3 Ch2 - InvestmentCriteria - ForCampus

Bachelor 2018-2019
FINANCE
Elie GRAY - e.gray@tbs-education.fr
David Le BRIS - d.le-bris@tbs-education.fr
Debrah MELOSO - d.meloso@tbs-education.fr
Chapter 2: INVESTMENT CRITERIA
1
Outline 2
I - Introduction
II - Net Present Value and other Investment criteria

II.1 - Net Present Value (NPV) / Valor Actual Neto (VAN)
II.2 - Internal Rate of Return (IRR) / Tasa Interna de Retorno (TIR)
II.3 - Discounted Payback Period (DPB) / Periodo de Amortizacion

Descontado
III - Conclusion
IV - Applications
I - Introduction 3
Objective of the Chapter
➢ Apply the concept of time value of money to capital budgeting decisions
➢ We will see how to determine which long-term investments a firm should adopt (in
which project a firm should invest)
✓ The main task of a financial manager is to ensure that the firm creates value
✓ The main channel for value creation is to invest in fixed asset
✓ Investing in fixed asset corresponds to a capital budgeting decision
✓ Capital budgeting decision (i.e. investment decision) involves cash flows that
will be received at different points of time
➢ Project selection requires investment criteria / rules in order to ensure that

investments create value
➢ Investment criteria rely upon the concept of time value of money

I – Introduction – PROJECT 4
What is an investment project?

➢ Anything that generates a series of cash flows. For instance:
✓ Airbus plans to invest $600 million in a new factory in Alabama. Airbus is to
receive $158 million in financial and logistical support for the factory. Airbus
expects to sell 200 A320 passenger planes per year for 20 years.
✓ A real estate developer plans to invest in €4 million in a new project which
consist in buying some real estate properties and to built new housing. He
expects to be able to get net profits of €1 million at the end of the first year,
then €400 000 per year (end of each year) for the next 5 years, and finally €1,8
million at the end the seventh year.
✓ An investor purchases a bond from a firm for €10 000. The coupon rate is 7%
(paid semiannually) and the maturity is 2 years. The investor will receive €700
every 6 months for the next 2 years from the firm. The firm will repay €10 000
in two years.
✓ A lottery ticket that costs $1, and offers to pay $14 million with some
probability.
➢ Projects can consist of physical investments, in R&D investments, in pure

monetary investments, in financial investments, in gambles
I - Introduction 5
What is the Balance-Sheet model of a firm?
ASSETS LIABILITIES
Current
CurrentAssets
Assets(Activos corrientes)
(Actifs circulants) Current Liabilities (Pasivos de C.P.)
▪ inventories (inventario) ▪Account payable (cuentas por pagar)
(stocks)
▪Account receivable (cuentas por cobrar) ▪ Overdraft (descubierto bancario)
(Customer accounts)
▪ Cash (trésorerie)
Long-Term Debt (Pasivos de L.P.)
▪Bank loans (Prestamos bancarios)
▪Bond loans (prestamos de obligacion)
Fixed Assets (Activos fijos)
▪ Tangible (land, buildings, machines…)
Shareholders’ Equity
▪ Intangible (Patent, Brand…)
(Capital propio)
I - Introduction 6
What is the Net Working Capital (NWC) of a firm?
Current Assets (Activos corrientes) Current Liabilities (Pasivos de C.P.)

▪Account payable (cuentas por pagar)
▪ inventories (inventario)
▪ Overdraft (descubierto bancario)
▪ Account receivable (cuentas por cobrar)
▪ Cash
(Capital propio)
I - Introduction 7
In which long-term investments should a firm engage in?

▪ Cash
(Capital propio)
I - Introduction 8
How can the firm raise the money for the required investments?

▪ Cash
(Capital propio)
I - Introduction 9
COST OF CAPITAL (COC) – Discount rate for the firm (Part 2 of the course)
The cost of capital (COC) for a firm is the opportunity cost the firm has to bear to raise
the money necessary for the required investments
Lend money
Bondholders
Banks
First repays debt to Invest these funds
banks & bondholders into projects
Then, the remaining Firm

Projects
resources belong to
These projects
shareholders
generate money
Shareholders
Equityholders
Invest in stocks
➢ Firms raise the money for the required investments via Debt & Equity
➢ Hence, the cost of raising this money consists both in the cost of debt (return given
to the debtholders) and in the cost of equity (return given to the equityholders)
I - Introduction 10
COST OF CAPITAL (COC) - See Part 2
The cost of capital (COC) for a firm is the opportunity cost the firm has to bear for
raising the money necessary for the required investments
Bondholders
Banks Compensate RISK
bondholders for this risk
Firm
Projects
Compensate
shareholders
Shareholders for this risk
Equityholders
➢ For the whole system to work, investors (bondholders and shareholders) expect
their investments to give them as much return (on average) as the return they could
get from investments of similar risk
➢ This is why capital has an (opportunity) cost

I - Introduction 11
COST OF CAPITAL (COC) - See Part 2
➢ What is the risk (and therefore the cost of capital) of a project?

✓ This depends on the project
✓ But the sum of all the projects is the firm itself. So, the cost of capital of the
average (typical) project of a firm is the cost of capital for the entire firm
➢ In Part 2, you will see that

✓ the COC for a firm is the expected return on the portfolio of its debt and equity
✓ the COC for a firm depends on the risk of the firm’s portfolio of projects
✓ if the firm uses several forms of financing (equity and debt), one approach is
that the COC be a weighted average of its cost of debt and its cost of equity
(Weighted Average Cost of Capital –WACC )
➢ The opportunity cost of capital of a firm is this firm’s time value of money  use
the COC as the relevant discount rate to analyze a firm’s projects
I - Introduction 12
The fundamental principles of project evaluation: Capital Budgeting Stages
➢ Step 1 – Determine the Cash Flows (see Ch. 5) Terminal

Initial Cash flow
outlay CF1 CF2 … Cash Flows CFN-1
Periodic CFN
0 1 2 … N-1 N
✓ Initial outlay (investissement initial): costs of equipment, staff training, installation costs…
✓ Periodic CFs: Free Cash Flows (FCF - Flux de trésorerie disponibles) of the project (determination of
the incremental CFs over the life of the project)
✓ Terminal Cash Flow: terminal value of the project (including the liquidation of the assets of the project)
➢ Step 2 - Evaluate the risk of the project and determine the COC that should be
used to study the project
✓ In this Chapter, we will assume that the risk of the project is the same as the risk of the overall firm and
corresponds to the firm’s COC (i.e. the CFs of the projects will be discounted using the COC)
✓ In this Chapter, the COC will always be given in applications
✓ The CAPM is the basic tool for computing the Weighted Average COC (WACC) of the firm (see Part 2)
➢ Step 3 - Evaluation of the project (the purpose of this Chapter)

✓ Application of one or more investment rules (capital budgeting rule) and make a decision on whether
one should accept or reject the project
I - Introduction 13
The fundamental principles of project evaluation: Investment Criteria
➢ Net Present Value (NPV) / Valor Actual Neto (VAN)

✓ The NPV of a project gives the value today of this project
➢ Internal Rate of Return (IRR) / Tasa Interna de Retorno (TIR)

✓ The IRR of a project gives the return of this project
➢ Discounted Payback Period (DPB) / (Periodo de amortizacion descontado)

✓ The DPB gives the date at which the project becomes profitable
NB: Capital budgeting decisions depends of the considered discount rate, the Cost of
Capital (COC)
Assumptions:
✓ No risk (CFs and discount rate are supposed to be known with certainty)
✓ No inflation (prices and discount rates remain constant)
I - Introduction 14
The fundamental principles of project evaluation: Application
➢ In order to review each of the three investment criteria, we will use the application
Real estate developer (presented in the previous Chapter - see slides 27, 28 & 52)
A real estate developer plans to invest in €4 million in a new project which consist in buying some real
estate properties and to built new housing.
Assume that the discount rate that should be used to study these projects is 10%.
Consider the following scenarios:
a) The developer expects to be able to sell all new housing in one year for €4.8 million.
b) The developer expects to be able to get net profits of €1,2 million per year for the next 4 years (end of
each year).
c) The developer expects to be able to get net profits of €100 000 per month (end of each month) for the
next 4 years (e.g. renting).
d) The developer expects to be able to get net profits of €1 million at the end of the first year, then €400000
per year (end of each year) for the next 5 years, and finally €1.8 million at the end the seventh year.
For each scenario (a and b in class & c and d HOMEWORK), determine

1. the NPV (you already computed the NPV of these projects)
2. the IRR
3. the DPB
What about for a COC of 25%?

II – Net Present Value and other Investment Criteria 15
II.1- Net Present Value (NPV) / Valor Actual Neto (VAN)
➢ The NPV is a way to deal with the time dimension
➢ The NPV rule is a fundamental tool in finance: it is used in order to

✓ value investment projects (see Chapters 2 & 3)
✓ value financial assets (see Part 2)
➢ The NPV of an investment project gives the value today of this investment project
➢ The NPV is the discounted sum of all the CFs inherent in the project (discounted
at the opportunity COC):
CF0 CF1 CF2 … CFN-1 CFN
0 1 2 … N-1 N
Given that i = COC, then
N
CFt 𝑁
NPV  NPV (COC )   𝐶𝐹𝑡
t 0 1  COC t 𝑁𝑃𝑉 𝑖 = ෍
𝑡=0
1+𝑖 𝑡

N N N
CFt CFt CFt
NPV    CF0     IO  
t 0 1  COC t
t 1 1  COC t
t 1 1  COC t
➢ The NPV of an investment is the present value of the expected CFs (CFt, t>0)
discounted at the COC minus (net of) the initial cost of the investment (CF0 = Initial
Outlay)
➢ Computing the present value of the expected CFs requires a discount rate (the COC)
➢ NB: Excel function discounts the first CF as well !!! – see applications
➢ Capital budgeting decision: the project will be undertaken if the NPV is positive
✓ Accept the project if its NPV >0
✓ Indifference if NPV=0
✓ Reject it if its NPV < 0
➢ Application scenario a), with COC=10%

CF0=-4 000 000 CF1=4 800 000
0 1
N
CFt CF1 4800000
NPV    CF   4000000   363636.4  0
t 0 1  COC t 0
1  COC 1  10%
NPV of scenario a) is positive: the project is profitable.
Developer should invest in this project
What if the COC=25%?

N
CFt CF1 4800000
NPV    CF0   4000000   -160000  0
t  0 1  COC  1  COC 1  25%
t
NPV of scenario a) is negative: the project is NOT profitable.

Developer should NOT invest in this project
NB: this underlines the importance of the COC in the capital budgeting decision
➢ Application scenario b), with COC=10%

-4M 1,2M 1,2M 1,2M 1,2M
0 1 2 3 4
Regular annuity of
size 4, CFt = 1.2M
N
CFt 1  1  10% 4 
NPV    CF0  PVRA, 4  4 M  1.2 M 
1.2 M
  -196161.5

t  0 1  COC t
 10 % 
NPV of scenario b) is negative: the project is NOT profitable.

You not have to do any computation to determine that the NPV of scenario b) would
be negative if the COC is 25% (NPV already negative with COC=10%)
➢ Application scenario c) , with COC=10% NB: monthly CFs!!!

-4M 100.000 100.000 … 100.000
0 1 2 … 48
N
CFt 1  1  iM ,10%  48

NPV    CF0  PVRA, 48  4 M  100000 
100000

t  0 1  COC 
t
 iM ,10% 
What is iM ?
1  iM  1  10%   iM  1  10%   1  0.797...% per month
1 / 12 1 / 12

1  1  10% 1/12 48 
NPV  4 M  100000  

 1  10%   1 
1 / 12
1  1.1 48 /12   1  1.1 4 

 4 M  100000    4 M  100000    -24818.6
 1.1  1   1.1  1
1 / 12 1 / 12
NPV of scenario c) is negative: the project is NOT profitable.

Developer should NOT invest in this project (idem if COC=25%!)
➢ Application scenario d), with COC=10% Regular annuity of size 5, CFt = 400000
-4 M 1M 400 000 400 000 400 000 400 000 400 000 1.8
0 1 2 3 4 5 6 7
N 400000
CFt 1M PVRA 1.8 M
NPV    4 M   ,5

t 0 1  COC t
1  10 % 1  10 % 1  10 % 7
1M 1 1  1  10% 5  1 .8 M
 4 M   .400000   
1  10% 1  10%  10 %  1  10 % 7
 4 M  909090.9  1 378 467.9  923684.6  -788 756.6
NPV of scenario d) is negative: the project is NOT profitable.


You not have to do any computation to determine that the NPV of scenario d) would
be negative if the COC is 25% (NPV already negative with COC=10%)
II.3- Discounted Payback Period (DPB) / Periodo de amortizacion descontado
➢ The DPB gives the date at which the project becomes profitable
➢ DPB = amount of time (i.e. number of periods, e.g. years) until the discounted net
cash flows (discounted at the opportunity COC) exceed the initial outlay:
If the DPB exists, it verifies

𝐶𝐹𝑡 𝐶𝐹𝑡
σ𝐷𝑃𝐵
𝑡=0 𝑡 ≥ 0, but σ 𝐷𝑃𝐵−1
𝑡=0 <0
1+𝐶𝑂𝐶 1+𝐶𝑂𝐶 𝑡
➢ NB1: The DPB of a project exists only if the project has a positive NPV
➢ Capital budgeting decision:
the project will be undertaken if its DPB is lower than some pre-specified number of
periods (set by management before any project evaluation)
➢ NB2: this investment rule may reject positive NPV investments
• It requires an arbitrary cutoff date
• ⟹ It ignores all the CFs beyond the cutoff date
• Biased against long-term projects (e.g. R&D projects)
II.3- Discounted Payback Period (DPB)
➢ Application scenario a)
CF0= - 4 000 000 CF1=4 800 000
0 1
• If COC=10%: NPV  363636.4  0 and IRR  20%  COC  10%
What is the DPB?

DPB=1 year
• If COC=25%: NPV  -160000  0 and IRR  20%  COC  25%
What is the DPB?

DPB does not exist since the project is not profitable
➢ Application scenario b)
-4M 1,2M 1,2M 1,2M 1,2M
0 1 2 3 4
• If the COC=10%, what is the DPB? We obtain that DPB is

• You may solve the following equation for N: around
4 years and 3 months…
1  1  10%  1  1.1
 N*  N*
4M
 4 M  PV 1, 2 M
RA, N *  0  4 M  1.2 M 0 
10% 0 .1 1. 2 M
ln 2 / 3
 1.1
N*

 2 / 3  ln 1.1
N*
  ln 2 / 3  N * ln 1.1  ln 2 / 3  N *  
ln 1.1
 4.2542
NO!!!! N*>4 means that the DPB does not exist!!! (NPV<0)
• NB: Careful when you solve this type of equation for N, a natural number – “N
= 4.25” has no meaning except that DPB is the next natural number
We will always use rudimentary method to find DPB (Excel)
II.3- Discounted Payback Period (DPB) - HOMEWORK
➢ Application scenario b)
-4M 1,2M 1,2M 1,2M 1,2M
0 1 2 3 4
• With COC=10%, the project has no DPB
• What if the COC was 5%?
➢ Application scenario c) (NB: monthly CFs!!!)
-4M 100.000 100.000 … 100.000
0 1 2 … 48
• What is the DPB if COC=10%?
➢ Application scenario d)
-4 M 1M 400 000 400 000 400 000 400 000 400 000 1.8
0 1 2 3 4 5 6 7
EXCEL – DPB & NPV

II.2- Internal Rate of Return (IRR) / Tasa Interna de Retorno (TIR)
➢ The return of a project is given by its IRR
➢ The IRR is the discount rate such that the discounted sum of all the CFs inherent
in the project is zero:
✓ IRR = the discount rate that allows discounted benefits to cover expenses
✓ IRR = the discount rate, which applied to the future cash flows allows to
recapture the initial investment (IO)
N N
CFt CFt
IRR verifies   0   IO    0 NPV ( IRR)  0
t  0 1  IRR  t 1 1  IRR 
t t
➢ Capital budgeting decision: the project will be undertaken if its IRR exceeds the
cost of capital (COC)
✓ Accept the project if its IRR > COC
✓ Indifference if IRR=COC
✓ Reject it if its IRR < COC
➢ NB1: Do not Confuse IRR and COC!

✓ The IRR is specific to the project
✓ The COC is the required rate of return (opportunity cost of capital, it
depends on what you have to give up in order to invest in the project)
If IRR > COC, money grows faster in the project than in its best alternative
(i.e. opportunity cost)
➢ NB2: not always possible to compute the IRR (see below)
➢ NB3: obviously, the NPV rule and the IRR rule (if possible to compute) will yield
the same capital budgeting decisions (for a single project):
IRR > COC necessarily means that NPV > 0
➢ NB4: might be misleading when comparing projects (see below)

➢ Application scenario a), with COC=10%

CF0= - 4 000 000 CF1=4 800 000
0 1
4.8M  4 M
Return of the project   0.2  20%
4M
Now use the previous definition to compute the IRR of the project:
N
CFt 4 .8 M
IRR verifies   0  4 M  0
t  0 1  IRR  1  IRR
t
4 .8 M 4 .8 M 4 .8 M  4 M
 1  IRR   IRR  1   20%
4M 4M 4M
IRR=20% > COC=10% : the project is profitable, developer should invest
IRR=20% < COC=25% : the project is NOT profitable
Same conclusions as when we used the NPV rule!

➢ Application scenario a) - GRAPHICALLY

NPV(COC)
1 000 000 €
N
CFt
800 000 €
IRR verifies 
t  0 1  IRR 
t
 0  NPV ( IRR)  0
IRR  20%
600 000 €
400 000 €
Invest in
200 000 €
the project
0€
10,21%
11,06%
11,91%
12,76%
13,61%
14,46%
15,31%
16,16%
17,01%
17,86%
18,71%
19,56%
20,41%
21,26%
22,11%
22,96%
23,81%
24,66%
25,51%
26,36%
27,21%
28,06%
28,91%
29,76%
30,61%
31,46%
32,31%
33,16%
34,01%
34,86%
35,71%
36,56%
37,41%
38,26%
39,11%
39,96%
40,81%
41,66%
42,51%
43,36%
44,21%
45,06%
45,91%
46,76%
47,61%
48,46%
49,31%
50,16%
0,01%
0,86%
1,71%
2,56%
3,41%
4,26%
5,11%
5,96%
6,81%
7,66%
8,51%
9,36%
-200 000 € DO NOT

Invest in
-400 000 €
IRR  20%  COC  10% the project
-600 000 €
 invest in the project
-800 000 €
-1 000 000 €
NPV(i)
➢ Application scenario b), with COC=10%

-4M 1,2M 1,2M 1,2M 1,2M
0 1 2 3 4
Not possible to compute the IRR directly, you have to use the previous definition:
N
CFt
IRR verifies 
t  0 1  IRR 
t
 0  NPV ( IRR)  0
1 .2 M 1 .2 M 1 .2 M 1. 2 M
 4 M     0
1  IRR 1  IRR  2
1  IRR  1  IRR 
3 4
1  1  IRR 
4
 4 M  PVRA
1 .2 M
,4  0  4 M  1.2 M 0
IRR
Polynomial of degree 4! How do we solve this equation?
✓ Excel (Solver or IRR/TIR function) or a financial calculator
✓ Guess & iterate by hand
➢ Application scenario b) - GRAPHICALLY

NPV(i)
1 000 000 €
N
CFt
500 000 €
IRR verifies 
t  0 1  IRR 
t
 0  NPV ( IRR)  0
Invest in
the project
IRR  8%
0€
10,67%
11,49%
12,31%
13,13%
13,95%
14,77%
15,59%
16,41%
17,23%
18,05%
18,87%
19,69%
20,51%
21,33%
22,15%
22,97%
23,79%
24,61%
25,43%
26,25%
27,07%
27,89%
28,71%
29,53%
30,35%
31,17%
31,99%
32,81%
33,63%
34,45%
35,27%
36,09%
36,91%
37,73%
38,55%
39,37%
40,19%
41,01%
41,83%
42,65%
43,47%
44,29%
45,11%
45,93%
46,75%
47,57%
48,39%
49,21%
0,01%
0,83%
1,65%
2,47%
3,29%
4,11%
4,93%
5,75%
6,57%
7,39%
8,21%
9,03%
9,85%
DO NOT Invest in the project

-500 000 €
-1 000 000 €
-1 500 000 € IRR  7.714%  COC  10%

 do not invest in the project
-2 000 000 €
-2 500 000 €
NPV(i)
➢ Application scenario c), with COC=10% NB: monthly CFs!!!

-4M 100.000 100.000 … 100.000
0 1 2 … 48
N
CFt
IRR verifies   0  NPV ( IRR)  0
t  0 1  IRR 
t
100000 100000 100000

 4 M    ...  0
1  IRR 1  IRR  2
1  IRR 48
1  1  IRR 
 48
 4 M  PVRA
100000
, 48  0  4 M  100000 0
IRR
Polynomial of degree 48! How do we solve this equation?

✓ Excel (Solver or IRR/TRI function) or a financial calculator
➢ Application scenario c) - GRAPHICALLY

NPV(i)
1 000 000 €
N
CFt
IRR verifies 
t  0 1  IRR 
t
 0  NPV ( IRR)  0
500 000 €
IRR  9.5%
Invest in
the project
0€
0,01%
0,68%
1,35%
2,02%
2,69%
3,36%
4,03%
4,70%
5,37%
6,04%
6,71%
7,38%
8,05%
8,72%
9,39%
10,06%
10,73%
11,40%
12,07%
12,74%
13,41%
14,08%
14,75%
15,42%
16,09%
16,76%
17,43%
18,10%
18,77%
19,44%
20,11%
20,78%
21,45%
22,12%
22,79%
23,46%
24,13%
24,80%
25,47%
26,14%
26,81%
27,48%
28,15%
28,82%
29,49%
30,16%
30,83%
31,50%
32,17%
32,84%
33,51%
34,18%
34,85%
35,52%
36,19%
36,86%
37,53%
38,20%
38,87%
39,54%
-500 000 €
-1 000 000 €
IRR  9.643%  COC  10%
-1 500 000 €
-2 000 000 €
NPV(i)
➢ Application scenario d), with COC=10%

-4 M 1M 400 000 400 000 400 000 400 000 400 000 1.8
0 1 2 3 4 5 6 7
N
CFt
IRR verifies   0  NPV ( IRR)  0
t  0 1  IRR 
t
400000
1M PVRA 1 .8 M
 4 M   ,5
 0
1  IRR 1  IRR 1  IRR  7
1  1  IRR 
5
400000
1M IRR 1 .8 M
 4 M    0
1  IRR 1  IRR 1  IRR 7
How do we solve this equation?

✓ Excel (Solver or IRR/TRI function) or a financial calculator
➢ Application scenario d) - GRAPHICALLY

NPV(i)
1 000 000 € N
CFt
Invest
IRR verifies 
t  0 1  IRR 
t
 0  NPV ( IRR)  0
500 000 €
in the
project IRR  4.5%
0€
10,54%
11,35%
12,16%
12,97%
13,78%
14,59%
15,40%
16,21%
17,02%
17,83%
18,64%
19,45%
20,26%
21,07%
21,88%
22,69%
23,50%
24,31%
25,12%
25,93%
26,74%
27,55%
28,36%
29,17%
29,98%
30,79%
31,60%
32,41%
33,22%
34,03%
34,84%
35,65%
36,46%
37,27%
38,08%
38,89%
39,70%
40,51%
41,32%
42,13%
42,94%
43,75%
44,56%
45,37%
46,18%
46,99%
47,80%
48,61%
49,42%
0,01%
0,82%
1,63%
2,44%
3,25%
4,06%
4,87%
5,68%
6,49%
7,30%
8,11%
8,92%
9,73%
-500 000 €

-1 000 000 €
-1 500 000 €
IRR  4.253%  COC  10%

-2 000 000 €
-2 500 000 €
-3 000 000 €
NPV(i)
IRR versus NPV
NPV and IRR decision rules will lead to identical decisions if:
➢ One studies a project whose CFs are “conventional” (only one sign change):
E.g. Initial outlay = negative CF & then only positive periodic CFs
➢ One is willing to compare projects that are a priori similar (similar level of CFs and
similar duration)
NB: The use of IRR may be problematic in two cases:
i. If one studies a project with non-conventional CFs (change sign multiple times)
ii. If one compares projects that are too different

IRR versus NPV

i. Use of IRR is problematic when studying projects with non-conventional
Cash Flows (change sign multiple times)
For instance:
✓ Multi-stage project (several investments)
✓ Projects involving capital expenditures (CapEx)
*CapEx = funds used by a company to acquire new assets, to upgrade its assets, or to
maintain at its current condition physical assets (e.g. buy new property; replace or
repair industrial buildings, equipment; aircraft maintenance; …)
✓ Projects involving decommissioning costs (e.g. remove or retire a ship, an

airplane, … from active service; rehabilitation of polluted sites; decontamination
of a nuclear power plant site; …)
IRR versus NPV

i. Use of IRR is problematic when studying projects with non-conventional
Cash Flows (change sign multiple times) NPV(i)
Year CFs 40 000 €
0 - 500 000 € (Initial Outlay)

1 500 000 € 20 000 €
2 500 000 €
3 500 000 € 0€
0,01%
1,68%
3,35%
5,02%
6,69%
8,36%
10,03%
11,70%
13,37%
15,04%
16,71%
18,38%
20,05%
21,72%
23,39%
25,06%
26,73%
28,40%
30,07%
31,74%
33,41%
35,08%
36,75%
38,42%
40,09%
41,76%
43,43%
45,10%
46,77%
48,44%
4 - 1 000 000 € (CapEx)
5 100 000 € -20 000 €
6 - 600 000 € (CapEx)

7 400 000 € -40 000 €
N
CFt

In the case of projects with non-conventional -60 000 €
IRR verifies 0
t  0 1  IRR 
CF, the NPV(i) graph may intersect t
horizontal axis several times -80 000 €

 NPV ( IRR)  0
=> Several solutions to the equation
-100 000 €
What shall we do?
You cannot use the IRR rule, -120 000 €
NPV(i)
use the NPV rule instead!
IRR versus NPV

ii. Use of IRR is problematic when comparing projects that are too different
➢ The project with the highest IRR may not be the one that increases the value of
the firm the most (this is an issue only if projects under consideration are mutually
exclusive)
➢ The problem is the following:

IRR does not take into account the projects size (level of CFs) and duration
➢ Examples…
➢ Solution: USE the NPV!!! ALWAYS!!!

IRR versus NPV

1) For a given IRR, a project with larger CFs may have a higher NPV
e.g. choose one of these two riskless mutually exclusive investments (assume the
COC to study both projects is 10%):
Project A:
CF0= - 4 000 000 CF1=4 800 000 IRR  20%
0 1 and NPV (COC  10%)  363636.4
Project B:
CF0= - 400 CF1=800 IRR  100%
0 1 and NPV (COC  10%)  327.3
IRR ranks project B before project A, but fails to take account the sizes of these
projects: rather make € 363 636 than € 327!!!
IRR versus NPV

2) For a given IRR, a project with longer duration may have a higher NPV
e.g. consider that you can invest €1 million in one of these two riskless mutually
exclusive investments (assume the COC to study both projects is 10%)
Project X: pays €2 million after 1 year
Project Y: pays €300 000 per year, during 50 years
IRR versus NPV

2) For a given IRR, a project with longer duration may have a higher NPV
Project X: invest €1 million today, get €2 million after 1 year

Project Y: invest €1 million today, get €300 000 per year, during 50 years
2M
NPV X (COC  10%)  1M   818182 and IRRX  100%
1  10%
1  1  10% 50 
NPVY (COC  10%)  1M  PV 300.000
RA, 50  1M  300.000    1974444
 10 % 
50
300.000 1  1  IRRY 50  10 solver
NPV ( IRRY )  0    1M  0     IRRY  29.99%
t 1 1  IRRY 
t
 IRR Y  3
IRR ranks project X before project Y, but fails to take account the durations of these
projects: rather make € 2 000 000 than € 818 182!!!
EXCEL – IRR & NPV
➢ NB: the two investment criteria give the SAME capital budgeting decision
Recap slide chapter 2
Decision making methods
Criterion Calculation: data Calculation: Reference Decision
method
NPV • Cashflows Find present value The value 0 NPV> 0, accept
• Discount rate, of each CF, add project
COC them all up
DPP • Cashflows Find present value An ad-hoc DPP< x, accept

• Discount rate, of each CF. For chosen number project
COC each year, sum all of years, x (DPP is first year with
past and present positive sum of past and
present discounted CFs)
discounted CFs
IRR • Cashflows Solve an equation: The actual IRR> COC,
sum of present discount rate of accept project
value of all CFs, set the firm or
equal to zero.
project, COC
Unknown: discount
rate (IRR)
III – Conclusion 45
In this chapter,
❖ You have learned how to apply the concept of time value of money to capital
budgeting decisions
❖ You have leaned how to use investment criteria to select “good” investment projects
➢ The NPV rule:
✓ Always computable
✓ Always give a clear and objective financial argument
• to determine whether one should invest in a project or not,
• and to compare projects
➢ The IRR rule: not always computable & may be problematic when comparing projects
➢ The DPB rule: not always compatible with objective of firm “value maximization”,
since it may rejects projects with a positive NPV
❖ NB: In case of conflict between the NPV and the IRR criteria, ALWAYS use the
NPV because the NPV of an investment project gives its value (today)
IV - Applications 46
Application (homework)
A potential investment project has the following stream of cash-flows:
Year CFs
0 €(350 000) = -350 000
1 €100 000
2 €100 000
3 €100 000
4 €100 000
A) Assume that the cost of capital (discount rate) to study this project is 5%.
Question 1: What is the Discounted Payback Period of this project?
A. None
B. 3 years
C. 4 years
D. 5 years
Question 2: What is the Net Present Value of this project?
A. -€33013
B. €4595
C. €13947
D. €28996
Question 3: What is the Internal Rate of Return of this project?
A. 5%
B. 5.564%
C. 14.815%
D. 21.523%
IV - Applications 47
Application (homework)
B) NOW, assume that the cost of capital (discount rate) to study this project is 10%.
Question 1: What is the Discounted Payback Period of this project?
A. None
B. 3 years and 7 months
C. 3 years and 11 months
D. 3 years and 18 months
Question 2: What is the Net Present Value of this project?
A. -€33013
B. €4595
C. €13947
D. €28996
Question 3: What is the Internal Rate of Return of this project?
A. 5.564%
B. 10.000%
C. 14.815%
D. 21.523%

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Bachelor 2018-2019

Chapter 2: INVESTMENT CRITERIA

II - Net Present Value and other Investment criteria

II.2 - Internal Rate of Return (IRR) / Tasa Interna de Retorno (TIR)

II.3 - Discounted Payback Period (DPB) / Periodo de Amortizacion

Objective of the Chapter

➢ Apply the concept of time value of money to capital budgeting decisions

➢ Project selection requires investment criteria / rules in order to ensure that

➢ Investment criteria rely upon the concept of time value of money

What is an investment project?

➢ Projects can consist of physical investments, in R&D investments, in pure

What is the Balance-Sheet model of a firm?

What is the Net Working Capital (NWC) of a firm?

Current Assets (Activos corrientes) Current Liabilities (Pasivos de C.P.)

In which long-term investments should a firm engage in?

Current Assets (Activos corrientes) Current Liabilities (Pasivos de C.P.)

Current Assets (Activos corrientes) Current Liabilities (Pasivos de C.P.)

Then, the remaining Firm

COST OF CAPITAL (COC) - See Part 2

➢ This is why capital has an (opportunity) cost

COST OF CAPITAL (COC) - See Part 2

➢ What is the risk (and therefore the cost of capital) of a project?

➢ In Part 2, you will see that

The fundamental principles of project evaluation: Capital Budgeting Stages

➢ Step 1 – Determine the Cash Flows (see Ch. 5) Terminal

➢ Step 3 - Evaluation of the project (the purpose of this Chapter)

The fundamental principles of project evaluation: Investment Criteria

➢ Net Present Value (NPV) / Valor Actual Neto (VAN)

➢ Internal Rate of Return (IRR) / Tasa Interna de Retorno (TIR)

➢ Discounted Payback Period (DPB) / (Periodo de amortizacion descontado)

The fundamental principles of project evaluation: Application

For each scenario (a and b in class & c and d HOMEWORK), determine

What about for a COC of 25%?

II.1- Net Present Value (NPV) / Valor Actual Neto (VAN)

➢ The NPV is a way to deal with the time dimension

➢ The NPV rule is a fundamental tool in finance: it is used in order to

II.1- Net Present Value (NPV) / Valor Actual Neto (VAN)

II.1- Net Present Value (NPV) / Valor Actual Neto (VAN)

➢ Application scenario a), with COC=10%

What if the COC=25%?

NPV of scenario a) is negative: the project is NOT profitable.

II.1- Net Present Value (NPV) / Valor Actual Neto (VAN)

➢ Application scenario b), with COC=10%

What if the COC=25%?

II.1- Net Present Value (NPV) / Valor Actual Neto (VAN)

➢ Application scenario c) , with COC=10% NB: monthly CFs!!!

1  1.1 48 /12   1  1.1 4 

NPV of scenario c) is negative: the project is NOT profitable.

II.1- Net Present Value (NPV) / Valor Actual Neto (VAN)

 4 M  909090.9  1 378 467.9  923684.6  -788 756.6

NPV of scenario d) is negative: the project is NOT profitable.

What if the COC=25%?

II.3- Discounted Payback Period (DPB) / Periodo de amortizacion descontado

If the DPB exists, it verifies

II.3- Discounted Payback Period (DPB)

• If COC=10%: NPV  363636.4  0 and IRR  20%  COC  10%

What is the DPB?