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Key 1-1 Concepts and Skills
Understand the payback rule and its
shortcomings
Understand the internal rate of return and
its strengths and weaknesses
Understand the net present value rule and
why it is the best decision criteria
Chapter 8
Net Present Value
and Other
Investment Criteria
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McGraw-Hill/Irwin
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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved .
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Chapter Outline
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Good Decision Criteria
We need to ask ourselves the following
questions when evaluating decision
criteria
Net Present Value
The Payback Rule
The Internal Rate of Return
The Profitability Index
The Practice of Capital Budgeting
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
Net Present Value
The difference between the market
value of a project and its cost
How much value is created from
undertaking an investment?
You are looking at a new project and
you have estimated the following cash
flows:
Year 0:
Year 1:
Year 2:
Year 3:
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CF = -165,000
CF = 63,120;
CF = 70,800;
CF = 91,080;
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.
Your required return for assets of this
risk is 12%.
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NPV Decision Rule
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Project Example Information
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.
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;
Year 2:
CF = 70,800;
Year 3:
CF = 91,080;
Your required return for assets of this risk
is 12%.
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Calculating NPVs with a
Spreadsheet
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 criteria?
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
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Project Example Information
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
You are looking at a new project and
you have estimated the following cash
flows:
Year 0:
Year 1:
Year 2:
Year 3:
CF = -165,000
CF = 63,120;
CF = 70,800;
CF = 91,080;
Your required return for assets of this
risk is 12%.
Decision Rule Accept if the payback
period is less than some preset limit
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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 criteria?
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Advantages and Disadvantages
of Payback
Disadvantages
Advantages
Ignores the time value
of money
Requires an arbitrary
cutoff point
Ignores cash flows
beyond the cutoff date
Biased against longterm projects, such as
research and
development, and new
projects
Easy to understand
Adjusts for uncertainty
of later cash flows
Biased towards
liquidity
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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
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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Project Example Information
NPV Profile For the Project
You are looking at a new project and
you have estimated the following cash
flows:
60,000
50,000
40,000
NPV
Year 0:
Year 1:
Year 2:
Year 3:
IRR = 16.13%
70,000
CF = -165,000
CF = 63,120;
CF = 70,800;
CF = 91,080;
30,000
20,000
10,000
0
-10,000
-20,000
0
Your required return for assets of this
risk is 12%.
0.02 0.04 0.06 0.08
0.1
0.12 0.14 0.16 0.18
0.2
0.22
Discount Rate
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Decision Criteria Test - IRR
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Advantages of 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?
Knowing a return is intuitively appealing
It is a simple way to communicate the
value of a project to someone who doesnt
know all the estimation details
If the IRR is high enough, you may not
need estimate to a required return, which
is often a difficult task
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Summary of Decisions For the
Project
Calculating IRRs With a
Spreadsheet
You start with the cash flows the same as
you did for the NPV
You use the IRR function
Summary
Net Present Value
Accept
Payback Period
Reject
Internal Rate of Return
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Accept
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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IRR and Nonconventional Cash
Flows
NPV vs. IRR
NPV and IRR will generally give us the
same decision
Exceptions
Nonconventional 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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When the cash flows change signs 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
Nonconventional Cash Flows
NPV Profile
IRR = 10.11% and 42.66%
$4,000.00
Suppose an investment will cost $90,000
initially and will generate the following
cash flows:
$2,000.00
NPV
$0.00
Year 1: $132,000
Year 2: $100,000
Year 3: -$150,000
($2,000.00)
($4,000.00)
($6,000.00)
($8,000.00)
($10,000.00)
The required return is 15%.
Should we accept or reject the project?
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0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55
Discount Rate
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IRR and Mutually Exclusive
Projects
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
nonconventional cash flows, and that you
need to look at the NPV profile
Mutually exclusive projects
If you choose one, you cant choose the other
Example: You can choose to attend graduate
school next year 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
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Project
A
-500
Project
B
-400
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325
325
2
325
200
IRR for A = 19.43%
IRR
NPV
19.43% 22.17%
64.05
The required
return for both
projects is 10%.
NPV
Period
NPV Profiles
W hich project
should you
accept and why?
$160.00
$140.00
$120.00
$100.00
$80.00
$60.00
$40.00
$20.00
$0.00
($20.00)
($40.00)
IRR for B = 22.17%
Crossover Point = 11.8%
A
B
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0.05
0.1
0.15
0.2
0.25
0.3
Discount Rate
60.74
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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
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Modified Internal Rate of Return
(MIRR)
Compute IRR of modified cash flows
Controls for some problems with IRR
Discounting Approach Discount future
outflows to present and add to CF0
Reinvestment Approach - Compound all CFs
except the first one forward to end
Combination Approach Discount outflows to
present; compound inflows to end
MIRR will be a unique number for each
method, but is difficult to interpret;
discount/compound rate is externally supplied
Non-conventional cash flows
Mutually exclusive projects
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Example: MIRR
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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 receive $1.10
worth of benefits, so we create an
additional $0.10 in value
This measure can be very useful in
situations in which we have limited capital
Project cash flows:
Time 0: -$500 today;
Time 1: + $1,000;
Time 2: -$100
RRR = 11%
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Advantages and Disadvantages
of Profitability Index
Advantages
Closely related to
NPV, generally leading
to identical decisions
Easy to understand
and communicate
May be useful when
available investment
funds are limited
Disadvantages
May lead to incorrect
decisions in
comparisons of
mutually exclusive
investments
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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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Quick Quiz
Comprehensive Problem
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 the required
payback is 4 years.
An investment project has the following cash
flows: CF0 = -1,000,000; C01 C08 = 200,000
each
If the required rate of return is 12%, what
decision should be made using NPV?
How would the IRR decision rule be used for this
project, and what decision would be reached?
How are the above two decisions related?
What is the payback period?
What is the NPV?
What is the IRR?
Should we accept the project?
What should be the primary decision method?
When is the IRR rule unreliable?
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