Session 9-12

Net Present Value and Other

Investment Rules
 Evaluation Criteria

1. Discounted Cash Flow (DCF) Criteria
◦ Discounted payback period (DPB)
◦ Net Present Value (NPV)
◦ Internal Rate of Return (IRR)
◦ Profitability Index (PI)

2. Non-discounted Cash Flow Criteria
◦ Accounting Rate of Return (ARR)
◦ Payback Period (PB)
 Average Accounting Return
Average Net Income
AAR =
Average Book Value of Investment

Another attractive, but fatally flawed,

approach

Ranking Criteria and Minimum Acceptance
Criteria set by management

Based on the following information
calculate the ARR of the project:
Purchase price of Rs. 80,000
machinery
Installation Charges Rs. 20,000
Estimated salvage value at the Rs. 40,000
end of the useful life
Useful life 4 years
Working capital required Rs. 10,000
Annual earnings before Rs. 65,000
depreciation and tax
Tax rate 30%
Average Accounting Return

Disadvantages:
◦ Ignores the time value of money
◦ Uses an arbitrary benchmark cutoff rate
◦ Based on book values, not cash flows and
market values

Advantages:
◦ The accounting information is usually available
◦ Easy to calculate and understand
◦ Considers the entire profits over the life of
project
The Payback Period Method

How long does it take the project to “pay
back” its initial investment?

Payback Period = number of years to
recover initial costs

Minimum Acceptance Criteria:
◦ Set by management

Ranking Criteria:
◦ Set by management
Example

Assume that a project requires an outlay
of Rs 50,000 and yields annual cash inflow
of Rs 12,500 for 7 years. The payback
period for the project is:

Rs 50,000
PB = = 4 years
Rs 12,500
Acceptance Rule

The project would be accepted if its
payback period is less than the maximum
or standard payback period set by
management.

As a ranking method, it gives highest
ranking to the project, which has the
shortest payback period and lowest
ranking to the project with highest
payback period.
Payback
Example
Examine the three projects and note the mistake
we would make if we insisted on only taking
projects with a payback period of 2 years or less.

Payback
Project C0 C1 C2 C3 NPV@ 10%
Period
A - 2000 500 500 5000
B - 2000 500 1800 0
C - 2000 1800 500 0
Payback
Example
Examine the three projects and note the mistake
we would make if we insisted on only taking
projects with a payback period of 2 years or less.

Payback
Project C0 C1 C2 C3 NPV@ 10%
Period
A - 2000 500 500 5000 3 + 2,624
B - 2000 500 1800 0 2 - 58
C - 2000 1800 500 0 2 + 50
 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
 Evaluation Criteria

1. Discounted Cash Flow (DCF) Criteria
◦ Discounted payback period (DPB)
◦ Net Present Value (NPV)
◦ Internal Rate of Return (IRR)
◦ Profitability Index (PI)

2. Non-discounted Cash Flow Criteria
◦ Accounting Rate of Return (ARR)
◦ Payback Period (PB)
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?

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.
 Net Present Value Method

The formula for the net present value can be

written as follows:
 C1 C2 C3 Cn 
NPV =  + 2
+ 3
+L+ n  − C0
 (1 + k) (1 + k) (1 + k) (1 + k) 
n
Ct
NPV = ∑ t
− C0
t =1 (1 + k )
Why Use Net Present Value?

Accepting positive NPV projects benefits
shareholders.

NPV uses cash flows

NPV uses all the cash flows of the project

NPV discounts the cash flows properly

Reinvestment assumption: the NPV rule
assumes that all cash flows can be
reinvested at the discount rate.
 The Net Present Value (NPV) Rule

Net Present Value (NPV) =
Total PV of future CF’s - Initial Investment

Estimating NPV:
1. Estimate future cash flows: how much? and when?
2. Estimate discount rate
3. Estimate initial costs

Minimum Acceptance Criteria: Accept if NPV > 0

Ranking Criteria: Choose the highest NPV
 Calculating Net Present Value

Assume that Project X costs Rs 2,500 now and is expected
to generate year-end cash inflows of Rs 900, Rs 800, Rs 700,
Rs 600 and Rs 500 in years 1 through 5. The opportunity cost
of the capital may be assumed to be 10 per cent.

Lets solve Q8 on pg 131
 Which projects have positive NPV?
$1000
NPVA = − $1000 + = −$90.91
(1.10)

$1000 $1000 $4000 $1000 $1000

NPVB = − $2000 + + 2
+ 3
+ 4
+ 5
= +$4,044.73
(1.10) (1.10) (1.10) (1.10) (1.10)

$1000 $1000 $1000 $1000

NPVC = − $3000 + + + + = +$39.47
(1.10) (1.10) 2 (1.10) 4 (1.10) 5
Payback period

Payback A = 1 year

Payback B = 2 years

Payback C = 4 years

At 3 year payback…firm should choose..

A and B
Discounted payback period
$1000
PVA = = $909.09
(1.10)1

The present value of the cash inflows for Project A never

recovers the initial outlay for the project, which is always the
case for a negative NPV project.

The present values of the cash inflows for Project B are

shown in the third row of the table below, and the
cumulative net present values are shown in the fourth row:

C0 C1 C2 C3 C4 C5
-2,000.00 +1,000.00 +1,000.00 +4,000.00 +1,000.00 +1,000.00
-2,000.00 909.09 826.45 3,005.26 683.01 620.92
-1,090.91 -264.46 2,740.80 3,423.81 4,044.73

Since the cumulative NPV turns positive between year
two and year three, the discounted payback period is:

264.46
2+ = 2.09 years
3,005.26
The present values of the cash inflows for Project C are shown in
the third row of the table below, and the cumulative net present
values are shown in the fourth row:

C0 C1 C2 C3 C4 C5
-3,000.00 +1,000.00 +1,000.00 0.00 +1,000.00 +1,000.00
-3,000.00 909.09 826.45 0.00 683.01 620.92
-2,090.91 -1,264.46 -1,264.46 -581.45 39.47

Since the cumulative NPV turns positive between year four and year five,
the discounted payback period is:
581.45
4+ = 4.94 years
620.92
 The Profitability Index (PI)

Total PV of Future Cash Flows

PI =
Initial Investent

Minimum Acceptance Criteria:
◦ Accept if PI > 1, or if PI>0 ( if the formula is
NPV/Initial Investment)

Ranking Criteria:
◦ Select alternative with highest PI
Profitability Index

When resources are limited, the profitability
index (PI) provides a tool for selecting among
various project combinations and alternatives

A set of limited resources and projects can yield

various combinations.

The highest weighted average PI can indicate

which projects to select.
Profitability Index
Cash Flows (Rs. millions)
Profitability Index
Cash Flows (Rs. millions)

NPV
Profitability Index =
Investment
Profitability Index
NPV
Profitability Index =
Investment
Another Example
We only have Rs.300,000 to invest. Which do we select?

Proj NPV Investment PI

A 230,000 200,000 1.15
B 141,250 125,000 1.13
C 194,250 175,000 1.11
D 162,000 150,000 1.08
Profitability Index
Another Example - continued
Proj NPV Investment PI
A 230,000 200,000 1.15
B 141,250 125,000 1.13
C 194,250 175,000 1.11
D 162,000 150,000 1.08

Select projects with highest Weighted Avg PI

WAPI (BD) = 1.13(125) + 1.08(150) + 0.0 (25)
(300) (300) (300)
= 1.01
Profitability Index
Another Example - continued
Proj NPV Investment PI
A 230,000 200,000 1.15
B 141,250 125,000 1.13
C 194,250 175,000 1.11
D 162,000 150,000 1.08

Select projects with highest Weighted Avg PI

WAPI (BD) = 1.01
WAPI (A) = 0.77
WAPI (BC) = 1.12