9

Net Present Value and

Other Investment Criteria

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Outline

 Net Present Value

 The Payback Period
 The Discounted Payback
 The Internal Rate of Return – IRR
 The Profitability Index

9-1
 Investment Decision?

Spending for future benefit

CF1 CF2 CFi CFN

0 1 2 … N
CF0

9-2
 Investment Decision?

CF1 CF2 CFi CFN

R
0 1 2 … N
CF0

Uncertainty
Estimations of
Cash flows
CFs & R are
Risks of CFs (Required given
rate of return)
9-3
 Good Decision Criteria

 We need to ask ourselves the

following questions when evaluating
capital budgeting decision rules
 Does the decision rule adjust for the
time value of money?
 Does the decision rule adjust for risk?
 Does the decision rule provide
information on whether we are creating
value for the firm? 9-4
 Project Example Information

 You are looking at a new project and you

have estimated the following cash flows:
 Year 0:CF = -165,000
 Year 1:CF = 63,120; NI = 13,620
 Year 2:CF = 70,800; NI = 3,300
 Year 3:CF = 91,080; NI = 29,100
 Your required return for assets of this risk
is 12%.
CF or NI?
9-5
 Cash Flows vs. Net Income

Sales
-Costs
-Depreciations
EBIT
-Interest CF = NI+ Depreciation
EBT
-Tax • NI ignore Depreciation
Net Income
• Credit sale = Cash sale?
+ Depreciation
Cash Flows

9-6
 Is it a Good Investment?
63,120 70,800 91,080

R=12%

0 1 2 3
-165,000

Depends on investment criteria

9-7
 #1: Net Present Value
63,120 70,800 91,080

R=12%

0 1 2 3
-165,000

NPV = Market value of project – Costs

= PV of future CFs – Initial costs

CFo=-165,00; CF1=63,120; CF2=70,800;CF3=91,080

i=12%;  NPV = 12,627.41  Accept 9-8
 #1: Net Present Value
63,120 70,800 91,080

R=12%

0 1 2 3
-165,000 Take project if NPV>0,
reject if NPV<0

What if NPV=0?
How much return do we have
if NPV=0?

 A positive NPV means that the project is expected to add value

to the firm and will therefore increase the wealth of the owners.
 Since our goal is to increase owner wealth, NPV is a direct
measure of how well this project will meet our goal. 9-9
 #2: The Payback Period
63,120 70,800 91,080

R=12%

0 1 2 3
-165,000
Subtract the future cash flows
from the initial cost until
How long does it take the initial investment has been recovered
to get the initial cost back (ignore Time Value of Money)
in a nominal sense?

Accept if the payback period

is less than some preset limit
9-10
 #2: The Payback Period
63,120 70,800 91,080

R=12%

0 1 2 3
Year 0 1 2 3
CFs (165,000) 63,120 70,800 91,080
-165,000 Accumulated CF (165,000) (101,880) (31,080) 60,000

How much portion of year 3 needed?

Do we accept the project

if we demand it pays back within two years?

31,080/91,080=0.34 years
The PB period=2+0.34=2.34  reject!
9-11
 Decision Criteria Test - Payback

 Does the payback rule account for the

time value of money?
 Does the payback rule account for the
risk of the cash flows?
 Does the payback rule provide an
indication about the increase in value?
 Should we consider the payback rule for
our primary decision rule?

9-12
Advantages and Disadvantages of
Payback
 Advantages  Disadvantages
 Easy to understand  Ignores the time value
 Adjusts for of money
uncertainty of later  Requires an arbitrary
cash flows cutoff point
 Biased toward  Ignores cash flows
liquidity beyond the cutoff date
 Biased against long-
term projects, such as
research and
development, and new
projects
9-13
 Discounted Payback Period

 Compute the present value (PVi) of each

CF and then determine how long it takes
to pay back on a discounted basis.

(1)

(2)

(3)

(4)
9-14
 Discounted Payback Period

63,120 70,800 91,080

Required Payback period: 2 yrs
R=12%

0 1 2 3
Year 0 1 2 3
CFs (165,000) 63,120 70,800 91,080
-165,000 Accumulated CF (165,000) (101,880) (31,080) 60,000

 Year 1: 165,000 – 63,120/1.121 = 108,643

 Year 2: 108,643 – 70,800/1.122 = 52,202
 Year 3: 52,202 – 91,080/1.123 = -12,627 project
pays back in year 3
 Do we accept or reject the project?  Reject
9-15
 #3: Internal Rate of Return (IRR)
63,120 70,800 91,080

R=12%

0 1 2 3
-165,000 IRR is the return
that makes the NPV = 0
Accept the project
if the IRR ≥ required return

CFo=-165,000; CF1=63,120; CF2=70,800; CF3=91,080

 IRR =16.13% > 12%  Accept!
9-16
 #3: Internal Rate of Return (IRR)

 This is the most important alternative

to NPV
 It is often used in practice and is
intuitively appealing
 It is based entirely on the estimated
cash flows and is independent of
interest rates found elsewhere
9-17
 NPV Profile for the Project

70,000
60,000 IRR = 16.13%
50,000
40,000
30,000
NPV

20,000
10,000
0
-10,000 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22

-20,000
Discount Rate

9-18
 Decision Criteria Test - IRR

 Does the IRR rule account for the time

value of money?
 Does the IRR rule account for the risk of
the cash flows?
 Does the IRR rule provide an indication
about the increase in value?
 Should we consider the IRR rule for our
primary decision criteria?

9-19
 Advantages of IRR

 Knowing a return is intuitively appealing

 It is a simple way to communicate the
value of a project to someone who
doesn’t know all the estimation details
 If the IRR is high enough, you may not
need to estimate a required return, which
is often a difficult task

9-20
 Summary of Decisions for the
Project
Summary
Net Present Value Accept
Payback Period Reject
Internal Rate of Return Accept

9-21
 NPV vs. IRR

 NPV and IRR will generally give us

the same decision
 Exceptions
 Non-conventional cash flows – cash
flow signs change more than once
 Mutually exclusive projects
 Initial investments are substantially different
 Timing of cash flows is substantially different

9-22
IRR and Non-conventional CFs
132,000 100,000 -150,000

R=15%

0 1 2 3
-90,000

CFo=-90,000; CF1=132,000; CF2=100,000; CF3=-150,000

IRR =10.11% < 15%  Reject!

9-23
 IRR and Non-conventional CFs

$4,000.00
IRR = 10.11% and 42.66%

$2,000.00

$0.00
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55
($2,000.00)
NPV

($4,000.00)

($6,000.00) The NPV is positive at a required return of 15%,

so you should Accept
($8,000.00)

($10,000.00)
Discount Rate

NPV Profile 9-24

 IRR and Mutually Exclusive
Projects
 Mutually exclusive projects
 If you choose one, you can’t choose the other
 Example: You can choose to attend graduate school
at either BK or Stanford, but not both
 Intuitively you would use the following decision
rules:
 NPV – choose the project with the higher NPV
 IRR – choose the project with the higher IRR

9-25
Example With Mutually Exclusive Projects

Period Project Project The required return

A B for both projects is
10%.
0 -500 -400
1 325 325 Which project
should you accept
2 325 200
and why?
IRR 19.43% 22.17%
NPV 64.05 60.74
9-26
 NPV Profiles

$160.00 IRR for A = 19.43%

$140.00
IRR for B = 22.17%
$120.00
$100.00 Crossover Point = 11.8% (∆IRR)
$80.00
How to determine Which one
NPV

A
$60.00 the crossover rate? is red? B
$40.00
$20.00
$0.00
($20.00) 0 0.05 0.1 0.15 0.2 0.25 0.3
($40.00)
Discount Rate

9-27
How to determine crossover rate?

Period Project A Project B ∆=A-B

0 -500 -400 ?
1 325 325 ?
2 325 200 ?
IRR 19.43% 22.17% ?

NPV@10% 64.05 60.74

9-28
 NPV Profiles
#1: since IRR(A) < IRR(B)  A: red
#2: Calculate NPV @10% (near crossover)
NPV(A)=64.05 > NPV(B)=60.74

$160.00 IRR for A = 19.43%

$140.00 IRR for B = 22.17%
$120.00
Crossover Point = 11.8%
$100.00
$80.00 Which to choose
NPV

If required return is 5%? A

$60.00
B
$40.00
$20.00
$0.00
($20.00) 0 0.05 0.1 0.15 0.2 0.25 0.3
($40.00)
Discount Rate Which to choose
Which to choose If required return is 15%?
If required return is 25%?
9-29
 NPV Profiles
$160.00
$140.00 IRR for A = 19.43%
$120.00
IRR for B = 22.17%
$100.00
$80.00 Crossover Point = 11.8% (∆IRR)
NPV

A
$60.00
B
$40.00
$20.00
$0.00
($20.00) 0 0.05 0.1 0.15 0.2 0.25 0.3
($40.00)
Discount Rate

Required return NPV Choose

R < 11.8% NPVA > NPVB A
11.8% < R < 22.17% NPVA < NPVB B
22.7% < R NPVA < NPVB < 0 not A, B 9-30
 Conflicts Between NPV and IRR

 NPV directly measures the increase in

value to the firm
 Whenever there is a conflict between NPV
and another decision rule, you should
always use NPV
 IRR is unreliable in the following situations
 Non-conventional cash flows
 Mutually exclusive projects

9-31
 #4: Profitability Index (PI)
63,120 70,800 91,080

R=12%

0 1 2 3
-165,000 PI=[PV of future CFs]/[Initial Costs]
= 1+NPV/CFo

CFo=-165,000; CF1=63,120; CF2=70,800; CF3=91,080

i=12%, CPT NPV=12,627.41
PI =1+12,627.41/165,000 =1.0765 >1
9-32
 #4: Profitability Index (PI)
63,120 70,800 91,080

R=12%

0 1 2 3
-165,000

PI =1.0765 >1
For every $1 of investment,
we create an additional $0.0765 in value

Very useful in situations

in which we have limited capital
9-33
Advantages and Disadvantages of
Profitability Index
 Advantages  Disadvantages
 Closely related to  May lead to incorrect
NPV, generally decisions in
leading to identical comparisons of
decisions mutually exclusive
 Easy to understand investments
and communicate
 May be useful when
available investment
funds are limited

9-34
 Capital Budgeting In Practice

 We should consider several

investment criteria when making
decisions
 NPV and IRR are the most
commonly used primary investment
criteria
 Payback is a commonly used
secondary investment criteria
9-35
Summary – Discounted Cash Flow Criteria
 Net present value (NPV)
 Difference between market value and cost
 Take the project if the NPV is positive
 Has no serious problems
 Preferred decision criterion
 Internal rate of return (IRR)
 Discount rate that makes NPV = 0
 Take the project if the IRR is greater than the required return
 Same decision as NPV with conventional cash flows
 IRR is unreliable with non-conventional cash flows or mutually
exclusive projects
 Profitability Index (PI)
 Benefit-cost ratio
 Take investment if PI > 1
 Cannot be used to rank mutually exclusive projects
 May be used to rank projects in the presence of capital
rationing
9-36
 Summary – Payback Criteria
 Payback period
 Length of time until initial investment is recovered
 Take the project if it pays back within some specified
period
 Doesn’t account for time value of money and there is
an arbitrary cutoff period
 Discounted payback period
 Length of time until initial investment is recovered on
a discounted basis
 Take the project if it pays back in some specified
period
 There is an arbitrary cutoff period
9-37
 9
End of Chapter

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.