the NPV is negative, the NPV rule indicates you

should reject the deal.

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Figure 7.2 NPV of Star’s $1 Million Book
Deal

When the benefits of an investment occur before the costs,

the NPV is an increasing function of the discount rate.
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Pitfall 2: Multiple IRRs (1 of 4)
• Suppose Star informs the publisher that it needs to
sweeten the deal before he will accept it. The publisher
offers $550,000 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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Pitfall 2: Multiple IRRs (2 of 4)
• The cash flows would now look like

• The NPV is calculated as

500, 000 500, 000 500, 000 1, 000, 000
NPV = 550, 000   2
 3

1+ r (1 + r ) (1 + r ) (1 + r ) 4

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Pitfall 2: Multiple IRRs (3 of 4)
• 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.

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Figure 7.3 NPV of Star’s Book Deal with
Royalties

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Pitfall 2: Multiple IRRs (4 of 4)
• As seen in Figure 7.3, between 7.164% and 33.673%, the
book deal has a negative NPV.
• Since your opportunity cost of capital is 10%, you should
reject the deal.

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Pitfall 3: 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.
• With these cash flows, no IRR exists; there is no discount
rate that makes NPV equal to zero.

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Figure 7.4 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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Common Mistake
• IRR Versus the IRR Rule
– 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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Textbook Example 7.1 (1 of 2)
Problem with the IRR Rule
Problem
Consider projects with the following cash flows:
Project 0 1 2
A −375 −300 900
B −22,222 50,000 −28,000
C 400 400 −1,056
D −4,300 10,000 −6,000

Which of these projects have an IRR close to 20%? For

which of these projects is the IRR rule valid?

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Textbook Example 7.1 (2 of 2)
Solution
We plot the NPV profile for each project in Figure 7.5 from
the NPV profiles, we can see that projects A, B, and C each
have an IRR of approximately 20%, which project D has no
IRR. Note also that project B has another IRR of 5%.
The IRR rule is valid only if the project has a positive NPV for
every discount rate below the IRR. Thus, the IRR rule is only
valid for project A. this project is the only one for which all
the negative cash flows precede the positive ones.

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NPVProfiles for Example 7.1
While the IRR Rule works for project A, it fails for each of the
other projects.

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7.3 The Payback Rule (1 of 2)
• 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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Textbook Example 7.2 (1 of 2)
The payback Rule
Problem
Assume Fredrick’s requires all projects to have a payback
period of five years or less. Would the firm undertake the
fertilizer project under this rule?

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Textbook Example 7.2 (2 of 2)
Solution
Recall that the project requires an initial investment of $250
million, and will generate $35 million per year. The sum of
the cash flows from year 1 to year 5 is $35 × 5 = $175
million, which will not cover the initial investment of $250
million. In fact, it will not be until year 8 that the initial
investment will be paid back ($35 × 8 = $280 million).
Because the payback period for this project exceeds five
years, Fredrick’s will reject the project.

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The Payback Rule (2 of 2)
• Pitfalls
– 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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7.4 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

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Textbook Example 7.3 (1 of 2)
NPV and Mutually Exclusive Projects
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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Textbook Example 7.3 (2 of 2)
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
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 NPV. But, because we
can only choose one, the coffee shop is the best alternative.
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Alternative Example 7.3 (2 of 2)
• 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%
– Thus, all of the alternatives have a positive NPV. But,
because we can only choose one, the clothing store is the
best alternative.
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IRR Rule and Mutually Exclusive
Investments (1 of 4)
• Differences in Scale
– If a project’s size is doubled, its NPV will double.
 This is not the case with IRR.
– Thus, the IRR rule cannot be used to compare projects
of different scales.

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IRR Rule and Mutually Exclusive
Investments (2 of 4)
• Differences in Scale
– Consider two of the projects from Example 7.3.
Blank Book store Coffee shop
Initial Investment $300,000 $400,000
Cash Flow year 1 $363,000 $80,000
Annual Growth Rate 3% 3%
Cost of capital 8% 8%
IRR 24% 23%
NPV $960,000 $1,200,000

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IRR Rule and Mutually Exclusive Investments:
Differences in Scale (cont’d)

• Example 7.3, Differences in Scale:

• IRR calculation:
63.000
– Book Store:  300.000   0  IRR  24%
IRR  3%

80.000
– Coffee Shop:  400.000   0  IRR  23%
IRR  3%

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IRR Rule and Mutually Exclusive
Investments: Timing of Cash Flows
• Another problem with the IRR 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 earned.
• Consider two projects. Both have the same initial scale but different
horizon. Both have same IRR.

Short-Term Project
Long-Term Project

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Calculating NPV and IRR
WACC = 10%
150
NPVShort Term  100   $36.36
1 .1
759.375
NPVLong Term  100  5
 $371.51
1 .1

150
Short  Term : 100   0  IRR  50%
1  IRR
759.375
Long  Term : 100  0
1  IRR  5

759.375
 1  IRR 
5

100
5
7.59375  1  IRR  IRR  50%
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IRR Rule and Mutually Exclusive
Investments (3 of 4)
• Timing of Cash Flows
– Another problem with the IRR 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 earned.
– Consider again the coffee shop and the music store
investment in Example 7.3.
– 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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IRR Rule and Mutually Exclusive
Investments (4 of 4)
• 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 7.3.
– 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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The Incremental IRR Rule (1 of 2)
• 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.
– Rule: Calculate difference in cash flows A – B. When Incr. IRR > WACC
choose Project with lower IRR.
When Incr. IRR < WACC choose Project with higher IRR.

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Textbook Example 7.4 (1 of 4)
Using the Incremental IRR to Compare Alternatives
Problem
Your firm is considering overhauling its production plant. The
engineering team has come up with two proposals, one for a
minor overhaul and one for a major overhaul. The two options
have the following cash flows(in millions of dollars):

Proposal 0 1 2 3
Major overhaul −10 6 6 6
Minor overhaul −50 25 25 25

What is the IRR of each proposal? What is the incremental IRR?

If the cost of capital for both of these projects is 12%, what should
your firm do?
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Textbook Example 7.4 (2 of 4)
Solution
We can compute the IRR of each proposal using the annuity
calculator. For the minor overhaul, the IRR is 36.3%:
Blank NPER RATE PV PMT FV Excel Formula
Given 3 Blank −10 6 0 Blank
Solve for rate Blank 36.3% Blank Blank Blank =RATE(3,6,−10,0)

For the major overhaul, the IRR is 23.4%:

Blank NPER RATE PV PMT FV Excel Formula
Given 3 Blank −50 25 0 Blank
Solve for rate Blank 23.4% Blank Blank Blank =RATE(3,25,−50,0)

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Textbook Example 7.4 (3 of 4)
Which project is best? Because the projects have different
scales, we cannot compare their IRRs directly. To compute
the incremental IRR of switching from the minor overhaul to
the major overhaul, we first compute the incremental cash
flows:
Proposal 0 1 2 3
Major −50 25 25 25
overhaul
Less:Minor −(−10) −6 −6 −6
overhaul
Incremental −40 19 19 19
cash flow

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Textbook Example 7.4 (4 of 4)
These cash flows have an IRR of 20.0%
Blank NPER RATE PV PMT FV Excel Formula
Given 3 Blank −40 19 0 Blank
Solve for Rate Blank 20.0% Blank Blank Blank =RATE(3,19,−40,0)

Because the incremental IRR exceeds the 12% cost of capital,

switching to the major overhaul looks attractive (i.e., its larger
scale is sufficient to make up for its lower IRR). We can check this
result using Figure 7.5, which shows the NPV profiles for each
project. At the 12% cost of capital, the NPV of the major overhaul
does indeed exceed that of the minor overhaul, despite its lower
IRR. Note also that the incremental IRR determines the crossover
point of the NPV profiles, the discount rate for which the best
project choice switches from the major overhaul to minor one.
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Figure 7.5 Comparison of Minor and
Major Overhauls

In Example7.4, we can see that despite its lower IRR, the major overhaul
has a higher NPV at the cost of capital of 12%. Note also that the
incremental IRR of 20% determines the crossover point or discount rate
at which the optimal decision changes.
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The Incremental IRR Rule (2 of 2)
• 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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7.5 Project Selection with Resource
Constraints
• Evaluation of Projects with Different Resource Constraints
– Consider three possible projects with a $100 million
budget constraint:
Table 7.1 Possible Projects for a $100 Million Budget
Initial Investment Profitability Index
Project N P V ($ millions)
($ millions) N P V /Investment
I 110 100 1.1
II 70 50 1.4
III 60 50 1.2

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Profitability Index
• The profitability index can be used to identify the optimal
combination of projects to undertake

Value Created NPV

Profitability Index  
Resource Consumed Resource Consumed

– From Table 7.1, we can see it is better to take projects

II and III together and forgo project I.

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Textbook Example 7.5 (1 of 3)
Profitability Index with a Human Resource Constraint
Problem
Your division at NetIt, a larger networking company, has put together a project
proposal to develop a new home networking router. The excepted NPV of the
project is $17.7 million, and the project will require 50 software engineers. NetIt
has a total of 190 engineers available, and the router project must compete with
the following other projects for these engineers:
Project N P V ($ millions) Engineering Headcount
Router 17.7 50
Project A 22.7 47
Project B 8.1 44
Project C 14.0 40
Project D 11.5 61
Project E 20.6 58
Project F 12.9 32
Total 107.5 332

How should NetIt prioritize these projects?

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Textbook Example 7.5 (2 of 3)
Solution
The goal is to maximize the total NPV we can create with 190
engineers (at most). We compute the profitability index for each
project using Engineering Headcount in the denominator, and then
sort projects based on the index:

Engineering Profitability Index Cumulative E H C

Project NPV ($ millions)
Headcount(E H C) (N P V per E H C) Required
Project A 22.7 47 0.483 47
Project F 12.9 32 0.403 79
Project E 20.6 58 0.355 137
Router 17.7 50 0.354 187
Project C 14.0 40 0.350 Blank
Project D 11.5 61 0.189 Blank
Project B 8.1 44 0.184 Blank

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Textbook Example 7.5 (3 of 3)
We now assign the resource to the projects in descending
order according to the profitability index. The final column
shows the cumulative use of the resource as each project is
taken on until the resource is used up. To maximize NPV
within the constraint of 190 engineers. NetIt should choose
the first four projects on the list. There is no other
combination of projects that will create more value without
using more engineers than we have. Note, however, that the
resource constraint forces NetIt to forgo three otherwise
valuable projects (C, D, and B) with a total NPV of $3.36
million.

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Shortcomings of the Profitability Index
(1 of 2)

• In some situations, the profitability Index does not give an

accurate answer.
– Suppose in Example 7.4 that NetIt has an additional
small project with a NPV of only $120,000 that requires
three engineers. The profitability index in this case is
0.12
 0.04, so this project would appear at the bottom
3
of the ranking. However, three of the 190 employees
are not being used after the first four projects are
selected. As a result, it would make sense to take on
this project even though it would be ranked last.

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Shortcomings of the Profitability Index
(2 of 2)

• With multiple resource constraints, the profitability index

can break down completely.

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