Chapter 8

Net Present Value and

Other Investment Criteria
Simple and Compound Interests
• Simple interest is determined on the principal only.
principal * interest rate (%) * time

• Compound interest is determined on: the principal, and

any interest earned (and not withdrawn)

• Compound interest is the typical computation applied in

most time value applications.
Compound Interest Tables (5) in Time Value
of Money Measurements
• Future value of $1:

$1 deposited today and left to accumulate for a specified number of

periods till a future date

• Present value of $1:

Amount to be deposited today to yield $1 at some specified future date

• Future value of an ordinary annuity of $1:

$1 deposited end of each period and left to accumulate until a specified

future date.
Compound Interest Tables (5) in Time Value
of Money Measurements
• Present value of an ordinary annuity of $1:

Amount to be deposited today to permit withdrawals of

$1 at the end of each period for a specified number of
periods

• Present value of an annuity due of $1:

Amount to be deposited today to permit withdrawals of

$1 at the beginning of each period for a specified number
of periods
Annuity Computations
• An annuity requires that:

▫ the periodic payments or receipts always be of the

same amount,
▫ the interval between such payments or receipts be
the same, and
▫ the interest be compounded once each interval
Annuities - Future Value of an Ordinary
Annuity
Given:
Deposit made at the end of each period: $5,000
Compounding: Annual
Number of periods: Five
Interest rate: 12%

Determine the future value of these deposits.

$5,000 * (6.35285) = $ 31,764.25

Annuities - Present Value of an Ordinary
Annuity
Given:
Rental receipts at the end of each period: $6,000
Compounding: Annual
Number of periods (years): 5
Interest rate 12%

Determine the present value of these receipts.

$6,000 * (3.60478) = $ 21,268.68

Good decision criteria
• Does the rule take the time value of money into
consideration?

• Does the rule adjust for risk?

• Does the rule tell us whether and by how much the

project add value to the firm?
1st method: the NPV rule
• NPV = PV – C0: the difference between the present value
of the investment’s future net cash flows, i.e., benefits,
and its initial cost.

• Ideas:
(1) an investment is worth undertaking if it creates value
for its owners, and
(2) an investment creates value if it worth more than it
costs within the time value of money framework.
Net Present Value
• How much value is created from undertaking an
investment?

Step 1: Estimate the expected future cash flows.

Step 2: Estimate the required return for projects of this

risk level.

Step 3: Find the present value of the cash flows and

subtract the initial investment to arrive at the Net
Present Value.
Decision rule
• If NPV > = 0, accept the project.

• If NPV < 0, reject the project.

• A positive NPV suggests that the project is expected to

add value to the firm, and the project should improve
shareholders’ wealth.

• Because the goal of financial management is to increase

shareholders’ wealth, NPV is a good measure of how well
this project will meet this goal.
A proposed project
• Your company is looking at a new project that has the
following cash flows.

Year 0: initial cost, C0 = $100,000.

Year 1: CF1 = $30,000.
Year 2: CF2 = $50,000.
Year 3: CF3 = $60,000.
The applicable discount rate is 10%.
Solution: NPV
Year CF C(0) PVA PV NPV
0 100,000 13674
1 30,000 0.9091 27,272.73 >0
2 50,000 0.8264 41,322.31 Accept!
3 60,000 0.7513 45,078.89
113,673.93
Discount rate 10%
Net Present Value
• Advantages of NPV:
▫ Considers the time value of money.
▫ Good for analysis of single projects.
▫ A positive NPV means accept, a negative means reject.

• Disadvantages of NPV:
▫ Based on an arbitrary % discount rate.
▫ Time consuming and harder to calculate.
▫ Difficult to understand.
Another Illustration (Answer 1/4)
• You are looking at a new project and have estimated the
following cash flows, net income and book value data:
▫ 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
▫ Average book value = $72,000
• Your required return for assets of this risk is 12%.
• This project will be the example for all problem exhibits
in this chapter.
2nd method: Payback Period
• The amount of time required for an investment to
generate after-tax cash flows sufficient to recover its
initial cost.

• How long does it take to recover the initial cost of a

project?
Payback Period
• Computation
▫ Estimate the cash flows
▫ Subtract the future cash flows from the initial cost
until initial investment is recovered
▫ A “break-even” type measure
Decision rule
• An investment is accepted (rejected), if payback period <
(>) some specified number of time period.

• The cutoff is arbitrarily chosen by the manager or the

entrepreneur.
A proposed project
• Your company is looking at a new project that has the
following cash flows.

Year 0: initial cost, C0 = $100,000.

Year 1: CF1 = $30,000.
Year 2: CF2 = $50,000.
Year 3: CF3 = $60,000.
The applicable discount rate is 10%.
 Solution: Payback Period
Year CF C(0) Accu. CF $ to be recoved Payback period
0 100000
1 30000 30000 70000
2 50000 80000 20000 >2
3 60000 140000 -40000 <3
To be exact,
2+(20000/60000)
2.33 years
Decision Criteria Test Payback
• Does the payback rule:
▫ Account for the time value of money?
▫ Account for the risk of the cash flows?
▫ Provide an indication about the increase in value?
▫ Permit project ranking?

• Should we consider the payback rule for our primary

decision rule?
Payback Period
• Advantages
▫ Easy to understand
▫ Adjusts for uncertainty of later cash flows
▫ Biased towards liquidity
• Disadvantages
▫ Ignores the time value of money
▫ Requires an arbitrary cutoff point
▫ Ignores cash flows beyond the cutoff date
▫ Biased against long-term projects, such as research and
development, and new projects
Another Illustration (Answer 1/4)
• You are looking at a new project and have estimated the
following cash flows, net income and book value data:
▫ 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
▫ Average book value = $72,000
• Your required return for assets of this risk is 12%.
• This project will be the example for all problem exhibits
in this chapter.
3rd method: Average Accounting Return
• Many different definitions for average accounting
return (AAR)
• In this book: Average Net Income
AAR 
Average Book Value
• Note: Average book value depends on how the
asset is depreciated.
• Requires a target cut-off rate
• Decision Rule: Accept the project if the AAR is
greater than target rate.
•
Computing AAR for the Project
• You are looking at a new project and have estimated the
following cash flows, net income and book value data:
▫ 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
▫ Average book value = $72,000
• Required average accounting return = 25%
Solution
• Average Net Income:
($13,620 + 3,300 + 29,100) / 3 = $15,340

• AAR = $15,340 / 72,000 = .213 = 21.3%

• Do we accept or reject the project?

Average Accounting Return
• Advantages
▫ Easy to calculate
▫ Needed information usually available
• Disadvantages
▫ Not a true rate of return
▫ Time value of money ignored
▫ Uses an arbitrary benchmark cutoff rate
▫ Based on accounting net income and book values,
not cash flows and market values
4th method: Internal Rate of Return
• Most important alternative to NPV
• Widely used in practice
• Intuitively appealing
• Based entirely on the estimated cash flows
• Independent of interest rates
• The discounted rate that makes the NPV of an
investment zero.
Decision Rule
• Accept the project if the IRR is greater than the
required return
NPV vs. IRR
• For most projects, NPV and IRR lead to the same
conclusion.
• Practitioners really like to use IRR because this measure
gives practitioners a good idea about at what rate they
are able to earn. Knowing a return is intuitively
appealing.
• IRR provides a measure about the value of a project to
someone who doesn’t know all the estimation details.
• If the IRR is high enough, one may not need to estimate
the required return at all.
A proposed project
• Your company is looking at a new project that has the
following cash flows.

Year 0: initial cost, C0 = $100,000.

Year 1: CF1 = $30,000.
Year 2: CF2 = $50,000.
Year 3: CF3 = $60,000.
The applicable discount rate is 10%.
Solution
Year CF C(0) IRR-CF IRR PV
0 100,000 (100,000) 16.79%
1 30,000 30,000 25,686
2 50,000 50,000 36,654
3 60,000 60,000 37,660
100,000
Lesson
• Before you use your IRR estimate, always verify the
result with the NPV result.

• In real life, NPV and IRR are the 2 most popular decision
rules used by modern (big) U.S. corporations. And, they
tend to be used together.
IRR - Advantages
• Preferred by executives
▫ Intuitively appealing
▫ Easy to communicate the value of a project

• If the IRR is high enough, may not need to estimate a

required return
• Considers all cash flows
• Considers time value of money
• Provides indication of risk
IRR - Disadvantages
• Can produce multiple answers

• Cannot rank mutually exclusive projects

• Reinvestment assumption flawed

IRR
• “Non-conventional”
▫ Cash flows change sign more than once
▫ Most common:
 Initial cost (negative CF)
 A stream of positive CFs
 Negative cash flow to close project.
 For example, nuclear power plant or strip mine.
▫ More than one IRR ….
▫ Which one do you use to make your decision?
Non-Conventional Cash Flows
• Suppose an investment will cost $90,000 initially and
will generate the following cash flows:
▫ Year 1: 132,000
▫ Year 2: 100,000
▫ Year 3: -150,000

• The required return is 15%.

• Should we accept or reject the project?
Non-Conventional Cash Flows: Summary of
Decision Rules
• NPV > 0 at 15% required return, so you should Accept

• IRR =10.11% (using a financial calculator), which would

tell you to Reject

• Recognize the non-conventional cash flows and look at

the NPV profile
Solution
I= 15%  
YR CF  
0 -$90,000  
1 $132,000  
2 $100,000  
3 -$150,000  
NPV $1,769.54 >0
IRR-1 10.11% < 15%
IRR-2 42.66% > 15%
Independent versus Mutually Exclusive
Projects
• Independent
▫ The cash flows of one project are unaffected by the
acceptance of the other.
• Mutually Exclusive
▫ The acceptance of one project precludes accepting
the other.
Reinvestment Rate Assumption
• IRR assumes reinvestment at IRR
• NPV assumes reinvestment at the firm’s weighted
average cost of capital(opportunity cost of capital)
▫ More realistic
▫ NPV method is best
• NPV should be used to choose between mutually
exclusive projects
Example of Mutually Exclusive Projects
• The required return for both projects is 10%.
• Which project should you accept and why?
Period Project A Project B

0 -500 -400

1 325 325

2 325 200

IRR 19.43% 22.17%

NPV 64.05 60.74

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, always use NPV

• IRR is unreliable in the following situations:

▫ Non-conventional cash flows
▫ Mutually exclusive projects
Modified Internal Rate of Return (MIRR)
• Controls for some problems with IRR
• Three Methods:
1. Discounting Approach = Discount future outflows to
present and add to CF0
2. Reinvestment Approach = Compound all CFs except
the first one forward to end
3. Combination Approach – Discount outflows to
present; compound inflows to end
▫ MIRR will be unique number for each method
▫ Discount (finance) /compound (reinvestment) rate
externally supplied
MIRR Method 1 Discounting Approach
Step 1: Discount future outflows (negative cash flows) to
present and add to CF0
Step 2: Zero out negative cash flows which have been
added to CF0.
Step 3: Compute IRR normally
Method 1: Discounting Approach

R= 20%    

Yr CF ADJ MCF

0 -60 -69.444 -129.44444

1 155   155

2 -100   0

    IRR= 19.74%
MIRR Method 2 Reinvestment Approach
Step 1: Compound ALL cash flows (except CF0) to end of
project’s life
Step 2: Zero out all cash flows which have been added to
the last year of the project’s life.
Step 3: Compute IRR normally
Method 2: Reinvestment Approach
R= 20%

Yr CF ADJ MCF

0 -60   -60

1 155   0

2 -100 186 86

IRR= 19.72%
MIRR Method 3 Combination Approach
Step 1: Discount all outflows (except CF0) to present and
add to CF0.
Step 2: Compound all cash inflows to end of project’s life
Step 3: Compute IRR normally
Method 3: Combination Approach

R= 20%    

Yr CF ADJ MCF

0 -60 -69.444 -129.44444

1 155   0

2 -100  186 186

    IRR= 19.87%
MIRR versus IRR
• MIRR assumes reinvestment at opportunity correctly
cost = WACC

• MIRR avoids the multiple IRR problem

• Managers like rate of return comparisons, and MIRR is

better for this than IRR
Profitability Index
• Profitability index (PI) = PV / C0.
• Often used for government or other non-for-profit
investments.
• Measures the benefit per unit cost, based on the time
value of money.
• A profitability index of 1.2 suggests that for every $1 of
initial investment, we create an additional $0.20 in
value.
Decision rule
• For a project, we accept the project only if PI > 1.
• For mutually exclusive projects, practitioners sometimes
choose the project with the highest PI. However, this
approach is problematic.
• If there is no capital constraint, one should choose the
project with the highest NPV from the mutually exclusive
pool.
Solution
Year CF C(0) PV PI
0 100,000 1.1367
1 30,000 27,273 >1
2 50,000 41,322 Accept!
3 60,000 45,079
113,674
Discount rate 10%
Profitability Index
• Advantages:
▫ Related to NPV, generally leading to identical
decisions.
▫ Easy to understand and communicate.
• Disadvantage:
▫ Should not be used for making mutually exclusive
decisions.
Quick Quiz (Get 1 Sheet Yellow Paper)
• Consider an investment that costs $110,000 and has a cash
inflow of $30,000 every year for 5 years and cash outflow
of $10,000 on the sixth year. The required return is 9% and
required payback is 4 years.
▫ What is the payback period?
▫ What is the NPV?
▫ What is the Profitability Index?
▫ What is the IRR using MIRR Combination Approach?
▫ Should we accept the project?
• What decision rule should be the primary decision method?
• When is the IRR rule unreliable?