3.

The NPV Criterion

NPV focuses on all cash flows generated by the
project and by capitalizing them at a market-
determined discount rate
NPV = PVInflows - PVOutflows

The required rate of return (RRR) for a project is

the minimum rate of return that the project must
yield to justify its acceptance
NPV rule accepts projects with positive NPVs and
rejects projects with negative NPVs

14
Rationale for the NPV Method
NPV of zero signifies that project’s cash flows
are exactly sufficient to repay the invested
capital and to provide the required rate of return
on that capital
NPV of greater than zero is generating more
cash than is needed to service its debt and to
provide the required return to shareholders, and
this excess cash accrues solely to the firm’s
stockholders

CF1 CF2 CFn

NPV = + +...+ - ICO
(1+k)1 (1+k)2 (1+k)n

15
 NPV Solution
Basket Wonders has determined that
the appropriate discount rate (k) for
this project is 13%.

$10,000 $12,000 $15,000

NPV = + + +
(1.13)1 (1.13)2 (1.13)3
$10,000 $7,000
+ - $40,000
(1.13)4 (1.13) 5

16
 NPV Solution

NPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) +

$15,000(PVIF13%,3) + $10,000(PVIF13%,4) +
$ 7,000(PVIF13%,5) - $40,000
NPV = $10,000(.885) + $12,000(.783) +
$15,000(.693) + $10,000(.613) +
$ 7,000(.543) - $40,000
NPV = $8,850 + $9,396 + $10,395 +
$6,130 + $3,801 - $40,000
= - $1,428

17
NPV: Strengths & Weaknesses
Strengths: Weaknesses:
– Cash flows – May not include
assumed to be managerial options
reinvested at the embedded in the
hurdle rate project
– Accounts for TVM
– Considers all cash
flows

18
 4.The IRR Criterion
Internal Rate of Return (IRR) is that discount
rate that makes the present value of the cash
inflows equal to the present value of the cash
outflows

IRR = RRR NPV = PVInflows - PVOutflows = 0

Internal Rate of Return (IRR) accepts a project

if its IRR > RRR, and rejects a project if its IRR <
RRR
Hurdle Rate of Return (HRR) is that discount
rate that IRR must exceed if a project is to be
accepted

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 CF1 CF2 CFn
ICO = + +...+
(1+IRR)1 (1+IRR)2 (1+IRR)n

$40,000 = $10,000 $12,000

+ +
(1+IRR)1 (1+IRR)2
$15,000 + $10,000 + $7,000
(1+IRR)3 (1+IRR)4 (1+IRR)5

Find the interest rate (IRR) that causes

the discounted cash flows to equal
$40,000. 20
 IRR Solution (Try 10%)
$40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) +
$15,000(PVIF10%,3) + $10,000(PVIF10%,4) +
$ 7,000(PVIF10%,5)

$40,000 = $10,000(.909) + $12,000(.826) +

$15,000(.751) + $10,000(.683) +
$ 7,000(.621)

$40,000 = $9,090 + $9,912 + $11,265 +

$6,830 + $4,347
= $41,444 [Rate is too low!!]

21
 IRR Solution (Try 15%)

$40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) +

$15,000(PVIF15%,3) + $10,000(PVIF15%,4) +
$ 7,000(PVIF15%,5)

$40,000 = $10,000(.870) + $12,000(.756) +

$15,000(.658) + $10,000(.572) +
$ 7,000(.497)

$40,000 = $8,700 + $9,072 + $9,870 +

$5,720 + $3,479
= $36,841 [Rate is too high!!]

22
 IRR Solution (Interpolate)

0.10 41,444
X 1,444
0.05 IRR 40,000 4,603
0.15 36,841

X 1,444
=
0.05 4,603

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 IRR Solution (Interpolate)

0.10 41,444
X 1,444
0.05 IRR 40,000 4,603
0.15 36,841

X 1,444
=
0.05 4,603

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 IRR Solution (Interpolate)

0.10 41,444
X 1,444
0.05 IRR 40,000 4,603
0.15 36,841

1,444 * 0.05
X = X = 0.157
4,603

IRR = .10 + .0157 = .1157 or 11.57%

25
PBP: Strengths & Weaknesses
Strengths: Weaknesses:
– Accounts for – Assumes all cash
TVM flows reinvested at
– Considers all the IRR
cash flows – Difficulties with
– Less subjectivity project rankings
and Multiple IRRs

26
Rationale for the IRR Method
Why is the particular discount rate that equates a
project’s cost with the present value of its receipts
(the IRR) so special?

NPV of greater than zero is generating more

cash than is needed to service its debt and to
provide the required return to shareholders, and
this excess cash accrues solely to the firm’s
stockholders

27
5. The Profitability Index (PI) Criterion
Benefit-Cost Ratio
Profitability Index is the present value of the
cash inflows divided by the present value of the
cash outflows
PI = PVInflows
PVOuftlows

PI accepts a project if PI > 1 and rejects a project

if its PI < 1

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 Example:- A Computer Replacement Project

16,200 16,200 16,200 16,200 16,200+16,200

1 2 3 4 5

0
-51,700
NPV = PVInflows - PVOutflows
= -51,700+16,200(PVAF12%,5)+16,200(PVF12%,5)
= 18,046

Computer should be replaced as the market

value will increase by 18,046

29
 Example:- A Computer Replacement Project
10.26 18.29 26.32 26.32 26.32 26.32 26.32 33.44
1989 1990 1991 1992 1993 1994 1995 1996

1988
-54.60
NPV = PVInflows - PVOutflows
=- = -54.60 + 10.26(PVF12%,1) +
18.29(PVF12%,2) + 26.32(PVF12%,3) +
26.32(PVF12%,4) + 26.32(PVF12%,5) +
26.32(PVF12%,6) + 26.32(PVF12%,7) +
33.44(PVF12%,8)
= 58.28
Expanding the yogurt line is thus a productive
endeavor because the market value of the firm
will go up by 58.28 30