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Financial Principles and Analysis (FNCE5008)

Lecture 4
Investment Decision Rules
Learning Objectives:
• Understand investment decision rules and their drawbacks
• Choose between mutually exclusive alternatives
• Evaluate projects with different lives
• Rank projects when a company’s resources are limited and it cannot
take all positive- NPV projects

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Why Investment Decision Rules?

 How did Apple, Microsoft, Amazon,

and Tesla managers decide to commit
substantial capital to these initiatives?

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The Most Popular Decision Rules Used by CFOs

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Net Present Value
◦ NPV: Present value of all incremental cash flows, less the initial outlay

Remember this?!
𝐶𝐹 0 𝐶𝐹 1 𝐶𝐹 2 𝐶𝐹 𝑡
𝑁𝑃𝑉 = 0
+ 1
+ 2
+…+ 𝑡
(1+𝑟 ) (1+𝑟 ) (1+𝑟 ) (1+𝑟 )
◦ Opportunity cost of capital: Expected rate of return given up by investing in
a project

◦ Decision Rule
◦ NPV > 0: Accept (or Invest) since project adds value
◦ NPV < 0: Do Not Accept (Do Not Invest) since project destroys value
◦ Works for projects of ANY length

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Example : Valuing an Office Building
 Step 1: Forecast cash flows
Cost of building = C0 = $350,000
Sale price in year 1 = C1 = $400,000

 Step 2: Estimate opportunity cost of capital

If equally risky investments in the capital market offer a return of 7%, then cost of
capital = r = 7%

 Step 3: Discount future cash flows

 Step 4: Proceed if PV of payoff exceeds investment

NPV = -350,000 + 373,832 = $23,832 → Proceed with investment

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 The NPV Decision Rules
 Logic of the decision rule: When making an investment decision, take the
alternative with the highest NPV, which is equivalent to receiving its NPV in cash
today

 The NPV decision rule implies that we should:

• Accept positive-NPV projects; accepting them is
equivalent to receiving their NPV in cash today, and
• Reject negative-NPV projects; accepting them would
reduce the value of the firm, whereas rejecting them has
 no cost (NPV = 0)
Not all investments are equally risky. Higher risk projects require a higher rate of
return. Higher required rates of return cause lower PVs
PV of C1 = $400,000 at 7% PV of C1 = $400,000 at 12%

Higher risk = Lower value

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Example: Hoofdstad Project
 Consider the Hoofdstad Project which requires an investment of $1
billion initially, with subsequent annual cash flows of $200 million,
$300 million, $400 million, and $500 million. What is the net present
value of the project if the required rate of return of the project is 5%?
0 1 2 3 4

Timeline | | | | |

| | | | |

– $200 $300 $400 $500

$1,000

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Using the NPV Rule
 Researchers at Fredrick’s Feed and Farm have made a breakthrough. They
believe they can produce a new, environmentally friendly fertilizer at a
substantial cost saving over the company’s existing line of fertilizer. The
fertilizer will require a new plant that can be built immediately at a cost of
$81.6 million. Financial managers estimate that the benefits of the new
fertilizer will be $28 million per year, starting at the end of the first year and
lasting for four years, as shown by the following timeline:

 Assuming 10% cost of capital, should they undertake the project?

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Using the NPV Rule
 Given a discount rate r, the NPV is:

 We can also use the annuity formula:

 If the company’s cost of capital is 10%, the NPV is $7.2 million and
they should undertake the investment
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The NPV Profile
◦ The NPV of the project depends on its appropriate cost of capital. Often,
there may be some uncertainty regarding the project’s cost of capital. In
that case, it is helpful to compute an NPV profile, which graphs the
project’s NPV over a range of discount rates.

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Using the NPV Rule
 Measuring the Sensitivity with IRR
If you are unsure of your cost of capital estimate, it is important to
determine how sensitive your analysis is to errors in this estimate

The IRR can provide this information. IRR is the rate at which your
NPV is 0. It measures the average return of the investment.

 Alternative Rules Versus the NPV Rule

When evaluating alternative rules for project selection, understand
that alternative investment rules may or may not give the same
answer as the NPV rule

When the rules conflict, always base your decision on the NPV rule

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Internal Rate of Return
 IRR: Rate of return on a project at which NPV = 0

 IRR Decision Rule

NB: IRR ≠ Opportunity cost of capital
 IRR > r: Accept (or Invest) since project adds value
 IRR < r: Do Not Accept (Do Not Invest) since project
destroys value

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Example: IRR
 You can purchase a building for $375,000. The investment will
generate $25,000 in cash flows (rent) during the 1st 3-years. At the
end of 3-years you will sell the building for $450,000. What is the IRR
for this investment?

200
150
100
IRR=12.56%
50
NPV (,000s)

0
0 5 1 1 2 2 3 3
-50 0 5 0 5 0 5
-100
-150
-200 Calculating IRR by hand can be
Discount rate (%) laborious process
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IRR Pitfalls
 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. But in
other cases, the IRR rule may disagree with the NPV rule and thus
be incorrect.

Pitfall 1: 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
discount rate to be 10%. Should you accept the deal?

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Pitfall 1: Delayed Investments cont…..

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.

• What does IRR say?

 The IRR 23.38% is greater than the opportunity cost of

capital (discount rate) 10%. Thus, the IRR rule indicates
that you should accept the deal

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Pitfall 1: Delayed Investments cont…
The NPV $1 million Book Deal

When the benefits (positive CFs)

of an investment occur before the
costs (negative CFs), the NPV is
an increasing function of the
discount rate. The NPV is positive
in the green-shaded areas and
negative in the red-shaded areas.
Notice that the NPV is positive
when the cost of capital is above
23.38%, the IRR, so the NPV and
IRR rules conflict.

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Pitfall 2: Multiple IRRs
 Suppose the retired CEO 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?

= -$10,412.54

If we plot the NPV profile, we see that it has two 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.
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Pitfall 2: Multiple IRRs cont...

As seen in the above graph, between 7.164% and 33.673%, the book deal
has a negative NPV. Since opportunity cost of capital is 10%, he should
reject the deal.
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Pitfall 3: Nonexistent IRR
 Finally, he 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.

No IRR exists because the NPV is positive for all values of the discount
rate. Thus, the IRR rule cannot be used. NPV = $189,587.46 @ 10%
discount rate
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Payback Period
 Simplest Investment Rule
 The length of time it takes to recover the initial cash outlay of a
project from future incremental cash flows
 Decision Rule: Project should be accepted if its payback period is
less than a specified cutoff
 Example: Hoofdstad Project (used in slide 8) takes 4 years to pay
back the initial investment
Period Cash Flow ($m) Accumulated Cash Flows
0 -1,000 -1,000
1 200 -800
2 300 -500
3 400 -100
4 500 +400
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Pitfalls of Payback Period
Ignores the project’s Cost of Capital and Time Value of Money
Ignores cashflows after the payback period
No guidance as to correct payback cutoff
• Tend to accept too many short-lived projects and reject too many
long-lived ones
• This may be deliberate if managers favor quick projects because
they have quick results that lead to quick promotion (Agency
problem)

ÞUseful to communicate project desirability

ÞMost commonly used when capital investment is small or when
merits of the project are so obvious that more formal analysis is
unnecessary

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Discounted Payback Period
 Discounted Payback period is the length of time it takes for the
cumulative discounted cash flows to equal the initial outlay
 The length of time for the project to reach NPV = 0
 Only accept projects where the sum of the discounted cash flows
within the payback period is greater than or equal to the initial
investment
 Has the advantage that it will never accept a negative NPV project
 But it still does not take account of cash flows after the cutoff date
Discounted Accumulated Discounted
Cash Flows Cash Flows@5% Cash Flows
Year Project X Project Y Project X Project Y Project X Project Y

0 –£100.00 –£100.00 –£100.00 –£100.00 –£100.00 –£100.00

1 20.00 20.00 19.05 19.05 –80.95 –80.95
2 50.00 50.00 45.35 45.35 –35.60 –35.60
3 45.00 45.00 38.87 38.87 3.27 3.27
4 60.00 0.00 49.36 0.00 52.63 3.27

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Decision Rule for Mutually Exclusive Projects

 When you need to choose between mutually exclusive projects (equal

live), the decision rule is simple:
• Calculate the NPV of each project
• From the options that have a positive NPV, choose the one
whose NPV is highest
 Example: Select one of the following projects based on highest NPV.
Assume a 7% discount rate.

System C0 C1 C2 C3 NPV
Faster -800 350 350 350 +118.5
Slower -700 300 300 300 +87.3

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Investment Timing Problem
 Sometimes you have the ability to defer an investment and select a time that is
more ideal at which to make the investment decision
Today’s investment is competing with future investments
Decision Rule: Choose the investment date that produces the highest NPV
today
 Example: You may purchase a computer anytime within the next 5-years. While
the computer will save your firm money, the cost of computers continues to
decline. If your cost of capital is 10%, when should you purchase the computer?

Time Cost PV Savings NPV at Purchase NPV Today

(1) (2) (3) (4) = - (2) + (3)

0 50 70 20 20.0
1 45 70 25 22.7
2 40 70 30 24.8
3 36 70 34 25.5
4 33 70 37 25.3
5 31 70 39 24.2

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Evaluating mutually exclusive projects with different lives

 When comparing mutually exclusive projects with different

useful lives (unequal lives), we cannot simply compare NPVs
 Approaches
1. Calculate NPV for each project
2. Determine the annual annuity that is equivalent to investing in each project:
Equivalent Annual Annuity (EAA)
• The level annual cash flow that has the same present value as the cash
flows of a project.

NPV
EAA =
A nnuity factor

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Example: Evaluating projects with different lives

• Often, a company will need to choose between two solutions to the same
problem. A complication arises when those solutions last for different
periods of time.

Example: A firm could be considering two vendors for its internal network
servers. Each vendor offers the same level of service, but they use
different equipment. Vendor A offers a more expensive server with lower
per-year operating costs that it guarantees for three years. Vendor B offers
a less expensive server with higher per-year operating costs that it
guarantees for two years. The costs and PV of costs @ 10% cost of capital
are as below:

Cash Flows ($ Thousands) for Network Server Options

Year PV at 10% 0 1 2 3
A −12.49 −10 −1 −1 −1
B −10.47 −7 −2 −2 Blank

• Which options would you choose?

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Example: Evaluating projects with different lives
Solution Plan: On a timeline, equivalent annual annuity cash flows
would appear as follows:

EAAA

EAAB

• Server A is equivalent to spending $5020 per year and server B is equivalent to spending
$6030 per year to have a network server. Seen in this light, server A appears to be the less
expensive solution.

Decision: EAAA < EAAB :Copyright

Choose©A2019
(less expensive)
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Evaluating projects with different lives
• Important Considerations When Using the Equivalent Annual Annuity
– Required Life
 In the previous example, do you need the server in the 3rd year? If not,
then you would be paying for something that you would not use
ÞMight be cheaper with Option B

– Replacement Cost
 In the previous example we assumed the cost of server will not
change over time
 If a dramatic change in technology will reduce the cost of servers by
the third year to an annual cost of $2000 per year
ÞOption B has the advantage that we can upgrade to the new
technology sooner

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Choosing Among Projects with Resource Constraint
• Sometimes different investment opportunities demand different
amounts of a particular resource
• If there is a fixed supply of the resource so that you cannot undertake
all possible opportunities, simply picking the highest-NPV opportunity
might not lead to the best decision

• Profitability Index

• Rank projects according to their PI based on the constrained resource

and move down the list accepting value-creating projects until the
resource is exhausted

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Example: Profitability Index with a Human Resource Constraint
• Your division at NetIt, a large networking company, has put together a
project proposal to develop a new home networking router. The
expected NPV of the project is $17.7 million, and the project will
require 50 software engineers. NetIt has 190 engineers available and
is unable to hire additional qualified engineers in the short run.
Therefore, the router project must compete with the following other
projects for these engineers:
Project NPV($ Millions) Engineering Headcount (EHC)
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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Example: Profitability Index with a Human Resource
Constraint

• The goal is to maximize the total NPV that we can create with
190 engineers (at most).

• We can use Profitability Index to determine the profitability

index for each project

• In this case, since engineers are our limited resource, we will

use Engineering Headcount in the denominator

• Once we have the profitability index for each project, we can

sort them based on the index.
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Example: Profitability Index with a Human Resource
Constraint
Profitability
Engineering Index
NPV($ Millions) Headcount (NPV per EHC Cumulative
Project (1) (EHC) (2) = (1)/(2)) EHC Required
Project A 22.7 47 0.483 47
Project F 12.9 32 0.403 79(47 + 32)
Project E 20.6 58 0.355 137(79 + 58)
Router 17.7 50 0.354 187(137 + 50)
Project C 14.0 40 0.350 Blank
Project D 11.5 61 0.189 Blank
Project B 8.1 44 0.184 Blank

• We assigned 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.
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Example: Profitability Index with a Human Resource
Constraint
• By ranking projects in terms of their NPV per engineer, we find the
most value we can create, given our 190 engineers.
• There is no other combination of projects that will create more value
without using more engineers than we have.
• This ranking also shows us exactly what the engineering constraint
costs us
– This resource constraint forces NetIt to forgo three otherwise
valuable projects (C, D, and B) with a total NPV of $33.6 million.

Pitfall of the Profitability Index

• In some situations, it does not give an accurate answer if some

resources are not fully utilized (e.g. A project- 100K NPV and 3 EHC)

• With multiple resource constraints, the usefulness of the profitability

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Summary of Decision Rules
NPV Blank

Definition • The difference between the present value of an

investment’s benefits and the present value of its costs

Rule • Take any investment opportunity where the NPV is

positive; turn down any opportunity where it is negative

Advantages • Corresponds directly to the impact of the project on the

firm’s value
• Direct application of the Valuation Principle

Disadvantages • Relies on an accurate estimate of the discount rate

• Can be time-consuming to compute

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Summary of Decision Rules

IRR Blank
Definition • The interest rate that sets the net present value of
the cash flows equal to zero; the average return of
the investment
Rule • Take any investment opportunity where its IRR
exceeds the opportunity cost of capital; turn down
any opportunity where its IRR is less than the
opportunity cost of capital
Advantages • Related to the NPV rule and usually yields the same
(correct) decision
Disadvantages • Hard to compute
• Multiple IRRs lead to ambiguity
• Cannot be used to choose among projects
• Can be misleading if inflows come before outflows

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Summary of Decision Rules

Payback
Period
Definition • The amount of time it takes to pay back the initial
investment
Rule • Accept the project if the payback period is less than
a prespecified length of time—usually a few years;
otherwise, turn it down
Advantages • Simple to compute
• Favors liquidity
Disadvantages • No guidance as to correct payback cutoff
• Ignores cash flows after the cutoff completely
• Not necessarily consistent with maximizing
shareholder wealth

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Summary of Decision Rules
Profitability
Index
Definition • NPV/Resource Consumed
Rule • Rank projects according to their PI based on the
constrained resource and move down the list
accepting value-creating projects until the resource
is exhausted
Advantages • Uses the NPV to measure the benefit
• Allows projects to be ranked on value created per
unit of resource consumed
Disadvantages • Breaks down when there is more than one
constraint
• Requires careful attention to make sure the
constrained resource is completely utilized

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