NPV and Other Investment Criteria

 Net Present Value (NPV)

 Other Investment Criteria
 Internal rate of Return (IRR)
 Payback Period
 Discounted Payback period
 Book Rate of Return
 Investment criteria when projects interact
 Mutually Exclusive Projects
 The Investment Timing Decision
 Long- vs Short-Lived Equipment (Unequal Lives)
 Replacing an Old Machine
 Capital rationing- the profitability index
 Net Present Value
• Capital Budgeting Decision
– Central to the success of any company is the
investment decision, also known as the
capital budgeting decision.
• Capital Budgeting Decision
– NPV is defined as the PV of the cash flows
from an investment minus the initial
investment the capital outlay ( CO )
• NPV = PV – CO
 NPV AND OTHER CRITERIA
Applying Time Value of Money
to PROJECT SELECTION

• The Five Variable Framework as applied to

Projects and machinery decisions
TVM STOCKS
PV Present Value of Projects or Variable
machinery inflows and outflows
FV Salvage value of Project or Fixed
Machinery
N Life of Project Fixed
PMT Cash outflows and Inflows Variable
I/Y Cost of capital Variable
 An Example
• A Fruit and Vegetable (F&V) retail company is
debating whether to invest in a truck or not.
The purchase is being considered because it
will mean additional business for the F&V
company. The company does not have an
option to lease. The purchase of a truck will
require an expenditure plus operating
expenses.
• Should the F&V company buy the truck or
not?
 An Example
• Using what we have learnt from Chapter 05 as a
framework the F&V company will need information on
the following to be able to take a decision:
– What will be the cost of the truck (CO)
– What is the opportunity cost of own funds or borrowings?
(I/Y)
– What will be the operating costs and expected revenue ?
(PMT)
– What is the expected life of the truck? (N)
– Is there any sale price; scrap value or salvage value of the
truck? (FV)
 An Example
• F&V specific information
– The truck will cost $75000 and the company will
be using borrowed funds (from a bank) at 5% per
annum. The operating cost of the truck is $10000
per year and the expected additional annual
revenue from the purchase of the truck will be
25000. The truck will have to be scrapped for
$2500 after 7 years to ensure reliability in
operations.
 An Example
• F&V specific information:
– I/Y: 5%
– PMT= additional revenue - operating costs
= 25000 - 10000 = 15000 per year
– The truck has an effective life of 7 years after which
it could be sold for $2500 (salvage value); that is:
• FV = 2500
• N=7
 Net Present Value
• Capital Budgeting Decision
– The present value is dependent on the
discount rate. The discount rate is also known
as the opportunity cost of capital.
• It is called this because it is the return you give up
by investing in the project.
• Risk and Net Present Value
• The appropriate discount rate is a function of the
assessment of the riskiness of the project
 Net Present Value
• Valuing long lived projects
– The NPV rule works for projects of any
duration:
• Simply discount the cash flows at the appropriate
opportunity cost of capital and then subtract the
cost of the initial investment.
– The critical problems in any NPV problem
are to determine:
• The amount and timing of the cash flows.
• The appropriate discount rate.
 Other Investment Criteria
• Net Present Value vs Other Criteria
– Use of the NPV criterion for accepting or
rejecting investment projects will maximize
the value of a firm’s shares.
– Other criteria are sometimes used by firms
when evaluating investment opportunities.
• Some of these criteria simply need to be used with
care if you are to get the right answer!
 Other Investment Criteria
• Internal Rate of Return (IRR)
– IRR is simply the discount rate at which the
NPV of the project equals zero.
– You can calculate the rate of return on a
project by:
1. Setting the NPV of the project to zero.
2. Solving for “I/Y”.
 Other Investment Criteria
• Internal Rate of Return (IRR) vs NPV:
– The NPV Rule states that you invest in any
project which has a positive NPV when its
cash flows are discounted at the opportunity
cost of capital.
– The Rate of Return Rule states that you
invest in any project offering a rate of return
which exceeds the opportunity cost of capital.
• i.e., if you can earn more on a project than it costs
to undertake, then you should accept it!
 Other Investment Criteria
• Payback
– Payback is the time period it takes for the
cash flows generated by the project to cover
the initial investment in the project.
• Payback
– The Payback Rule states that a project
should be accepted if its payback is less than
a specified cutoff period.
 Other Investment Criteria
• Payback
– Payback is a very poor way of determining a
project’s acceptability.
– This is because it does not discount the future
a

cash flows to their present values

 Other Investment Criteria
• Discounted Payback
– Discounted payback is the time period it takes
for the discounted cash flows generated by
the project to cover the initial investment in
a

the project.
– Although better than payback, it still ignores
all cash flows after an arbitrary cutoff date.
• Therefore it will reject some positive NPV projects.
 Other Investment Criteria
• Book Rate of Return
– Book rate of return equals the company’s
accounting income divided by its assets. a

Book Rate of Return = Book Income / Book Assets

The components reflect historic costs and

accounting income, not market
values and cash flows.
a
 Project Interactions
• Investment Criteria When Projects
Interact
– The NPV rule can be adapted to deal with the
following situations:
• Mutually Exclusive Projects
• The Investment Timing Decision
• Long- vs Short-Lived Equipment (Unequal Lives)
• Replacing an Old Machine
 Project Interactions
• Mutually Exclusive Projects
– Most projects you deal with will be either-or
propositions.
• For example, you own a vacant piece of land.
• You have many either-or choices:
– You could construct a 2 storey building or a 50
storey one.
– You could heat it with oil or with natural gas.
– If you choose one of the options, you cannot
pursue the other.
 Project Interactions
• Mutually Exclusive Projects
– Mutually exclusive projects are two or more
projects which cannot be pursued
simultaneously.
– When choosing among mutually exclusive
projects:
1. Calculate the NPV of each project.
2. From those projects which have a positive NPV,
select the one whose NPV is highest.
 Project Interactions
• The Investment Timing Decision
– Sometimes your choice is start a project now
or wait and do it at a later date.
– The decision rule for investment timing is to
choose the investment date which results
in the highest net present value today.
 Project Interactions
• Long- vs Short-Lived Equipment
– Suppose you must choose between buying
Machine D and E.
• The two machines are designed differently, but
have identical capacity and do the same job.
• The difference?
– Machine D costs $15,000 and lasts 3 years. It costs
$4,000 per year to operate.
– Machine E costs $10,000 and lasts 2 years. It costs
$6,000 per year to operate.
– Which machine should the firm acquire?
 Project Interactions
• Long- vs Short-Lived Equipment
– Calculate PV of the costs for the projects if the
discount rate is 6%:
a

Cash OutFlows in Dollars

Project: C0 C1 C2 C3 PV @ 6%
Machine D 15 4 4 4 $25.69
Machine E 10 6 6 - $21.00

Should you accept Machine E

because the PV of its costs are lower?
.
 Project Interactions
• Long- vs Short-Lived Equipment
– Choosing Machine E may not be the best
decision.
– Why not? a

• All we know is that Machine E costs less to run over

2 years than Machine D does over 3 years.
• D is being penalized by having one extra year of
costs charged against it!
• What we should be asking is:

How much would it cost per year to

use Machine E as versus Machine D?

.
 Project Interactions
• Long- vs Short-Lived Equipment
– We solve this problem by calculating the Equivalent
Annual Cost of the two machines.
– The Equivalent Annual Cost is the cost per period with a

the same PV as the cost of the machine.

• Think of it as calculating the annual rental charge for the
machine.
• There will be equal annual payments (an annuity).
• The PV of these payments must equal the PV of the cost of
the machine.

.
 Project Interactions
• Calculating Equivalent Annual Cost:
Cash Flows in Dollars
Project: C0 C1 C2 C3 PV @ 6%
Machine D 15 4 4 4 $25.69
Equivalent
Annual cost: ?
9.61 ?
9.61 ?
9.61 $25.69

 The equivalent annual cost is calculated as follows:

Equivalent Annual Cost = Annuity based on the PV of
Costs
= $9.61 per year

.
 Project Interactions
Cash Flows in Dollars
Project: PV @ 6% Equivalent Annual Cost
D $25.69 $9.61
E $21.00 $11.45

• Long- vs Short-Lived Equipment

• We see from the equivalent annual costs that D is
actually the better choice because its annual cost is
lower than for Machine E.
• If mutually exclusive projects have unequal lives, then
you should calculate the equivalent annual cost of the
projects.
• This will allow you to select the project which will
maximize the value of the firm.
 The F&V Example
• F&V specific information
– The truck will cost $75000 and the company will
be using borrowed funds (from a bank) at 5% per
annum. The operating cost of the truck is $10000
per year and the expected additional annual
revenue from the purchase of the truck will be
25000. The truck will have to be scrapped for
$2500 after 7 years to ensure reliability in
operations.
 F&V EXAMPLE REVISITED
TRUCK COST TRUCK OP. LIFE OPERATING SALVAGE
COST VALUE
MAKE A 50,000 5 14000 1000
MAKE B 75,000 7 10000 2500
MAKE C 100,000 9 8000 3500

Interest on borrowing 5% p.a.

Expected Revenue $25000 p.a.
Which truck the F&V company should buy?
 Project Interactions
• Pitfalls with IRR – Lending vs Borrowing
– Calculate the IRR and NPV for the projects below:

Cash Flows in Dollars

Project: C0 C1 IRR NPV @ 6%
J -100 +150 50% + $36.4
K +100 -150 50% - $36.4

Both projects have the same IRR …

but Project J contributes more to the value of the firm.

You should prefer Project J!

.
 Capital Rationing
• Capital Rationing
– Occurs when a limit is set on the amount of
funds available to a firm for investment.
• Soft Rationing
– Occurs when these limits are imposed by
senior management.
• Hard Rationing
– Occurs when these limits are imposed by the
capital markets.
 Capital Rationing
• Rules for Project Selection
– A firm maximizes its value by accepting all
positive NPV projects.
• With capital rationing, you need to select a group
of projects which
 is within the company’s resources and
 gives the highest NPV.
 Capital Rationing
• Profitability Index (PI)
– The solution is to pick the projects that give
the highest NPV per dollar of investment.
– We do this by calculating the Profitability
Index:

PI = NPV / Initial Investment (C0)

 Capital Rationing
• Profitability Index (PI)
– For example: Suppose your firm had the following
projects and only $20 million to spend:
NPV @
Project C0 C1 C2 10%
L -3.00 2.20 2.42 1.00
M -5.00 2.20 4.84 1.00
N -7.00 6.60 4.84 3.00
O -6.00 3.30 6.05 2.00
P -4.00 1.10 4.84 1.00
Budget -25.00

Which Projects should your firm select?

 Capital Rationing
• Profitability Index

NPV @
Project C0 10% PI
L 3.00 1.00 1/3 = 0.33 ACCEPT

M 5.00 1.00 1/5 = 0.20

N 7.00 3.00 3/7 = 0.43 ACCEPT

O 6.00 2.00 2/6 = 0.33 ACCEPT

P 4.00 1.00 1/4 = 0.25 ACCEPT

 Summary
– NPV is the only measure which always gives
the correct decision when evaluating projects.
– The other measures can mislead you into
making poor decisions if used alone.
– The other measures are:
• IRR
• Payback
• Discounted Payback
• Book Rate of Return
• Profitability Index (PI)
 Summary
– It should be noted that when capital rationing
is in place, NPV by itself, cannot lead you to
the correct decision.
• You must combine NPV with the Profitability Index.
• Ranking the projects this way will allow you to
choose the package of projects which will offer the
highest NPV per dollar of investment.
– In summary:
NPV should always be used when
evaluating project acceptability!