NPV and Investment Criteria

Chapter Nine
 Good Decision Criteria

 We need to ask ourselves the following questions

when evaluating capital budgeting decision rules
 Does the decision rule adjust for the time value of
money?
 Does the decision rule adjust for risk?
 Does the decision rule provide information on whether
we are creating value for the firm?

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 Project Example Information

 You are looking at a new project and you have

estimated the following cash flows:
 Year 0: CF = -165,000
 Year 1: CF = 63,120; NI = 13,620
 Year 2: CF = 70,800; NI = 3,300
 Year 3: CF = 91,080; NI = 29,100
 Average Book Value = 72,000
 Your required return for assets of this risk is 12%.

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 Net Present Value
 The difference between the market value of a
project and its cost
 How much value is created from undertaking
an investment?
 The first step is to estimate the expected future cash
flows.
 The second step is to estimate the required return
for projects of this risk level.
 The third step is to find the present value of the
cash flows and subtract the initial investment.

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 NPV – Decision Rule
 If the NPV is positive, accept the project
 A positive NPV means that the project is

expected to add value to the firm and will

therefore increase the wealth of the owners.
 Since our goal is to increase owner wealth,

NPV is a direct measure of how well this

project will meet our goal.

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 Computing NPV for the Project

 Using the formulas:

 NPV = 63,120/(1.12) + 70,800/(1.12)2 +
91,080/(1.12)3 – 165,000 = 12,627.42
 Using the calculator:
 CF0 = -165,000; C01 = 63,120; F01 = 1; C02
= 70,800; F02 = 1; C03 = 91,080; F03 = 1;
NPV; I = 12; CPT NPV = 12,627.41
 Do we accept or reject the project?
6
 Decision Criteria Test - NPV

 Does the NPV rule account for the time value

of money?
 Does the NPV rule account for the risk of the
cash flows?
 Does the NPV rule provide an indication about
the increase in value?
 Should we consider the NPV rule for our
primary decision rule?

7
Calculating NPVs with a Spreadsheet
 Spreadsheets are an excellent way to
compute NPVs, especially when you have to
compute the cash flows as well.
 Using the NPV function
 The first component is the required return entered
as a decimal
 The second component is the range of cash flows
beginning with year 1
 Subtract the initial investment after computing the
NPV
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 Payback Period

 How long does it take to get the initial cost

back in a nominal sense?
 Computation
 Estimate the cash flows
 Subtract the future cash flows from the initial cost
until the initial investment has been recovered
 Decision Rule – Accept if the payback period
is less than some preset limit

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 Computing Payback for the Project

 Assume we will accept the project if it pays

back within two years.
 Year 1: 165,000 – 63,120 = 101,880 still to
recover
 Year 2: 101,880 – 70,800 = 31,080 still to recover

 Year 3: 31,080 – 91,080 = -60,000 project pays

back in year 3
 Do we accept or reject the project?

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 Decision Criteria Test - Payback

 Does the payback rule account for the time

value of money?
 Does the payback rule account for the risk of
the cash flows?
 Does the payback rule provide an indication
about the increase in value?
 Should we consider the payback rule for our
primary decision rule?

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Advantages and Disadvantages of Payback
 Advantages  Disadvantages
 Ignores the time value of
 Easy to understand
money
 Biased toward  Requires an arbitrary
liquidity cutoff point
 Ignores cash flows beyond
the cutoff date

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 Discounted Payback Period

 Compute the present value of each cash

flow and then determine how long it takes
to pay back on a discounted basis
 Compare to a specified required period

 Decision Rule - Accept the project if it

pays back on a discounted basis within

the specified time

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 Computing Discounted Payback for the Project
 Assume we will accept the project if it pays
back on a discounted basis in 2 years.
 Compute the PV for each cash flow and
determine the payback period using discounted
cash flows
 Year 1: 165,000 – 63,120/1.121 = 108,643
 Year 2: 108,643 – 70,800/1.122 = 52,202
 Year 3: 52,202 – 91,080/1.123 = -12,627 project
pays back in year 3
 Do we accept or reject the project?

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 Decision Criteria Test – Discounted
Payback
 Does the discounted payback rule account
for the time value of money?
 Does the discounted payback rule account

for the risk of the cash flows?

 Does the discounted payback rule provide

an indication about the increase in value?

 Should we consider the discounted

payback rule for our primary decision rule?

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 Advantages and Disadvantages of
Discounted Payback
 Advantages  Disadvantages
 Includes time value of  Requires an arbitrary
money cutoff point
 Easy to understand  Ignores cash flows
beyond the cutoff point
 Biased against long-term
projects, such as R&D
and new products

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 Average Accounting Return
 There are many different definitions for
average accounting return
 The one used in the book is:
 Average net income / average book value
 Note that the average book value depends on how
the asset is depreciated.
 Need to have a target cutoff rate
 Decision Rule: Accept the project if the AAR
is greater than a preset rate.

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 Computing AAR for the Project
 Assume we require an average
accounting return of 25%
 Average Net Income:

 (13,620 + 3,300 + 29,100) / 3 = 15,340

 AAR = 15,340 / 72,000 = .213 =
21.3%
 Do we accept or reject the project?

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 Decision Criteria Test - AAR

 Does the AAR rule account for the time value

of money?
 Does the AAR rule account for the risk of the
cash flows?
 Does the AAR rule provide an indication
about the increase in value?
 Should we consider the AAR rule for our
primary decision rule?

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Advantages and Disadvantages of
AAR  Disadvantages
 Advantages
 Not a true rate of
 Easy to calculate
return; time value of
 Needed
money is ignored
information will  Based on accounting
usually be net income and book
available values, not cash flows
and market values

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 Internal Rate of Return

 This is the most important alternative to

NPV
 It is often used in practice and is

intuitively appealing
 It is based entirely on the estimated cash

flows and is independent of interest rates

found elsewhere

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IRR – Definition and Decision Rule

 Definition:IRR is the return that

makes the NPV = 0
 Decision Rule: Accept the project if

the IRR is greater than the

required return

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Computing IRR for the Project
 Ifyou do not have a financial calculator,
then this becomes a trial and error
process
 Calculator

 Enter the cash flows as you did with NPV

 Press IRR and then CPT

 IRR = 16.13% > 12% required return

 Do we accept or reject the project?

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 NPV Profile for the Project

70,000
60,000 IRR = 16.13%
50,000
40,000
30,000
NPV

20,000
10,000
0
-10,000 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22

-20,000
Discount Rate

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 Decision Criteria Test - IRR
 Does the IRR rule account for the time value
of money?
 Does the IRR rule account for the risk of the
cash flows?
 Does the IRR rule provide an indication about
the increase in value?
 Should we consider the IRR rule for our
primary decision criteria?

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 Advantages of IRR

 Knowing a return is intuitively appealing

 It is a simple way to communicate the

value of a project to someone who

doesn’t know all the estimation details
 If the IRR is high enough, you may not

need to estimate a required return, which

is often a difficult task

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Summary of Decisions for the
Project
Summary
Net Present Value Accept

Payback Period Reject

Discounted Payback Period Reject

Average Accounting Return Reject

Internal Rate of Return Accept

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Calculating IRRs With A
Spreadsheet
 You start with the cash flows the same as you
did for the NPV
 You use the IRR function
 You first enter your range of cash flows,
beginning with the initial cash flow
 You can enter a guess, but it is not necessary
 The default format is a whole percent – you will
normally want to increase the decimal places to at
least two
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 NPV vs. IRR
 NPV and IRR will generally give us the
same decision
 Exceptions

 Non-conventional cash flows – cash flow

signs change more than once
 Mutually exclusive projects

 Initial investments are substantially different

 Timing of cash flows is substantially different

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IRR and Non-conventional Cash Flows
 When the cash flows change sign more
than once, there is more than one IRR
 When you solve for IRR you are solving

for the root of an equation and when you

cross the x-axis more than once, there
will be more than one return that solves
the equation
 If you have more than one IRR, which

one do you use to make your decision?

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Another Example – Non-conventional
Cash Flows
 Suppose an investment will cost $90,000
initially and will generate the following
cash flows:
 Year 1: 132,000
 Year 2: 100,000

 Year 3: -150,000

 The required return is 15%.

 Should we accept or reject the project?

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NPV Profile

$4,000.00
IRR = 10.11% and 42.66%

$2,000.00

$0.00
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55
($2,000.00)
NPV

($4,000.00)

($6,000.00)

($8,000.00)

($10,000.00)
Discount Rate

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Summary of Decision Rules

 The NPV is positive at a required return of

15%, so you should Accept
 If you use the financial calculator, you would
get an IRR of 10.11% which would tell you to
Reject
 You need to recognize that there are non-
conventional cash flows and look at the NPV
profile

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IRR and Mutually Exclusive Projects
 Mutually exclusive projects
 If you choose one, you can’t choose the other
 Example: You can choose to attend graduate
school at either Harvard or Stanford, but not both
 Intuitively you would use the following
decision rules:
 NPV – choose the project with the higher NPV
 IRR – choose the project with the higher IRR

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Example With Mutually Exclusive Projects

Period Project Project The required return

A B for both projects is
0 -500 -400 10%.
1 325 325

2 325 200 Which project

should you accept
IRR 19.43% 22.17% and why?

NPV 64.05 60.74

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NPV Profiles

$160.00 IRR for A = 19.43%

$140.00
IRR for B = 22.17%
$120.00
$100.00 Crossover Point = 11.8%
$80.00
A
NPV

$60.00
B
$40.00
$20.00
$0.00
($20.00) 0 0.05 0.1 0.15 0.2 0.25 0.3
($40.00)
Discount Rate

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Conflicts Between NPV and IRR

 NPV directly measures the increase in value to

the firm
 Whenever there is a conflict between NPV and
another decision rule, you should always use
NPV
 IRR is unreliable in the following situations
 Non-conventional cash flows
 Mutually exclusive projects

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 Profitability Index

 Measures the benefit per unit cost, based

on the time value of money
 A profitability index of 1.1 implies that for

every $1 of investment, we create an

additional $0.10 in value
 This measure can be very useful in

situations in which we have limited capital

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 Advantages and Disadvantages of
Profitability Index
 Advantages  Disadvantages
 Closely related to
 May lead to
NPV, generally
leading to identical
incorrect decisions
decisions in comparisons of
 Easy to understand mutually
and communicate exclusive
 May be useful when investments
available investment
funds are limited
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 Capital Budgeting In Practice

 We should consider several investment

criteria when making decisions
 NPV and IRR are the most commonly

used primary investment criteria

 Payback is a commonly used secondary

investment criteria

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Summary – Discounted Cash Flow Criteria
 Net present value
 Difference between market value and cost
 Take the project if the NPV is positive
 Has no serious problems
 Preferred decision criterion
 Internal rate of return
 Discount rate that makes NPV = 0
 Take the project if the IRR is greater than the required return
 Same decision as NPV with conventional cash flows
 IRR is unreliable with non-conventional cash flows or mutually
exclusive projects
 Profitability Index
 Benefit-cost ratio
 Take investment if PI > 1
 Cannot be used to rank mutually exclusive projects
 May be used to rank projects in the presence of capital rationing

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Summary – Payback Criteria
 Payback period
 Length of time until initial investment is recovered
 Take the project if it pays back within some specified period
 Doesn’t account for time value of money and there is an
arbitrary cutoff period
 Discounted payback period
 Length of time until initial investment is recovered on a
discounted basis
 Take the project if it pays back in some specified period
 There is an arbitrary cutoff period

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Summary – Accounting Criterion

 Average Accounting Return

 Measure of accounting profit relative to
book value
 Similar to return on assets measure

 Take the investment if the AAR exceeds

some specified return level

 Serious problems and should not be used

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Quick Quiz
 Consider an investment that costs $100,000 and has a
cash inflow of $25,000 every year for 5 years. The
required return is 9% and required payback is 4 years.
 What is the payback period?
 What is the discounted payback period?
 What is the NPV?
 What is the IRR?
 Should we accept the project?
 What decision rule should be the primary decision
method?
 When is the IRR rule unreliable?

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