BDS PPT ch06

Chapter 6
Investment
Decision Rules
Copyright 2012 Pearson Canada Inc.
Chapter Outline
6.1 NPV and Stand-Alone Projects
6.2 Internal Rate of Return Rule
6.3 Payback Rule
6.4 Choosing between Projects
6.5 Project Selection with Resource Constraints
6-2
Learning Objectives
1. Define net present value, internal rate of return, payback
period, incremental IRR, and profitability index.
2. Describe decision rules for each of the tools in objective
1, for both stand-alone and mutually exclusive projects.
3. Given cash flows, compute the NPV, internal rate of
return, payback period, incremental IRR, and profitability
index for a given project.
4. Compare each of the capital budgeting tools above, and
tell why NPV always gives the correct decision.
6-3
6.1 NPV and Stand-Alone Projects

Consider a take-it-or-leave-it investment decision
involving a single, stand-alone project for
Saskatchewan Fertilizer Corporation (SFC).
The project costs $250 million and is expected to
generate cash flows of $35 million per year, starting at
the end of the first year and lasting forever.
6-4
NPV Rule
The NPV of the project is calculated as:
35
NPV 250
r
The NPV is dependent on the discount rate.
6-5
Figure 6.1
6-6
Measuring Sensitivity with IRR

At 14%, the NPV is equal to 0, thus the projects
IRR is 14%. For SFC, if their cost of capital
estimate is more than 14%, the NPV will be
negative, as illustrated on the previous slide.
In general, the difference between the cost of capital
and the IRR is the maximum amount of estimation error
in the cost of capital estimate that can exist without
altering the original decision.
6-7
Alternative Rules versus the NPV Rule

Sometimes alternative investment rules may give
the same answer as the NPV rule, but at other
times they may disagree.
When the rules conflict, the NPV decision rule should
be followed.
6-8
6.2 The Internal Rate of Return Rule

Internal Rate of Return (IRR) Investment Rule
Take any investment where the IRR exceeds the cost of
capital. Turn down any investment whose IRR is less
than the cost of capital.
6-9
6.2 The Internal Rate of Return (cont'd)

The IRR Investment Rule will give the same
answer as the NPV rule in many, but not all,
situations.
In general, the IRR rule works for a stand-alone
project if all of the projects negative cash flows
precede its positive cash flows.
In Figure 6.1, whenever the cost of capital is below the
IRR of 14%, the project has a positive NPV and you
should undertake the investment.
6-10

In other cases, the IRR rule may disagree with the
NPV rule and thus be incorrect.
Situations where the IRR rule and NPV rule may be
in conflict:
Unconventional cash flows
Multiple IRRs
6-11

Unconventional Cash Flows
Assume you have just retired as the CEO of a
successful company. A major publisher has offered you
a book deal. The publisher will pay you $1 million
upfront if you agree to write a book about your
experiences. You estimate that it will take three years to
write the book. The time you spend writing will cause
you to give up speaking engagements amounting to
$500,000 per year. You estimate your opportunity cost
to be 10%.
6-12

Should you accept the deal?
Calculate the IRR.
The 23.38% IRR is greater than the cost capital. Thus,

the IRR rule indicates you should accept the deal.
6-13

The 23.38% IRR is larger than the 10% opportunity
cost of capital, should you accept the deal?
NPV 1,000,000
500, 000
500, 000
500, 000
$243,426
2
3
1.1
1.1
1.1
Since the NPV is negative, the NPV rule indicates you

should reject the deal.
6-14
Figure 6.2
When the benefits of an investment occur before the costs, the NPV is an
increasing function of the discount rate.
6-15

Multiple IRRs
Now assume the lecture deal fell through. You inform
the publisher that it needs to increase its offer before
you will accept it. The publisher then agrees to make
royalty payments of $20,000 per year forever, starting
once the book is published in three years.
Should you accept or reject the new offer?
6-16

Multiple IRRs
The cash flows would now look like:
The NPV is calculated as:

NPV 1,000, 000
1,000, 000
500, 000
500, 000
20, 000
20, 000
20, 000
L
1 r
(1 r ) 2
(1 r )3
(1 r ) 4
(1 r )5
500, 000
1
1
20, 000
1
r
(1 r )3
(1 r )3
r
6-17

Multiple IRRs
By setting the NPV equal to zero and solving for r, we
find the IRR. In this case, there are two IRRs: 4.723%
and 19.619%. Because there is more than one IRR, the
IRR rule cannot be applied.
6-18

Multiple IRRs
Between 4.723% and 19.619%, the book deal has a
negative NPV. Since your opportunity cost of capital is
10%, you should reject the deal.
6-19
Figure 6.3
6-20

Nonexistent IRR
Assume now that you are offered $1 million per year if
you agree to go on a speaking tour for the next three
years. If you lecture, you will not be able to write the
book. Thus your net cash flows would look like:
6-21

Nonexistent IRR
500, 000
500, 000
500, 000
NPV
2
1 r
(1 r )
(1 r )3
By setting the NPV equal to zero and solving for r, we

find the IRR. In this case, however, there is no discount
rate that will set the NPV equal to zero.
6-22
Figure 6.4
No IRR exists because the NPV is positive for all values of the discount rate.
Thus the IRR rule cannot be used.
6-23
Example 6.1
6-24
Example 6.1 (Contd)
6-25

IRR Versus the IRR Rule
While the IRR rule has shortcomings for making
investment decisions, the IRR itself remains useful. IRR
measures the average return of the investment and the
sensitivity of the NPV to any estimation error in the cost
of capital.
6-26
6.3 The Payback Rule

The Payback Rule
The payback period is the amount of time it takes to
recover or pay back the initial investment. If the
payback period is less than a pre-specified length of
time, you accept the project. Otherwise, you reject
the project.
The payback rule is used by many companies because of
its simplicity.
However, the payback rule does not always give a reliable
decision since it ignores the time value of money.
6-27
Example 6.2
6-28
Example 6.2 (cont'd)
6-29
Alternative Example 6.2

Problem
Projects A, B, and C each have an expected life
of 5 years.
Given the initial cost and annual cash flow
information below, what is the payback period
for each project?
A
Cost
$80
$120
$150
Cash Flow
$25
$30
$35
6-30
Alternative Example 6.2

Solution
Payback A
$80 $25 = 3.2 years
Project B
$120 $30 = 4.0 years
Project C
$150 $35 = 4.29 years
6-31
6.4 Choosing between Projects

Mutually Exclusive Projects
When you must choose only one project among several
possible projects, the choice is mutually exclusive.
NPV Rule
Select the project with the highest NPV.
IRR Rule
Selecting the project with the highest IRR may lead
to mistakes.
When projects differ in their scale of investment, the timing
of their cash flows, or their riskiness, then their IRRs cannot
be meaningfully compared.
6-32
Example 6.3
6-33
Example 6.3 (contd)
6-34
Differences in Scale
If a projects size is doubled, its NPV will double.
This is not the case with IRR because IRR
measure average return of the investment. Thus,
the IRR rule cannot be used to compare projects
of different scales.
6-35
Differences in Scale (cont'd)

Consider the investment in the bookstore versus the
coffee shop in Example 6.3, can you compute the IRR for
each project? You should have:
Bookstore IRR = 24%
Coffee Shop IRR = 23%
If we have to choose one out of the two projects, which
one would you choose?
6-36
Differences in Scale (cont'd)
Both projects have IRRs that exceed their cost of

capital of 8%. But although the coffee shop has a
lower IRR, because it is on a larger scale of
investment, it generates a higher NPV and thus is
more valuable.
6-37
Differences in Timing
Even when projects have the same scale, the IRR
may lead you to rank them incorrectly due to
difference in the timing of the cash flows.
The IRR is expressed as a return, but not the
timing of the return.
In Example 6.3, although the music store has a
higher IRR than the coffee shop (26% vs 23%), it
has a lower NPV.
The coffee shop has a lower initial cash flows but
higher long-run cash flows than the music store.
6-38
Differences in Risk
The IRR that is attractive for a safe project need
not be attractive for a much riskier project.
In Example 6.3, the IRR of the electronics store is
28%, but it has the lowest NPV due to the high
risk.
6-39
The Incremental IRR Rule

Incremental IRR Investment Rule
Apply the IRR rule to the difference between the
cash flows of the two mutually exclusive alternatives
(the increment to the cash flows of one investment
over the other).
6-40
Example 6.4
6-41
Example 6.4 (contd)
6-42
Figure 6.5
6-43
The Incremental IRR Rule (cont'd)

Shortcomings of the Incremental IRR Rule
You must ensure that the incremental cash flows are
initially negative and then become positive.
The incremental IRR may not exist.
Multiple incremental IRRs could exist.
The fact that the IRR exceeds the cost of capital for
both projects does not imply that both projects have a
positive NPV.
The incremental IRR rule assumes that the riskiness of
the two projects is the same.
6-44
6.5 Project Selection

with Resource Constraints
Evaluation of Projects with Different Resource
requirements
Consider three possible projects that require
warehouse space.
6-45
Profitability Index
The profitability index can be used to identify the
optimal combination of projects to undertake.
Profitability Index
Value Created
NPV
Resource Consumed
Resource Consumed
From Table 6.1, we can see it is better to take projects

B & C together and forego project A.
6-46
Example 6.5
6-47
Example 6.5 (cont'd)
6-48
Capital Rationing Constraints

Capital Rationing: A firm may not be able to raise
additional funds for investment or a budget may
be limited.
When there is capital rationing, ranking projects
by their profitability index is useful.
In Table 6.2, suppose you have a $100million
budget, a better choice is to take project II and III
for a higher combined NPV than project I.
6-49
Shortcomings of the Profitability Index

In some situations the profitability Index does not
give an accurate answer.
Suppose in Example 6.5 that Northern Networks has an
additional small project with a NPV of only $100,000
that requires 3 engineers. The profitability index in this
case is 0.1 / 3 = 0.03, so this project would appear at
the bottom of the ranking. However, 3 of the 190
employees are not being used after the first four
projects are selected. As a result, it would make
sense to take on this project even though it would
be ranked last.
6-50
Shortcomings of the Profitability

Index (cont'd)
With multiple resource constraints, the profitability
index can break down completely.
6-51
Questions?
6-52

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Chapter 6

Copyright 2012 Pearson Canada Inc.

Copyright 2012 Pearson Canada Inc.

Copyright 2012 Pearson Canada Inc.

6.1 NPV and Stand-Alone Projects

Copyright 2012 Pearson Canada Inc.

Copyright 2012 Pearson Canada Inc.

Copyright 2012 Pearson Canada Inc.

Measuring Sensitivity with IRR

Copyright 2012 Pearson Canada Inc.

Alternative Rules versus the NPV Rule

Copyright 2012 Pearson Canada Inc.

6.2 The Internal Rate of Return Rule

Copyright 2012 Pearson Canada Inc.

6.2 The Internal Rate of Return (cont'd)

Copyright 2012 Pearson Canada Inc.

6.2 The Internal Rate of Return (cont'd)

Copyright 2012 Pearson Canada Inc.

6.2 The Internal Rate of Return (cont'd)

Copyright 2012 Pearson Canada Inc.

6.2 The Internal Rate of Return (cont'd)

The 23.38% IRR is greater than the cost capital. Thus,

Copyright 2012 Pearson Canada Inc.

6.2 The Internal Rate of Return (cont'd)

Since the NPV is negative, the NPV rule indicates you

Copyright 2012 Pearson Canada Inc.

Copyright 2012 Pearson Canada Inc.

6.2 The Internal Rate of Return (cont'd)

Copyright 2012 Pearson Canada Inc.

6.2 The Internal Rate of Return (cont'd)

The NPV is calculated as:

Copyright 2012 Pearson Canada Inc.

6.2 The Internal Rate of Return (cont'd)

Copyright 2012 Pearson Canada Inc.

6.2 The Internal Rate of Return (cont'd)

Copyright 2012 Pearson Canada Inc.

Copyright 2012 Pearson Canada Inc.

6.2 The Internal Rate of Return (cont'd)

Copyright 2012 Pearson Canada Inc.

6.2 The Internal Rate of Return (cont'd)

By setting the NPV equal to zero and solving for r, we

Copyright 2012 Pearson Canada Inc.

Copyright 2012 Pearson Canada Inc.

Copyright 2012 Pearson Canada Inc.

Example 6.1 (Contd)

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6.2 The Internal Rate of Return (cont'd)

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6.3 The Payback Rule

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Example 6.2 (cont'd)

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Alternative Example 6.2

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Alternative Example 6.2

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6.4 Choosing between Projects

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Example 6.3 (contd)

Copyright 2012 Pearson Canada Inc.

Copyright 2012 Pearson Canada Inc.