Managerial Finance

Master of Business Administration

(MBA)

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4th Lecture cont.
Net Present Value and Other Investment Rules

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 Learning Objectives
• Identifying capital budgeting and its different techniques.
• Using the net present value to evaluate projects.
• Using the internal rate of return to evaluate projects.
• Using the profitability index to evaluate projects.
• Using the the payback period to evaluate projects.
• Using the discounted payback period to evaluate projects.
• Using the average accounting return to evaluate projects.

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Capital Budgeting

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 Capital Budgeting
• Capital Budgeting is deciding which long term investments
should the firm take on.
• It’s a decision making process for accepting or rejecting
projects by evaluating them using 6 methods/techniques.
• Projects might be:
Either OR
Independent Projects Mutually Exclusive Projects
- Accepting or rejecting a - Accept A, or accept B, or reject
project does not affect both (can’t accept both)
accepting or rejecting another - RANK all alternatives, and select
- Must exceed a MINIMUM the best one if acceptable.

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Capital Budgeting Techniques
1. The Net Present Value (NPV)  BEST

2. The Internal Rate of Return (IRR) MOSTLY USED

3. The Profitability Index (PI)
4. The Payback Period Method (PBP)
5. The Discounted Payback Period Method (DPBP)
6. The Average Accounting Return Method (AAR)

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1. The Net Present Value (NPV)

• NPV is the value that a project creates to the firm

• NPV is the difference between the sum of the present values
of the project’s future cash flows (CFs) and the initial cost (IC)
of the project.
• NPV = - IC + PV of future CFs
The value of the firm increases by the NPV of the project
(positive NPV projects benefit shareholders)

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1. The NPV (The Discount Rate)

• Capital markets help us estimate the discount rate used in

the NPV method.
• The riskless rate, perhaps proxied by the yield on a
Treasury instrument, would be the appropriate rate for a
riskless investment.
• Conceptually, the discount rate on a risky project is the
return that one can expect to earn on a financial asset of
comparable risk. This discount rate is often referred to as
an opportunity cost because corporate investment in the
project takes away the stockholder’s opportunity to invest
the dividend in a financial asset.

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1. The NPV (Example)

You are asked to decide whether or not to launch a new

product. The expected cash flows over the 3 year life of the
project will be $2,000, $3,000, and $4,000 in the first, second,
and third years respectively. It will cost you $5,000 to start the
project. What should you do if the discount rate is 10%.

2,000 3,000 4,000

NPV  5,000     $2,302.78
(1  10%) (1  10%) 2
(1  10%) 3

Accept if NPV > 0  Accept

Reject if NPV < 0
Ranking Criteria: Choose the highest NPV
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1. NPV Advantages

• Uses cash flows not earnings (NI) as earnings do not represent cash.
(NCF=Cash In - Cash out)
(NI= Revenues - Expenses)
• NPV uses all the cash flows of the project.
• NPV discounts the cash flows properly (takes into account time value
of money).

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2. The Internal Rate of Return (IRR)
• The Internal Rate of Return (IRR) is the number that summarizes the merits of a
project (i.e. as if it is the rate of return that the project yields).
• It’s considered the most important alternative to NPV.
• The IRR is about getting as close as you can to the NPV without actually being the
NPV.
• That number does not depend on the interest rate prevailing in the capital market.
That is why it is called the internal rate of return; the number is internal or intrinsic
to the project and does not depend on anything except the cash flows of the
project.
• The IRR is is the rate that causes the NPV of the project to be zero, and it is
computed through trial and error as it is the discount rate that sets NPV to zero.
• This means that any discount rate below the IRR will result in a positive NPV.

Accept if: IRR  Required Return or Discount Rate

Reject if: IRR < Required Return or Discount Rate
Indifferent if: IRR = Req. return or Discount Rate
Ranking Criteria: Choose the highest IRR
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2. The IRR (Example)
Consider the following project if you know that the discount rate is 20%:

$100 $100 $100

0 1 2 3
-$200
$100 $100 $100
NPV  0  200   
(1  IRR) (1  IRR) (1  IRR) 3
2

The internal rate of return for this project is 23.37%

 Accept 12
2. The IRR (Example)
If we graph NPV versus the discount rate, we can see the IRR
as the x-axis intercept.
When Discount rate < IRR,
 Accept,
Also NPV is +ve

When Discount rate  IRR,

\ Reject,
Also NPV is –ve,

Here, the discount rate is 20%, if we

accept this project because the
discount rate is less than the IRR, we
will also be accepting positive NPV
project.

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2. The IRR (Advantages and Disadvantages)
Advantages:
• Easy to understand and communicate as it is stated as a single rate of
return.
Disadvantages:
• IRR rule is reversed if the project is a financing project (+ve cash flow,
then –ve cash flow), not an investing project (-ve cash flow, then +ve
cash flow)
• There may be multiple IRRs in case of nonconventional cash flows (cash
flow signs change more than once; e.g. –ve cash flows, then +ve cash
flows, then –ve cash flows again), therefore rely on NPV, or modified
IRR.
• Misleading when deciding on some mutually exclusive projects (when
projects have different scales and different timings of major cash flows;
then we can use NPV, or incremental IRR).
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 NPV vs. IRR

1. You must know the discount rate to compute the NPV of a

project, but you compute the IRR without referring to the
discount rate.
2. Hence, the IRR rule is easier to apply than the NPV rule
because you don’t use the discount rate when applying
IRR.

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3. The Profitability Index (PI)
• PI is the ratio of the present value of the future expected
cash flows after initial investment divided by the amount of
the initial investment.
• It is the value created per dollar invested.

Total PV of Future Cash Flows

PI 
Initial Investent
Accept if PI > 1, as NPV is positive.
Reject if PI < 1, as NPV is negative
Indifferent if PI = 1, NPV = zero
Ranking Criteria: in cases of limited capital, select project
with highest PI, instead of highest NPV
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3. The PI (Example)
You are asked to decide whether or not to launch a new
product. The expected cash flows over the 3 year life of the
project will be $2,000, $3,000, and $4,000 in the first, second,
and third years respectively. It will cost you $5,000 to start the
project. What should you do if the discount rate is 10%.

2,000 3,000 4,000

 
(1  10%) (1  10%) (1  10%)
2 3
PI   1.46
5,000

 Accept
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3. The PI (Advantages)
• Easy to understand and communicate correct decisions,
especially when evaluating independent projects.

Both projects should be accepted because NPV is positive in each case,

and the profitability index (PI) is greater than 1 whenever the NPV is
positive.
• Helps in correctly ranking projects when capital is rationed.

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3. The PI (Capital Rationing)
• Consider the case when the firm does not have enough capital to fund all
positive NPV projects.

• Also, assume that;

(1) the projects are independent, but
(2) the firm has only $20 million to invest.
• Because project 1 has an initial investment of $20 million, the firm cannot
select both this project and another one. Conversely, because projects 2 and 3
have initial investments of $10 million each, both these projects can be chosen.
In other words, the cash constraint forces the firm to choose either project 1 or
projects 2 and 3. What should the firm do?
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3. The PI (Capital Rationing) “Cont’d.”
• Individually, projects 2 and 3 have lower NPVs than project 1 has. However,
when the NPVs of projects 2 and 3 are added together, the sum is higher than
the NPV of project 1. Thus, common sense dictates that projects 2 and 3
should be accepted.
• In the case of limited funds, we cannot rank projects according to their NPVs.
Instead we should rank them according to the ratio of present value to initial
investment. This is the PI rule. Both project 2 and project 3 have higher PI
ratios than does project 1. Thus they should be ranked ahead of project 1 when
capital is rationed.
• However, what economists term indivisibilities may reduce the effectiveness of
the PI rule;
Imagine that the company has $30 million available for capital investment, not just $20
million. The firm now has enough cash for projects 1 and 2. Because the sum of the NPVs of
these two projects is greater than the sum of the NPVs of projects 2 and 3, the firm would
be better served by accepting projects 1 and 2. But because projects 2 and 3 still have the
highest profitability indexes, the PI rule now leads to the wrong decision.

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 3. The PI (Disadvantages)

• Might be misleading with mutually exclusive projects that are

different in size.

NPV analysis says accept project 1 because this project has the bigger
NPV. Because project 2 has the higher PI, the profitability index leads to
the wrong selection (The Scale Problem).

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3. The PI (The Scale Problem)
• Project 2 is smaller than project 1. Because the PI is a ratio, this index
misses the fact that project 1 has a larger investment than project 2
has. Thus, like IRR, PI ignores differences of scale for mutually exclusive
projects.
• However, like IRR, the flaw with the PI approach can be corrected using
incremental analysis. We write the incremental cash flows after
subtracting project 2 from project 1 as follows:

• Because the profitability index on the incremental cash flows is

greater than 1.0, we should choose the bigger project—that is,
project 1. This is the same decision we get with the NPV approach.
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4. The Payback Period (PBP)

• How long does it take the project to “pay back” or recover its
initial investment?
• Payback Period = number of years to recover initial costs
• The payback period rule for making investment decisions is
simple. A particular cutoff date, say two years, is selected by
management. All investment projects that have payback periods
of two years or less are accepted, and all of those that pay off in
more than two years—if at all—are rejected.
Accept if PBP ≤ Cutoff PBP (pre-specified number of years set
by management)
Reject if PBP > Cutoff PBP
Ranking Criteria: Select project with lower PBP
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4. The PBP (Example)

Should this project be accepted if the cutoff PBP is 3 years?

$20,000 $30,000 $40,000

0 1 2 3
-$50,000

PBP = 2 years  Accept

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4. The PBP (Example)
Should this project be accepted if the cutoff PBP is 3 years?

$20,000 $60,000 $40,000

0 1 2 3
-$50,000 -$30,000

30,000
PBP  1   1.5 years  Accept
60,000
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4. The PBP (Advantages and Disadvantages)
Advantages:

• Easy to understand and use for small decisions

Disadvantages:

1. Ignores the time value of money (compare projects A & B)

2. Ignores cash flows after payback period (compare projects B & C)
Because of the short-term orientation of the payback method, some valuable long-term projects
are likely to be rejected. The NPV method does not have this flaw because, as we pointed out
earlier, this method uses all the cash flows of the project.
3. Requires an arbitrary acceptance criteria.
There is no specific guidelines for choosing the payback cutoff date, such as the reference made to
the capital market rate when using the NPV.

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4. The PBP (Uses)

• The payback method is often used by large, sophisticated

companies when making relatively small decisions.
Examples include;
1. The decision to build a small warehouse, or
2. The decision to pay for a tune-up for a truck.
• It’s also used for managerial control purposes, as with the
payback method we know in two years whether the
manager’s assessment of the cash flows was correct.
• It has also been suggested that firms with good investment
opportunities but no available cash may justifiably use
payback.
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5. The Discounted Payback Period (DPBP)

• How long does it take the project to “pay back” its initial
investment, taking the time value of money into account?
• First: discount the cash flows, then calculate PBP
Accept if discounted PBP ≤ Cutoff
Reject if discounted PBP > Cutoff
Ranking Criteria: Select project with lower DPBP

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5. The DPBP (Example)
Should this project be accepted if the cutoff PBP is 2 years and the
discount rate 10%?
0 1 2 3

-$50,000 $20,000 $30,000 $40,000

20,000 30,000 40,000

(1  10%) (1  10%) 2
(1  10%)3

-$50,000 $18,181.8 $24,793.4 $30,052.6

7,024.8
PBP  2   2.23 years  Reject
30,052.6 29
5. The DPBP (Disadvantages)
• Discounted payback first requires us to make a somewhat
magical choice of an arbitrary cutoff period, and then it
ignores all cash flows after that date.
• If we have already gone to the trouble of discounting the
cash flows, any small appeal to simplicity or to managerial
control that payback may have has been lost. We might just
as well add up all the discounted cash flows and use NPV to
make the decision.

Although discounted payback looks a bit like NPV, it is just a

poor compromise between the payback method and NPV.

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6. The Average Accounting Return (AAR)
• The average accounting return is the average project
earnings after taxes and depreciation, divided by the
average book value of the investment during its life.
• It is used frequently in the real world.
Average Net Income
AAR 
Average Book Value of Investment
Similar to Return on Assets measure (ROA)

Accept if AAR >= Target AAR (set by management)

Reject if AAR < Target AAR
Ranking Criteria: Select project with higher AAR

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6. The AAR (Example)

Or =

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2. The AAR Advantages and Disadvantages
Advantages:

• The accounting information is usually available, and therefore easy to calculate;

especially when managers focus on profitability.
It is frequently used as a “backup” to discounted cash flow methods. Perhaps this is so
because it is easy to calculate and uses accounting numbers readily available from the
firm’s accounting system. In addition, both stockholders and the media pay a lot of
attention to the overall profitability of a firm. Thus, some managers may feel
pressured to select projects that are profitable in the near term, even if the projects
come up short in terms of NPV. These managers may focus on the AAR of individual
projects more than they should.
Disadvantages:

• Not a true rate of return but a ratio of two accounting numbers, which are affected
by the accountant’s judgment (e.g. depreciation).
• Ignores the time value of money.
• Target AAR is set arbitrarily (same as the PBP).
• Based on book values not market values, and net income not cash flows.
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Assignment (2)

• Consider an investment that costs $100,000 and has a cash

inflow of $25,000 every year for 5 years. The required return is
9%, and payback cutoff is 4 years.
• What is the payback period?
• What is the discounted payback period?
• What is the NPV?
• What is the IRR?
• Should we accept the project?
What method should be the primary decision rule?

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The end of lecture
thank you

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