Investment Decision Rules

Chapter 8
Investment
Decision
Rules
to find IRR
Rate Lian t it s
Payment
Chapter Outline
8.1The NPV Decision Rule 1 180

8.2Using the NPV Rule 19 426
É 8.3Alternative Decision Rules 43 570
8.4Choosing Between Projects 58 95C
8.5Evaluating Projects with Different Lives96 106
8.6Choosing Among Projects When Resources
Are Limited 107 1200
8.7 Putting it all Together 121 1240
Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

Learning Objectives
• Calculate Net Present Value

• Use the NPV rule to make investment
decisions
• Understand alternative decision rules and
their drawbacks
• Choose between mutually exclusive
alternatives

Learning Objectives
• Evaluate projects with different lives

• Rank projects when a company’s resources
are limited so that it cannot take all
positive- NPV projects

8.1 The NPV Decision Rule
• Most firms measure values in terms of Net

Present Value–that is, in terms of cash
today
NPV = PV (Benefits) – PV (Eq. 8.1)

a
(Costs)
i
NPV Pr benefits Pukosts

• Logic of the decision rule:

– When making an investment decision, take the
alternative with the highest NPV, which is
e
equivalent to receiving its NPV in cash today

• A simple example:
– In exchange for $500 today, your firm will
receive $550 in one year. If the interest rate is
int 8% per year:
I
yeast
• PV(Benefit)= ($550 in one year) ÷ ($1.08 $ in one

year/$ today) = $509.26 today
– This is the amount you would need to put in the
bank today to generate $550 in one year
– NPV= $509.26 - $500 = $9.26 today
bitefits in i year
pr of 585 5,9
8 94 500.26
Copyright ©2015 Pearson Education, Inc. All rights reserved.

g 8-0
• You should be able to borrow $509.26 and

use the $550 in one year to repay the loan
• This transaction leaves you with $509.26 -
$500 = $9.26 today
• As long as NPV is positive, the decision
increases the value of the firm regardless of
current cash needs or preferences

• The NPV decision rule implies that we

should:
– Accept positive-NPV projects; accepting them is
equivalent to receiving their NPV in cash today,
and
– Reject negative-NPV projects; accepting them
would reduce the value of the firm, whereas
rejecting them has no cost (NPV = 0)

Example 8.1 The NPV Is Equivalent
to Cash Today
Problem:
• After saving $1,500 waiting tables, you are about to buy a
42-inch plasma TV. You notice that the store is offering “one-
year same as cash” deal. You can take the TV home today
and pay nothing until one year from now, when you will owe
the store the $1,500 purchase price. If your savings account
earns 5% per year, what is the NPV of this offer? Show that
its NPV represents cash in your pocket.

to Cash Today
Solution:
Plan:
• You are getting something (the TV) worth $1,500 today and in
exchange will need to pay $1,500 in one year. Think of it as
getting back the $1,500 you thought you would have to spend
today to get the TV. We treat it as a positive cash flow.
Today In one year
Cash flows: $ 1,500 –$ 1,500
• The discount rate for calculating the present value of the

payment in one year is your interest rate of 5%. You need to
compare the present value of the cost ($1,500 in one year) to
the benefit today (a $1,500 TV).

to Cash Today
Execute:
1,500
NPV = +1,500 −
(1.05)
= 1,500 − 1, 428.57 = $71.43
D
1 0.03
5
• You could take $1,428.57 of the $1,500 you had saved for the
TV and put it in your savings account. With interest, in one
year it would grow to $1,428.57 (1.05) = $1,500, enough to
to
pay the store. The extra $71.43 is money in your pocket to
spend as you like (or put toward the speaker system for your
new media room).
initial amount of futervalue 1428.579105
Present future
pre money I have 1500
btwn Present

to Cash Today
Evaluate:
• By taking the delayed payment offer, we have extra net cash
flows of $71.43 today.
• If we put $1,428.57 in the bank, it will be just enough to
offset our $1,500 obligation in the future.
• Therefore, this offer is equivalent to receiving $71.43 today,
without any future net obligations.

Example 8.1a The NPV Is Equivalent
to Cash Today
Problem:
• After saving $2,500 waiting tables, you are about to buy a
50-inch LCD TV. You notice that the store is offering “one-
year same as cash” deal. You can take the TV home today
and pay nothing until one year from now, when you will owe
the store the $2,500 purchase price. If your savings account
earns 4% per year, what is the NPV of this offer? Show that
its NPV represents cash in your pocket.
Pu 2500 2500 2403.84 961

P CMF
interest rate
year I
0.041 fV 2403.84 1.04 250
we will have 96 extra

to Cash Today
Solution:
Plan:
• You are getting something (the TV) worth $2,500 today and in
exchange will need to pay $2,500 in one year. Think of it as
getting back the $2,500 you thought you would have to spend
today to get the TV. We treat it as a positive cash flow.
Today In one year
Cash flows: $ 2,500 –$ 2,500
• The discount rate for calculating the present value of the

payment in one year is your interest rate of 4%. You need to
compare the present value of the cost ($2,500 in one year) to
the benefit today (a $2,500 TV).

to Cash Today
Execute:
$1,500
NPV = +$2,500 − = $2,500 − $2,403.85 = $96.15
1.04
• You could take $2,403.85 of the $2,500 you had saved for the
TV and put it in your savings account. With interest, in one
year it would grow to $2,403.85 (1.04) = $2,500, enough to
pay the store. The extra $96.15 is money in your pocket to
spend as you like.

to Cash Today
Evaluate:
• By taking the delayed payment offer, we have extra net cash
flows of $96.15 today. If we put $2,403.85 in the bank, it will
be just enough to offset our $2,500 obligation in the future.
Therefore, this offer is equivalent to receiving $96.15 today,
without any future net obligations.
stopped here 26 Sep

8.2 Using the NPV Rule
• A take-it-or-leave-it decision:
as
– A fertilizer company can create a new
environmentally friendly fertilizer at a large
savings over the company’s existing fertilizer
– The fertilizer will require a new factory that can
be built at a cost of $81.6 million. Estimated
return on the new fertilizer will be $28 million
after the first year, and last four years 2M
year 2t.cn
yearI 28M in 4 years
year2 28M
year3 28M
4 28M
year
• Computing NPV
– The following timeline shows the estimated
return:

discount intrestrate isunknown

• Given a Idiscount rate r, the NPV is:
28 28 28 28
D E
NPV = −81.6 + + 2
+ (Eq. 3
+
1 + r (1 + r ) (1 + r ) (1 + r ) 4
• 8.2)
We can also use the annuity formula:
28 ⎛ 1 ⎞ I
NPV = −81.6 + ⎜⎜1 − ⎟⎟ (Eq.
r ⎝ (1 + r ) 4 ⎠ 8.3)

• If the company’s cost of capital is 10%, the

NPV is $7.2 million and they should
F
undertake the investment

• NPV of Fredrick’s project

– The NPV depends on cost of capital
– NPV profile graphs the NPV over a range of
discount rates
– Based on this data the NPV is positive only when
the discount rates are less than 14%

FIGURE 8.1 NPV of Fredrick’s New Project
Positive
npr
negative

8.3 Alternative Decision Rules
FIGURE 8.2 The Most Popular Decision Rules
Used by CFOs

• The Payback Rule

– Based on the notion that an opportunity that
pays back the initial investment quickly is the
best idea
• Calculate the amount of time it takes to pay back the
initial investment, called the payback period
• Accept if the payback period is less than required
• Reject if the payback period is greater than required

Example 8.2 Using the Payback Rule
Problem:
• Assume Frederick’s requires all projects to have a payback
period of two years or less. Would the firm undertake the
project under this rule?

Solution:
Plan:
• In order to implement the payback rule, we need to know
whether the sum of the inflows from the project will exceed
the initial investment before the end of 2 years. The project
has inflows of $28 million per year and an initial investment of
$81.6 million.
yeah1 28M re jct ed

J
56M a 81 G M
year 2 28 Mt
28M
year3 28Mt 28Mt 28 M 84 Gal If

Execute:
• The sum of the cash flows from year 1 to year 2 is $28m x 2
= $56 million, this will not cover the initial investment of
$81.6 million. Because the payback is > 2 years (3 years
required $28 x 3 = $84 million) the project will be rejected.

Evaluate:
• While simple to compute, the payback rule requires us to use
an arbitrary cutoff period in summing the cash flows.
• Further, also note that the payback rule does not discount
future cash flows.
• Instead it simply sums the cash flows and compares them to
a cash outflow in the present.
• In this case, Fredrick’s would have rejected a project that
would have increased the value of the firm.

Example 8.2a Using the Payback
Rule
Problem:
• Assume a company requires all projects to have a payback
period of three years or less. For the project below, would the
firm undertake the project under this rule?
yes
Year Expected Net Cash Flow
0 -$10,000
1 $1,000
2 $1,000
3 $12,000 14k at
ends of year
Rule
Solution:
Plan:
has inflows of $1,000 for two years, an inflow of $12,000 in
year three, and an initial investment of $10,000.

Rule
Execute:
• The sum of the cash flows from years 1 through 3 is $14,000.
This will cover the initial investment of $10,000. Because the
payback is less than 3 years the project will be accepted.

Rule
Evaluate:
future cash flows.

Example 8.2b Using the Payback
Rule
Problem:
• Assume a company requires all projects to have a payback
period of three years or less. For the project below, would the
firm undertake the project under this rule?
NO
Year Expected Net Cash Flow
0 -$10,000
1 $1,000
2 $1,000
3 $1,000
4 $1,000,000

Rule
Solution:
Plan:
has inflows of $1,000 for three years, an inflow of $1,000,000
in year four, and an initial investment of $10,000.

Rule
Execute:
• The sum of the cash flows from years 1 through 3 is $3,000.
• This will not cover the initial investment of $10,000.
• Because the payback is more than 3 years the project will not
be accepted, even though the 4th cash flow is very high!

Rule
Evaluate:
future cash flows – in this case, a huge mistake!

Example 8.2c Using the Payback
Rule
Problem:
• When choosing between two projects, assume a company
chooses the one with the lowest payback period. Which of the
following two projects would the firm undertake the project
under this rule?
Year Project A Project B Expected
Expected Net Net Cash Flow B Payback
Cash Flow
0 -$10,000 -$10,000
Period is
1 $1,000 $5,000 2 gets
is lower
2 $1,000 $5,000
3 $8,000 $5,000 than A 3yea
4 $1,000,000 $5,000

Rule
Solution:
Plan:
when the sum of the inflows from the project will equal the
initial investment.
• Project A has inflows of $1,000 for two years, an inflow of
$8,000 in year 3, and an inflow of $1,000,000 in year four.
Initial investment is $10,000.
• Project B has inflows of $5,000 for four years with an initial
investment of $10,000.

Rule
Execute:
• For Project A:
– The sum of the cash flows from years 1 - 3 is $10,000.
– This will cover the initial investment of $10,000 at the end
of year 3.
• For Project B:
– The sum of the cash flows from years 1 and 2 is $10,000.
– This will cover the initial investment of $10,000 at the end
of year 2.
• Because the payback for Project B is faster than for Project A,
Project B will be chosen, even though the 4th cash flow for
Project A is very high!

Rule
Evaluate:
future cash flows – in this case, a huge mistake!

• Weakness of the Payback Rule

– Ignores the time value of money
– Ignores cash-flows after the payback period
– Lacks a decision criterion grounded in economics
stander d
‫يفتقر إلى معيار القرار القائم على االقتصاد‬
ee
• The Internal Rate of Return Rule

– Take any investment opportunity where IRR
exceeds the opportunity cost of capital

Table 8.1 Summary of NPV, IRR, and
Payback for Fredrick’s New Project

• Weakness in IRR
– In most cases IRR rule agrees with NPV for
stand- alone projects if all negative cash flows
precede positive cash flows
– In other cases the IRR may disagree with NPV
e

• Delayed Investments
– Two competing endorsements:
• Offer A: single payment of $1million upfront
• Offer B: $500,000 per year at the end of the next three
years
• Estimated cost of capital is 10%
– Opportunity timeline:

How
• The NPV is:
500,000 500, 000 500, 000
NPV = 1, 000,000 − − 2
− 3
1+ r (1 + r ) (1 + r)
bear been seat
• Set NPV to zero and solve for r to get IRR.
Given: 3 1,000,000 -500,000 0

Solve for: 23.38
Excel Formula: =RATE(NPER,PMT,PV,FV)
= RATE(3,-500000,1000000,0)

• 23.38% > the 10% opportunity cost of

capital, so according to IRR, Option A best
• However, NPV shows that Option B is best
500,000 500, 000 500, 000
NPV = 1, 000,000 − − 2
− 3
= −$243,426
1.1 1.1 1.1
• To resolve the conflict we can show a NPV
Profile

• For most FIGURE 8.3 NPV of Cole’s $1 Million

investments QuenchIt Deal
expenses are
upfront and cash
is received in the
future
• In these cases a
low rate is best
• When cash is
upfront a high
interest rate is
best

• Multiple IRRs
– Suppose the cash flows in the previous example
change
– The company has agreed to make an additional
payment of $600,000 in 10 years

• The new timeline:
• The NPV of the new investment opportunity

is: why
o
500,000 500,000 500,000 600,000
NPV = 1,000,000 − − 2
− 3
+
(1 + r ) (1 + r ) (1 + r ) (1 + r )10
• If we plot the NPV profile, we see that it has

two IRRs!

FIGURE 8.4 NPV of Evan’s Sports Drink Deal with
Additional Deferred Payments

• Modified Internal Rate of Return (MIRR)

– Used to overcome problem of multiple IRRs
– Computes the discount rate that sets the NPV of
modified cash flows to zero
– Possible modifications
• Bring all negative cash flows to the present and
incorporate into the initial cash outflow
• Leave the initial cash flow alone and compound all of
the remaining cash flows to the final period of the
project

Figure 8.5 NPV Profile with Multiple
IRRs

Figure 8.6 NPV Profile of MIRR

• MIRR: A Final Word

– Is it advisable to modify the cash flows?
– It is not really an internal rate of return?
– It does not solve some of the problems of IRR

8.4 Choosing Between Projects
• Mutually exclusive projects.

– Can’t just pick the project with a positive NPV
– The projects must be ranked and the best one
chosen
– Pick the project with the highest NPV

Example 8.3 NPV and Mutually
Exclusive Projects
Problem:
• You own a small piece of commercial land near a university.
You are considering what to do with it. You have been
approached recently with an offer to buy it for $220,000. You
are also considering three alternative uses yourself: a bar, a
coffee shop, and an apparel store. You assume that you would
operate your choice indefinitely, eventually leaving the
business to your children. You have collected the following
information about the uses. What should you do?
ooo
Initial Cash flow in Growth Cost of
Investment the First Year rate capital
Bar $400,000 $60,000 3.5% 12%
Coffee shop $200,000 $40,000 3% 10%
Apparel Store $500,000 $85,000 3% 13%

Exclusive Projects
Solution:
Plan:
• Since you can only do one project (you only have one piece of
land), these are mutually exclusive projects. In order to
decide which project is most valuable, you need to rank them
by NPV. Each of these projects (except for selling the land)
has cash flows that can be valued as a growing perpetuity, the
present value of the inflows is CF1 / (r-g). The NPV of each
investment will be
CF1
− Initial Investment
r−g

Exclusive Projects
Execute: The NPVs are:
$60, 000
Bar − $400, 000 = $305,882
0.12 − 0.035
$40, 000
Coffee Shop: − $200, 000 = $371, 429
0.10 − 0.03
$75, 000
Apparel Store: − $500, 000 = $250, 000
0.13 − 0.03
Based on the rankings the coffee shop should be chosen

Exclusive Projects
Evaluate:
• All of the alternatives have positive NPVs, but you can only
take one of them, so you should choose the one that creates
the most value.
• Even though the coffee shop has the lowest cash flows, its
lower start-up cost coupled with its lower cost of capital (it is
less risky), make it the best choice.

Example 8.3a NPV and Mutually
Exclusive Projects
Problem:
• You own a small piece of commercial land near a university. You
are considering what to do with it. You have been approached
recently with an offer to buy it for $300,000. You are also
considering three alternative uses of the land for yourself: a bar, a
coffee shop, and an apparel store. You assume that you would
operate your choice indefinitely, eventually leaving the business to
your children. You have collected the following information about
the uses. What should you do?
Initial Cash flow in the First

Growth rate Cost of capital
Investment Year
Bar $400,000 $65,000 5.0% 12.0%
Coffee shop $250,000 $45,000 5.5% 12.5%
Apparel Store $800,000 $90,000 4.5% 13.0%

Exclusive Projects
Solution:
Plan:
investment will be
CF1
r−g

Exclusive Projects

$65,000
Bar : - $425,000 = $503,571
0.12 - 0.05
$45,000
Coffee Shop : - $250,000 = $392,857
0.125 - 0.055
$90,000
Apparel Store : - $700,000 = $358,824
0.13 - 0.45
Alternative NPV
Bar $503,571
Coffee Shop $392,857
Apparel Store $358,824
Sell the Land $300,000
Based on the rankings the bar should be chosen.

Exclusive Projects
Evaluate:
the most value.
• Even though the coffee shop has the lowest start-up costs,
the higher cash flows of the bar, along with its lower cost of
capital (it is less risky), makes it the best choice.

Example 8.3b NPV and Mutually
Exclusive Projects
Problem:
• You own a small piece of commercial land near a university.
You are considering what to do with it. You have been
approached recently with an offer to buy it for $2,500,000. You
are also considering three alternative uses of the land for
yourself: a laundromat, a bakery, and a bike shop. You assume
that you would operate your choice indefinitely, eventually
leaving the business to your children. You have collected the
following information about the uses. What should you do?
Initial Cash flow in the First
Growth rate Cost of capital
Investment Year
Laundromat $200,000 $35,000 2.0% 7.0%
Bakery $750,000 $45,000 3.5% 6.5%
Bike Shop $800,000 $40,000 4.5% 7.0%

Exclusive Projects
Solution:
Plan:
investment will be
CF1
r−g

Exclusive Projects

$35,000
Laundromat : - $200,000 = $500,000
0.07 - 0.02
$45,000
Bakery : - $750,000 = $750,000
0.065 - 0.035
$40,000
Bike Shop : - $800,000 = $800,000
0.07 - 0.045
Alternative NPV
Laundromat $500,000
Bakery $750,000
Bike Shop $800,000
Sell the Land $600,000
Based on the rankings the bike shop should be chosen.

Exclusive Projects
Evaluate:
the most value.
• Even though the Laundromat has the lowest start-up costs,
the higher cash flows of the bike shop, along with its higher
growth rate, makes it the best choice.
Its
• Differences in Scale
– A 10% IRR can have very different value
implications for an initial investment of $1 million
vs. an initial investment of $100 million

• Identical Scale
– NPV of Javier’s investment in his girlfriend’s
business:
6000 6000 6000
NPV = −10,000 + + 2
+ 3
= $4, 411
1.12 1.12 1.12
– NPV of Javier’s investment in the Internet café:
3
5000 5000 5000

NPV = −10,000 + + 2
+ 3
= $2, 209
1.12 1.12 1.12

• Identical Scale
– IRR of his girlfriend’s business:
Given: 3 -10,000 6,000 0
Solve for:
0
Excel Formula: =RATE(NPER,PMT,PV,FV) =
36.3
RATE(3,6000,-10000,0)
Copyright ©2015 Pearson Education, Inc. All rights reserved. How 8-0
Figure 8.7 NPV of Javier’s
Investment Opportunities

• Change in Scale:
– Javier realizes he can just as easily install five
times as many computers in the Internet café
– Setup costs would be $50,000 and annual cash
flows would be $25,000
25,000 25,000 25,000

NPV = −50,000 + + 2
+ 3
= $10,046
1.12 1.12 1.12

How
• Change in Scale
– IRR is unaffected by scale
– IRR of girlfriend’s business is the same
Given: 3 -50,000 25,000 0
Solve for: 23.4
Excel Formula: =RATE(NPER,PMT,PV,FV) =

RATE(3,25000,-50000,0)

Figure 8.8 NPV of Javier’s
Investment Opportunities

Example 8.4 Computing the
Crossover Point
Problem:
• Solve for the crossover point for Javier from Figure 8.8.

Crossover Point
Solution:
Plan:
• The crossover point is the discount rate that makes the NPV
of the two alternatives equal. We can find the discount rate by
setting the equations for the NPV of each project equal to
each other and solving for the discount rate. In general, we
can always compute the effect of choosing Project A over
Project B as the difference of the NPVs. At the crossover point
the difference is 0.

Crossover Point
Execute:
• Setting the difference equal to 0:
25, 000 25, 000 25, 000 ⎛ 6, 000 6, 000 6, 000 ⎞

NPV = −50, 000 + + + − ⎜ −10, 000 + + + ⎟=0
1+ r (1 + r ) 2 (1 + r )3 ⎜⎝ (1 + r ) (1 + r ) 2 (1 + r )3 ⎟⎠
19, 000 19, 000 19, 000
−40, 000 + + + =0
(1 + r ) (1 + r ) 2 (1 + r )3
As you can see, solving for the crossover point is just like
solving for the IRR, so we will need to use a financial
calculator or spreadsheet:

Crossover Point
Execute (cont’d):
• And we find that the crossover occurs at a discount rate of
20% (20.04% to be exact).
Given: 3 -40,000 19,000 0
Solve for: 20.04
Excel Formula: =RATE(NPER, PMT, PV,FV) =

RATE(3,19000,-40000,0)

Crossover Point
Evaluate:
• Just as the NPV of a project tells us the value impact of taking
the project, so the difference of the NPVs of two alternatives
tells us the incremental impact of choosing one project over
another.
• The crossover point is the discount rate at which we would be
indifferent between the two projects because the incremental
value of choosing one over the other would be zero.

Example 8.4a Computing the
Crossover Point
Problem:
• Solve for the crossover point for the following two projects.
Expected Net Cash Flow

Year
Project A Project B
0 -$12,000 -$10,000
1 $5,000 $4,100
2 $5,000 $4,100
3 $5,000 $4,100
nooo II IF Goooo 9 9,17 71 o

ko 16 7 16 647 8-0
Crossover Point
Solution:
Plan:
of the two alternatives equal.
• We can find the discount rate by setting the equations for the
NPV of each project equal to each other and solving for the
discount rate.
• In general, we can always compute the effect of choosing
Project A over Project B as the difference of the NPVs. At the
crossover point the difference is 0.

Crossover Point
Execute:
$5,000 $5,000 $5,000 ⎛ $4,100 $4,100 $4,100 ⎞

NPV = −$12,000 + + + − −$10,000 + + + =0
1+ r (1 + r) 2 (1 + r)3 ⎜⎝ 1+ r (1 + r) 2 (1 + r)3 ⎟⎠
$900 $900 $900
NPV = −$2,000 + + + =0
1 + r (1 + r) 2 (1 + r)3

Crossover Point
Execute (cont’d):
16.65%.
Given: 3 -2,000 900 0
Solve for: 16.65

e
RATE(3,900,-2000,0)

Crossover Point
Evaluate:
another.

Example 8.4b Computing the
Crossover Point
Problem:
• Solve for the crossover point for the following two projects.
Expected Net Cash Flow

Year
Project A Project B
0 -$12,000 -$20,000
1 $5,000 $8,100
2 $5,000 $8,100
3 $5,000 $8,100

Crossover Point
Solution:
Plan:
of the two alternatives equal.
• We can find the discount rate by setting the equations for the
NPV of each project equal to each other and solving for the
discount rate.
• In general, we can always compute the effect of choosing
Project A over Project B as the difference of the NPVs. At the
crossover point the difference is 0.

Crossover Point
Execute:
$5,000 $5,000 $5,000 ⎛ $8,100 $8,100 $8,100 ⎞

NPV = −$12,000 + + + − −$20,000 + + + =0
1+ r (1 + r) 2 (1 + r)3 ⎜⎝ 1+ r (1 + r) 2 (1 + r)3 ⎟⎠
−$3,100 −$3,100 −$3,100
NPV = $8,000 + + + =0
1+ r (1 + r) 2 (1 + r)3

Crossover Point
Execute (cont’d):
16.65%.
Given: 3 8,000 -3,100 0
Solve for:
o
7.924%
RATE(3,-3100,8000,0)

Crossover Point
Evaluate:
another.

• Timing of the Cash Flows

– Suppose Javier could sell the Internet café
business at the end of the first year for $40,000
– Should he plan to sell it?

Figure 8.9 NPV With and Without
Selling

• The Bottom Line on IRR

– Picking the investment opportunity with the
largest IRR can lead to a mistake
– In general, it is dangerous to use the IRR in
choosing between projects
– Always rely on NPV

8.5 Evaluating Projects with
Different Lives
•Often, a company will need to choose between two

solutions to the same problem
TABLE 8.2 Cash Flows ($ Thousands) for Network Server Options

i
TABLE 8.3 Cash Flows ($ Thousands) for Network Server Options,

Expressed as Equivalent Annual Annuities

Example 8.5 Computing an
Equivalent Annual Annuity
Problem:
• You are about to sign the contract for Server A from Table 8.2
when a third vendor approaches you with another option that
lasts for 4 years. The cash flows for Server C are given below.
Should you choose the new option or stick with Server A?

Solution:
Plan:
• In order to compare this new option to Server A, we need to

put it an equal footing by computing its annual cost. We can
do this
1. Computing its NPV at the 10% discount rate we used
above
2. Computing the equivalent 4-year annuity with the same
present value.
dismount rate
Execute:
years
74
go
Is
⎡ 1 1 ⎤
PV = −14 − 1.2 ⎢ − 4
⎥ = −17.80
⎢⎣ .10 .10 (1.10 ) ⎥⎦
a
PV −17.80
Cash Flow = = = −5.62
⎡ 1 1 ⎤ ⎡ 1 1 ⎤
⎢ − 4
⎥ ⎢ − 4
⎥
⎢⎣ .10 .10 (1.10 ) ⎥⎦ ⎢⎣ .10 .10 (1.10 ) ⎥⎦
• Its annual cost of 5.62 is greater than the annual cost of
Server A (5.02), so we should choose Server A.

Evaluate:
• In this case, the additional cost associated with purchasing
and maintaining Server C is not worth the extra year we get
from choosing it. By putting all of these costs into an
equivalent annuity, the EAA tool allows us to see that.

Example 8.5a Computing an
Problem:
• You considering a maintenance contract from two vendors.
Vendor Y charges $100,000 upfront and then $12,000 per
year for the three-year life of the contract. Vendor Z charges
$85,000 upfront and then $35,000 per year for the two-year
life of the contract. Compute the NPV and EAA for each
vendor assuming an 8% cost of capital.
Y Z
PV tooooo 12000ft shop 130025 Pt 25000 35ooofhng.org 147414
ash
g p fun
gg.p
gg gygg
Chose U be
z is treater 8-0
Solution: 0 1 2 3
Plan: Vendor Y
-$100,000 -$12,000 -$12,000 -$12,000
0 1 2
Vendor Z
• In order to compare the two options,
-$75,000 -$35,000 we-$35,000
need to put both on
an equal footing by computing its annual cost. We can do this
1. Computing its NPV at the 8% discount rate we used
above
2. Computing the equivalent annual annuity with the same
present value.

Execute:
⎡ 1 1 ⎤
PVY = −$100,000 − $12,000 ⎢ − 3⎥
= −$130,925
⎣ .08 .08(1.08) ⎦
PVY − $130,925
Cash Flow Y = = = −$50,803
⎡ 1 1 ⎤ ⎡ 1 1 ⎤
⎢ .08 − .08(1.08) 3 ⎥ ⎢ .08 − .08(1.08) 3 ⎥
⎣ ⎦ ⎣ ⎦

Execute (cont’d):
⎡ 1 1 ⎤
PVZ = −$75,000 − $35,000 ⎢ − 2⎥
= −$137,414
⎣ .08 .08(1.08) ⎦
PVZ − $137,414
Cash Flow Z = = = −$77,058
⎡ 1 1 ⎤ ⎡ 1 1 ⎤
⎢ .08 − .08(1.08) 2 ⎥ ⎢ .08 − .08(1.08) 2 ⎥
⎣ ⎦ ⎣ ⎦
• The annual cost of Vendor Z is greater than the annual cost of
Vendor Y, so we should choose Vendor Y.

Evaluate:
• In this case, the higher upfront cost associated with Vendor Y
is worth the extra year we get from choosing it. By putting all
of these costs into an equivalent annuity, the EAA tool allows
us to see that.

8.6 Choosing Among Projects when
Resources are Limited
• Sometimes different investment

opportunities demand different amounts of a
particular resource
• If there is a fixed supply of the resource so
that you cannot undertake all possible
opportunities, simply picking the highest-
NPV opportunity might not lead to the best
decision

8.6 Choosing Among Projects
when Resources are Limited
TABLE 8.4 Possible Projects for $200 Million Budget

8.6 Choosing Among Projects when
Resources are Limited
Profitability Index
Value Created NPV (Eq. 8.4)
Profitability Index = =
Resource Consumed Resource Consumed

Example 8.6 Profitability Index with
a Human Resource Constraint
Problem:
• Your division at NetIt, a large networking company, has put
together a project proposal to develop a new home
networking router. The expected NPV of the project is $18.8
million, and the project will require 50 software engineers.
NetIt has a total of 190 engineers available, and is unable to
hire additional qualified engineers in the short run. Therefore,
the router project must compete with the following other
projects for these engineers:

Problem Project NPV ($

millions)
Engineering
Headcount
(cont’d): Router 17.7 50
• How should NetIt Project A 22.7 47
prioritize these Project B 8.1 44
projects? Project C 14.0 40
Project D 11.5 61
Project E 20.6 58
Project F 12.9 32
Total 107.5 332

Solution:
Plan:
• The goal is to maximize the total NPV we can create with 190
employees (at most). We can use Eq. 8.4 to determine the
profitability index for each project. In this case, since
engineers are our limited resource, we will use Engineering
Headcount in the denominator. Once we have the profitability
index for each project, we can sort them based on the index.

Execute:

Execute (cont’d):
• We now assign the resource to the projects in descending
order according to the profitability index.
• The final column shows the cumulative use of the resource as
each project is taken on until the resource is used up. To
maximize NPV within the constraint of 190 employees, NetIt
should choose the first four projects on the list.

Evaluate:
• By ranking projects in terms of their NPV per engineer, we find
the most value we can create, given our 190 engineers.
• There is no other combination of projects that will create more
value without using more engineers than we have.
• This ranking also shows us exactly what the engineering
constraint costs us—this resource constraint forces NetIt to
forgo three otherwise valuable projects (C, D, and B) with a
total NPV of $33.6 million.

Example 8.6a Profitability Index
with a Human Resource Constraint
Problem:
• AaronCo is considering several projects to undertake. All of
the projects currently under consideration have a positive
NPV, but AaronCo has a fixed capital budget of $300 million.
The company does not believe they will be able to raise any
additional funds. How should AaronCo prioritize the projects
(listed on the following slide)?

Problem (cont’d):
Pl
Project NPV ($ Millions) Initial Cost ($ Millions)
A $15 $25 as I
B $25 $75 as 3
C $110 $200 0 5 2
D $60 $150
E $25 $50
F $20 $35
G $35 $40
Total $290 $575

3 8-0
Solution:
Plan:
• The goal is to maximize the total NPV we can create with
$300 million (at most). We can use Eq. 8.3 to determine the
profitability index for each project. In this case, since money
is our limited resource, we will use Initial Cost in the
denominator. Once we have the profitability index for each
project, we can sort them based on the index.
It
12 000

Execute:
joy
Cumulative Initial Cost
Project NPV ($ Millions) Initial Cost ($ Millions) PI ($ Millions)
G $35 $40 0.88 $40
A $15 $25 0.60 $65
F $20 $35 0.57 $100
C $110 $200 0.55 $300
E $25 $50 0.50 $350
D $60 $150 0.40 $500
B $25 $75 0.33 $575

Execute (cont’d):
• We now assign the resource to the projects in descending
order according to the profitability index. The final column
shows the cumulative use of the resource as each project is
taken on until the resource is used up. To maximize NPV
within the constraint of $300 million, AaronCo should choose
the first four projects on the list.

Evaluate:
• By ranking projects in terms of their NPV per engineer, we find
the most value we can create, given our $300 million budget.
• There is no other combination of projects that will create more
value without using more money than we have.
• This ranking also shows us exactly what the budget constraint
costs us—this resource constraint forces AaronCo to forgo
three otherwise valuable projects (B, D, and E) with a total
NPV of $110 million.

8.7 Putting It All Together
TABLE 8.5
Summary of
Decision Rules

8.7 Putting It All Together
TABLE 8.5
Summary of
Decision
Rules (cont.)

Chapter Quiz
1. Explain the NPV rule for stand-alone projects.

2. Under what conditions will the IRR rule lead to
the same decision as the NPV rule?
3. What is the most reliable way to choose
between mutually exclusive projects?
4. Explain why choosing the option with the
highest NPV is not always correct when the
options have different lives.
5. What does the profitability index tell you?

Investment Decision Rules

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Investment Decision Rules

Uploaded by

Copyright:

Available Formats

Chapter 8

8.1The NPV Decision Rule 1 180

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

• Calculate Net Present Value

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

• Evaluate projects with different lives

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

• Most firms measure values in terms of Net

NPV = PV (Benefits) – PV (Eq. 8.1)

NPV Pr benefits Pukosts

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

• Logic of the decision rule:

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

• PV(Benefit)= ($550 in one year) ÷ ($1.08 $ in one

Copyright ©2015 Pearson Education, Inc. All rights reserved.

• You should be able to borrow $509.26 and

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

• The NPV decision rule implies that we

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

• The discount rate for calculating the present value of the

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

Pu 2500 2500 2403.84 961

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

• The discount rate for calculating the present value of the

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

stopped here 26 Sep

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

discount intrestrate isunknown

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

• If the company’s cost of capital is 10%, the

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

• NPV of Fredrick’s project

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

• The Payback Rule

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

yeah1 28M re jct ed

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

• Weakness of the Payback Rule

‫يفتقر إلى معيار القرار القائم على االقتصاد‬

• The Internal Rate of Return Rule

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0

Copyright ©2015 Pearson Education, Inc. All rights reserved. 8-0