Chapter 9

Net Present Value and Other Investment Criteria

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?

9-2
Net Present Value
 The difference between the market value of a project and
its cost
 Net Present Value (NPV) =
Total PV of future CF’s + Initial Investment

 How much value is created today 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.

9-3
Project Example Information
 You are reviewing a new project and 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 level is
12%.

9-4
NPV – Decision Rule
 If the NPV is positive, accept the project
 If the NPV is negative, reject the project
 If the NPV is zero, Indifferent between taking the
investment and not taking it

 A positive NPV means that the project is expected to add

value to the firm and will therefore increase the wealth of the
owners.

 Ranking Criteria: Choose the highest NPV

9-5
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
 This is the increase in the value of the firm from the
project
 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
= 12,627.42
 Do we accept or reject the project?

7-6
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

9-7
The Payback Period Method
 How long does it take the project to “pay
back” its initial investment?
 Computation
 Estimate the cash flows
 Subtract the future cash flows from the initial cost until
the initial investment has been recovered
 Payback Period = number of years to recover initial costs
 Decision Rule :
 Set by management: Accept projects that
“payback” in the desired time frame. 7-8
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?

7-9
The Payback Period Method
 Disadvantages:
 Ignores the time value of money
 Ignores cash flows after the payback period
 Requires an arbitrary acceptance criteria
 A project accepted based on the payback
criteria may not have a positive NPV
 Advantages:
 Easy to understand
 Biased toward liquidity
7-10
The Discounted Payback Period
 How long does it take the project to “pay back” its initial
investment, taking the time value of money into account?

 Take PV of cash flows – then calculate payback

 Decision rule: Accept the project if it pays back on a

discounted basis within the specified time.

 By the time you have discounted the cash flows, you might as
well calculate the NPV.

 Still flawed:
 Ignores cash flows after the payback period 7-11
 Requires an arbitrary cutoff point
Computing Discounted Payback
 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?

9-12
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
9-13
Internal Rate of Return
 Definition: IRR is the return that makes the NPV = 0
 It is the rate that makes the PV of Cash inflow equals the
PV of Cash outflow

 Decision Rule:
 Accept when IRR > Required Return
 Reject when IRR < Required Return

7-14
Computing IRR for the Project
 If you 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?

9-15
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

9-16
Summary of Decisions for the Project
Summary
Net Present Value Accept
Payback Period Reject
Discounted Payback Period Reject
Internal Rate of Return Accept

9-17
IRR: Example
Consider the following project:
$50 $100 $150

0 1 2 3
-$200
The internal rate of return for this project is 19.44%

$50 $100 $150

N P V  0   200   2

(1  IRR ) (1  IRR ) (1  IRR ) 3
7-18
NPV Payoff Profile
If we graph NPV versus the discount rate, we can see the IRR
as the x-axis intercept.
0% $100.00 $120.00
4% $73.88 $100.00
8% $51.11 $80.00
12% $31.13 $60.00
16% $13.52 $40.00 IRR = 19.44%
NPV

20% ($2.08) $20.00

24% ($15.97) $0.00
28% ($28.38) ($20.00)
-1% 9% 19% 29% 39%
32% ($39.51) ($40.00)
36% ($49.54) ($60.00)
40% ($58.60) ($80.00)
44% ($66.82)
Discount rate

7-19
Internal Rate of Return (IRR)
 Advantages:
 Easy to understand and communicate
 Closely related to NPV, often leading to identical
decisions
 Knowing a return is intuitively appealing

7-20
NPV vs. IRR
 NPV and IRR will generally give us the same
decision
 Exceptions (Problems with IRR)
 Does not distinguish between investing and borrowing
 Nonconventional cash flows – cash flow signs change
more than once
 IRR may not exist, or there may be multiple IRRs
 Problems with mutually exclusive investments
 The Scale Problem: Initial investments are substantially different
 The Timing Problem: Timing of cash flows is substantially
different
9-21
IRR – Lending or Borrowing?

 Withsome cash flows the NPV of the project

increases as the discount rate increases

Project C0 C1 IRR NPV @ 10%

A  1,000  1,500  50%  364
B  1,000  1,500  50%  364

7-22
IRR – Nonconventional Cash Flows
 Certain
cash flows can generate NPV= 0 at two different
discount rates.

 The
following cash flow generates NPV=$ 3.3 million at
10%. It has IRRs of (-44%) and +11.6%.

Cash Flows

C0 C1...... ......C9 C10

 60 12 12  15

7-23
IRR – Nonconventional Cash Flows
NPV
600

IRR=11.6%
300

0 Discount
Rate

-30 IRR=-44%

-600

7-24
24
IRR – Nonconventional Cash Flows
Pitfall - Nonconventional Cash Flows:
 It is possible to have no IRR and a positive
NPV

Project C0 C1 C2 IRR NPV @ 10%

C  100  200  150 None  42

7-25
IRR – Nonconventional Cash Flows
NPV $70.00

$60.00

$50.00

$40.00

$30.00

$20.00

$10.00

$0.00
.1 0 1 2 3 4 5 6 7 8 9 1 1 2 3 4 5 Discount
-0 0. 0. 0. 0. 0. 0. 0. 0. 0. 1. 1. 1. 1. 1.
Rate
7-26
Another Example – Nonconventional
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?

9-27
NPV Profile
IRR = 10.11% and 42.66%
$4,000.00

$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
9-28
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
9-29
Modified IRR
 The Modified IRR (MIRR) method handles
the multiple IRR problem by combining CFs
until only one change in sign remains.

 Benefits: single answer and specific rates

7-30
Modified IRR
 Example: Suppose the CFs from a project are:
(-100, 230, -132) r = 14%

 This project has 2 IRRs: 10% & 20%

 Solution: NPV or Modified IRR

7-31
Modified IRR
 Modified IRR: The value of the last CF (-132) is: -132/1.14 =
-$115.79 as of date 1

 The adjusted CF at date 1 is: 230 – 115.79 = $114.21

 The MIRR approach produces the following 2 CF project:

(-100, 114.21)

The IRR of this project is 14.21% > 14% => Accept Project

7-32
IRR and Mutually Exclusive Projects
 Independent Projects: accepting or rejecting one project does
not affect the decision of the other projects.

 Mutually exclusive projects

 Only ONE of several potential projects can be chosen  If
you choose one, you can’t choose the other(s)
 Example: You can choose to attend graduate school at
either Harvard or Stanford, but not both
 RANK all alternatives, and select the best one.

9-33
The Scale Problem
Would you rather make 100% or 50% on your
investments?
What if the 100% return is on a $1
investment, while the 50% return is on a
$1,000 investment?

7-34
The Scale Problem
IRR sometimes ignores the magnitude of the project.
 The required return for both projects is 10%.

Project C0 C1 IRR NPV @ 10%

D  10,000  20,000 100%  8,182
E  20,000  35,000  75%  11,818
 Correct Choice: Choose the Project with the highest NPV

7-35
The Scale Problem
 IncrementalIRR (Crossover Rate): Calculate the
incremental CF from choosing the large budget instead of
small budget.

 Theincremental IRR is the IRR on the incremental

investment from choosing the large project instead of the
small project.

 NPV of the incremental CF can also be calculated.

7-36
The Scale Problem
 To calculate Incremental IRR  Subtract the smaller
project’s CFs from the bigger project’s CFs.

Project C0 C1 IRR NPV @ 10%

E D  10,000  15,000 50%  3,636

=> It is beneficial to invest an additional $10,000 in order to

receive an additional $15,000 at date 1.

7-37
The Scale Problem
 Mutually exclusive projects can be handled in 1 of 3 ways:
1) Compare the NPVs of the 2 projects  Choose project with higher NPV
2) Calculate the incremental NPV  If NPV is +ve, choose the large-budget
project
3) Compare the incremental IRR to the discount rate  If incremental IRR
> discount rate, choose the large budget project

 All 3 approaches always give the same decision

7-38
The Timing Problem
$10,000 $1,000
$1,000
Project A
0 1 2 3
-
$10,000
$1,000 $1,000
$12,000
Project B
0 1 2 3
-
$10,00 7-39

0
The Timing Problem
$5,000.00 Project A
$4,000.00 Project B
$3,000.00
$2,000.00
10.55% = crossover rate
$1,000.00
NPV

$0.00
($1,000.00) 0% 10% 20% 30% 40%

($2,000.00)
($3,000.00)
($4,000.00)
12.94% = IRRB 16.04% = IRRA
($5,000.00)

Discount rate
7-40
 Calculating the Crossover Rate
Compute the incremental IRR for either project “A-B” or “B-A”
Year Project A Project B Project B-A
0 ($10,000) ($10,000) $0
1 $10,000 $1,000 ($9,000)
2 $1,000 $1,000 $0
3 $1,000 $12,000 $11,000

$2,500.00
$2,000.00
$1,500.00 10.55% = IRR
$1,000.00
NPV

$500.00 B-A
$0.00
($500.00) % % % % % % % % % % %
0 2 4 6 8 10 12 14 16 18 20
($1,000.00)
($1,500.00)
Discount rate
7-41
The Timing Problem
 Mutually exclusive projects can be handled in one of 3
ways: (Assuming Incremental Cf is calculated for project
B-A)
1) Compare the NPVs of the 2 projects  Given the discount rate, choose
project with higher NPV
2) Calculate the incremental NPV  If NPV is +ve, choose B (given the
discount rate)
3) Compare the incremental IRR to the discount rate  If incremental IRR
(crossover rate) > discount rate, choose B

 All 3 approaches always give the same decision

7-42
Mutually Exclusive Projects - Summary
 Mutually exclusive projects should not be ranked
based on their returns
 Looking at IRRs can be misleading
 Look at NPVs to choose correctly
o We are ultimately interested in creating value for the
shareholders, so the option with the higher NPV is
preferred, regardless of the relative returns.
 Note: You can also look at incremental IRR or
incremental NPV to choose correctly

9-43
Internal Rate of Return
 IRR is better than payback method or discounted payback
method

 If IRR and NPV give different results  Use NPV

 For mutually exclusive projects, if different projects have

the same NPV  Choose the project with the highest IRR
Project C0 C1 C2 C3 NPV @ IRR
8%
A -9,000 2,900 4,000 5,400 1,400 15.58%
B -9,000,000 2,560,000 3,540,000 4,530,000 1,400 8.01%
7-44
Profitability Index (PI)
T o ta l P V o f F uture C ash F lo w s
PI 
Initial Investent
 Measures the benefit per unit cost, based on the time
value of money
 The PI gives the dollar return for the $1 invested
 A profitability index of 1.1 implies that for every $1 of
investment, we create an additional $0.10 in value
 Decision Rule:
 Accept if PI > 1

9-45
Profitability Index (PI)

Project C0 C1 C2 PV @ 12% of future NPV @ PI

CFs
12%
A -$20 70 10 $70.5 $50.5 3.53
B -10 15 40 45.3 $35.3 4.53

 The problem with the profitability index for mutually exclusive

projects is the same as the scale problem with the IRR

7-46
Advantages and Disadvantages of Profitability
Index
 Advantages  Disadvantages
 Closely related to  May lead to
NPV, generally incorrect
leading to decisions in
identical decisions comparisons of
 Easy to mutually
understand and exclusive
communicate investments

9-47
Summary – DCF Criteria
 Net present value
 Difference between market value and cost
 NPV directly measures the increase in value to the firm
 Take the project if the NPV is positive
 Has no serious problems
 Preferred decision criterion  Whenever there is a conflict between NPV and
another decision rule, you should always use NPV
 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 nonconventional cash flows or mutually exclusive
projects
 Profitability Index
 Benefit-cost ratio
 Take investment if PI > 1
 Cannot be used to rank mutually exclusive projects
9-48
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

9-49
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 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?

9-50
Problem
 Consider the following cashflows on two
mutually exclusive projects for the Bahamas
Recreation Corporation. Both require an
annual return of 15%.
Year Deepwater New Submarine
Fishing Ride
0 -750,000 -2,400,000
1 360,000 1,700,000
2 420,000 800,000
3 340,000 850,000 7-51
Problem
Ifyour decision is based on IRR, which
project should you choose?

What mistake did you just make? Show how

to fix it using only IRR.

Now, compute the NPV. Is this consistent

with the IRR?
7-52
52