Net Present Value Investment Rules

The chapter focuses on making decisions for long-term investment (practice of capital
budgeting) using Net Present Value (NPV), Internal Rate of Return (IRR), Payback (PB),
Discounted Payback (Discount PB), Profitability Index (PI).
Net Present Value (NPV)
NPV measures the incremental value that is created when a firm take up an investment. A firm
should accept a project if the NPV for that project is positive. A project with zero has its NPV
means that the project earns exactly its required return. In other words, it earns exactly what the
firm asked. NPV is the present value of all the cash flow that a firm is expecting in the future
minus the net investment.
In other words, NPV = Benefits - Cost Analysis
Formula: NPV = CF1 ⁒ (1 + r)1 + CF2 ⁒ (1 + r)2 + CF3 ⁒ (1 + r)3 +… CFt ⁒ (1 + r)t – CF0
N.B: Required return is also known as market interest rate or discount rate or cost of capital.
If there are two positive NPVs, a firm can decide to choose both projects if they can afford it or
they can choose the highest out of the two positive NPVs.
Internal Rate of Return (IRR)
IRR is the expected return of a project that makes NPV equal to zero. The calculator is used to
find this value. If a project’s IRR exceed the project’s cost of capital (required return), the firm
should take the project. The formula for IRR is:
CF1 ⁒ (1 + IRR)1 + CF2 ⁒ (1 + IRR)2 + CF3 ⁒ (1 + IRR)3 +… CFt ⁒ (1 + IRR)t – CF0 = 0
Furthermore, there are times that there is conflict between the NPVs and IRRs of a project. For
example, If project A’s NPV = 16.15 and project B’s NPV = 20.70; Project A’s IRR = 19.073%
and project B’s IRR = 17.410%. In this case, the NPV says the firm should choose project B
while the IRR says the firm should go for project A because the values are high. Since both NPV
and IRR rules disagree with each other, then the firm should use the NPV. Anytime both rules
disagree, use NPV. Although this is true, there are instances that the decisions based on IRR and
NPV can differ if there are mutually exclusive or non-conventional projects.
When it comes to the Mutually exclusive projects, there are problems with the IRR rule.
Cashflow timing and size difference is responsible for these problems. In the mutually exclusive
projects’ case, the cashflows of a project decides the IRRR and the discount rate (required return)
does not affect IRR rankings. Also, IRR assumes reinvestment which can be unrealistic if it is
high.
If finding incremental IRR (crossover rate) with mutually exclusive projects, calculate the
incremental cashflow (Cashflow B – A) and use the IRR function key on the calculator.
Regarding the problems with IRR in a non-conventional cashflow case: in the non-
conventional projects, the initial cashflow is positive and the subsequent flows are all negative.
With this project, if the NPV is negative and the discount rate is less than the IRR, the firm
should reject the project. If the IRR is less than the discount rate, the firm should accept
the project. At the end of the day, use NPV to make decisions.
Furthermore, for non-conventional projects, future expected cashflows have different signs
(positive and negative). This type of projects have multiple IRRs. A firm can either reject or
accept one of the IRRs. Ultimately, only NPV lets one know which one is correct.
Payback (PB)
PB measures the length of time it takes for the accumulated cashflows equal or exceed the
investment. It helps a firm to have control on liquidity, offers a different type of risk control,
easy to compute and understand. It ignores cashflows beyond the cut-off mark and the time
value of money and risk. A firm should accept a project if the payback is less than the present
number of years. An example below:
If a project required return (r) = 10%, NPVA = 16.15, NPVB = 20.70. If a firm figures that the
payback of Project A is 2 years and the payback for Project B is 3 years. Based on the NPV, the
firm should choose Project B. In this case, NPVB is greater than NPVA.
Discounted Payback (DPB)
DPB takes into account the time value of money. Based on the example in the paragraph above,
if a firm picks project A which payback is in 2 years, we will find and use the PVs two years of
project A. So, if based on calculating PV, the cashflows of project A are [-$100, 45.45, 41.32,
22.5, 6.8], respectively, First we calculate, future cashflow of year 1 and 2 combined minus the
cost. So, 45.45 + 41.32 = 86.77. Subtract 86.77 from 100, we get 13.23. Therefore, we need
13.23 to recover $100. Next we use the discount payback formula = 2 + how much we need ⁒
how much we will get. So 2 + 13.23 ⁒ 22.5 = 2 + 0.58 = 2.58 years.
Both payback and discounted payback rule may reject some projects with positive NPVs and
accept the ones with negative NPV.
Profitability Index (PI)
The PI is a benefit to cost ratio. It does not work fine for mutually exclusive projects. A firm
should accept a project if its PI is greater than 1.0
Formula: PI = 1 + (NPV ⁒ the initial investment).
In capital rationing, a firm does not have enough capital to take all the projects that have positive
projects. So, if a firm has limited funds and has to choose between projects, the firm
should choose the projects with the highest PI depending on how much they have to invest.
In the Practice of Capital Budgeting, most firms use IRR because it is closely related to NPV
and easy to understand and communicate. Although it may result in multiple answers like the
non-conventional cash flow case or lead to incorrect decisions when comparing mutually
exclusive investments. Also, large firms use NPV and small firms use IRR and payback.