T9.

1 Chapter Outline

Chapter 9
Net Present Value and Other Investment Criteria
Chapter Organization
! 9.1 Net Present Value
! 9.2 The Payback Rule
! 9.3 The Average Accounting Return
! 9.4 The Internal Rate of Return
! 9.5 The Profitability Index
! 9.6 The Practice of Capital Budgeting
! 9.7 Summary and Conclusions

Irwin/McGraw-Hill copyright © 2002 McGraw-Hill Ryerson, Ltd.

T9.2 NPV Illustrated

! Assume you have the following information on Project X:

Initial outlay -$1,100 Required return = 10%
Annual cash revenues and expenses are as follows:
Year Revenues Expenses
1 $1,000 $500
2 2,000 1,000

! Draw a time line and compute the NPV of project X.

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T9.2 NPV Illustrated (concluded)

0 1 2

Initial outlay Revenues $1,000 Revenues $2,000

($1,100) Expenses 500 Expenses 1,000
Cash flow $500 Cash flow $1,000

– $1,100.00
1
$500 x
1.10
+454.55
1
$1,000 x
1.10 2
+826.45

+$181.00 NPV

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T9.3 Underpinnings of the NPV Rule

! Why does the NPV rule work? And what does “work” mean?
Look at it this way:
A “firm” is created when securityholders supply the funds to acquire
assets that will be used to produce and sell a good or a service;
The market value of the firm is based on the present value of the
cash flows it is expected to generate;
Additional investments are “good” if the present value of the
incremental expected cash flows exceeds their cost;
Thus, “good” projects are those which increase firm value - or, put
another way, good projects are those projects that have positive
NPVs!
Moral of the story: Invest only in projects with positive NPVs.

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T9.4 Payback Rule Illustrated

Initial outlay -$1,000

Year Cash flow
1 $200
2 400
3 600

Accumulated
Year Cash flow
1 $200
2 600
3 1,200

Payback period = 2 2/3 years

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T9.5 Discounted Payback Illustrated
Initial outlay -$1,000
R = 10%
PV of
Year Cash flow Cash flow
1 $ 200 $ 182
2 400 331
3 700 526
4 300 205

Accumulated
Year discounted cash flow
1 $ 182
2 513
3 1,039
4 1,244
Discounted payback period is just under 3 years

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T9.6 Ordinary and Discounted Payback (Table 9.3)

Cash Flow Accumulated Cash Flow

Year Undiscounted Discounted Undiscounted Discounted

1 $100 $89 $100 $89

2 100 79 200 168

3 100 70 300 238
4 100 62 400 300
5 100 55 500 355

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T9.7 Average Accounting Return Illustrated

! Average net income:

Year
1 2 3

Sales $440 $240 $160

Costs 220 120 80
Gross profit 220 120 80
Depreciation 80 80 80
Earnings before taxes 140 40 0
Taxes (25%) 35 10 0
Net income $105 $30 $0

Average net income = ($105 + 30 + 0)/3 = $45

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T9.7 Average Accounting Return Illustrated (concluded)

! Average book value:

Initial investment = $240

Average investment = ($240 + 0)/2 = $120

! Average accounting return (AAR):

Average net income $45

AAR = = = 37.5%
Average book value $120

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T9.8 Internal Rate of Return Illustrated

Initial outlay = -$200

Year Cash flow
1 $ 50
2 100
3 150

! Find the IRR such that NPV = 0

50 100 150
0 = -200 + + +
(1+IRR)1 (1+IRR)2 (1+IRR)3

50 100 150
200 = + +
(1+IRR)1 (1+IRR)2 (1+IRR)3

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T9.8 Internal Rate of Return Illustrated (concluded)

! Trial and Error

Discount rates NPV

0% $100
5% 68
10% 41
15% 18
20% -2

IRR is just under 20% -- about 19.44%

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T9.9 Net Present Value Profile

Net present value

120 Year Cash flow

0 – $275
100 1 100
2 100
80 3 100
4 100
60

40

20

– 20

– 40 Discount rate
2% 6% 10% 14% 18% 22%
IRR

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T9.10 Multiple Rates of Return

! Assume you are considering a project for

which the cash flows are as follows:

Year Cash flows

0 -$252

1 1,431
2 -3,035
3 2,850
4 -1,000

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T9.10 Multiple Rates of Return (continued)

! What’s the IRR? Find the rate at which

the computed NPV = 0:

at 25.00%: NPV = _______

at 33.33%: NPV = _______
at 42.86%: NPV = _______
at 66.67%: NPV = _______

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T9.10 Multiple Rates of Return (continued)

! What’s the IRR? Find the rate at which

the computed NPV = 0:

at 25.00%: NPV = 0
at 33.33%: NPV = 0
at 42.86%: NPV = 0
at 66.67%: NPV = 0

! Two questions:
" 1. What’s going on here?
" 2. How many IRRs can there be?

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T9.10 Multiple Rates of Return (concluded)
NPV
$0.06

$0.04

IRR = 1/4
$0.02

$0.00

($0.02) IRR = 1/3 IRR = 2/3

IRR = 3/7
($0.04)

($0.06)

($0.08)

0.2 0.28 0.36 0.44 0.52 0.6 0.68

Discount rate
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T9.11 IRR, NPV, and Mutually Exclusive Projects

Net present value

Year
160 0 1 2 3 4
140 Project A: – $350 50 100 150 200
120
100 Project B: – $250 125 100 75 50
80
60
40
Crossover Po int
20
0
– 20
– 40
– 60
– 80
– 100 Discount rate
0 2% 6% 10% 14% 18% 22% 26%

IRRA IRRB

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T9.12 Profitability Index Illustrated

! Now let’s go back to the initial example - we assumed the

following information on Project X:
Initial outlay -$1,100Required return = 10%
Annual cash benefits:
Year Cash flows
1 $ 500
2 1,000

! What’s the Profitability Index (PI)?

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T9.12 Profitability Index Illustrated (concluded)

! Previously we found that the NPV of Project X is equal to:

($454.55 + 826.45) - 1,100 = $1,281.00 - 1,100 = $181.00.

! The PI = PV inflows/PV outlay = $1,281.00/1,100 = 1.1645.

! This is a good project according to the PI rule. Can you explain

why?
It’s a good project because the present value of the inflows
exceeds the outlay.

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T9.13 Summary of Investment Criteria

! I. Discounted cash flow criteria

A. Net present value (NPV). The NPV of an investment is the

difference between its market value and its cost. The NPV
rule is to take a project if its NPV is positive. NPV has no
serious flaws; it is the preferred decision criterion.
B. Internal rate of return (IRR). The IRR is the discount rate that
makes the estimated NPV of an investment equal to zero. The IRR
rule is to take a project when its IRR exceeds the required return. When
project cash flows are not conventional, there may be no IRR or there
may be more than one.
C. Profitability index (PI). The PI, also called the benefit-cost ratio, is
the ratio of present value to cost. The profitability index rule is to
take an investment if the index exceeds 1.0. The PI
measures the present value per dollar invested.

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T9.13 Summary of Investment Criteria (concluded)

! II. Payback criteria

A. Payback period. The payback period is the length of time until the
sum of an investment’s cash flows equals its cost. The payback period
rule is to take a project if its payback period is less than some
prespecified cutoff.
B. Discounted payback period. The discounted payback period is the
length of time until the sum of an investment’s discounted cash flows
equals its cost. The discounted payback period rule is to take an
investment if the discounted payback is less than some prespecified
cutoff.

! III. Accounting criterion

A. Average accounting return (AAR). The AAR is a measure of

accounting profit relative to book value. The AAR rule is to
take an investment if its AAR exceeds a benchmark.

Irwin/McGraw-Hill copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 21

T9.14 The Practice of Capital Budgeting

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T9.15 Chapter 9 Quick Quiz

1. Which of the capital budgeting techniques do account for both the time
value of money and risk?

2. The change in firm value associated with investment in a project is

measured by the project’s _____________ .
a. Payback period
b. Discounted payback period
c. Net present value
d. Internal rate of return
3. Why might one use several evaluation techniques to assess a given
project?

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T9.15 Chapter 9 Quick Quiz

1. Which of the capital budgeting techniques do account for both the time
value of money and risk?
Discounted payback period, NPV, IRR, and PI
2. The change in firm value associated with investment in a project is
measured by the project’s Net present value.

3. Why might one use several evaluation techniques to assess a given

project?
To measure different aspects of the project; e.g., the payback period
measures liquidity, the NPV measures the change in firm value, and
the IRR measures the rate of return on the initial outlay.

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T9.16 Solution to Problem 9.3

! Offshore Drilling Products, Inc. imposes a payback cutoff of 3

years for its international investment projects. If the company
has the following two projects available, should they accept
either of them?
Year Cash Flows A Cash Flows B
0 -$30,000 -$45,000
1 15,000 5,000
2 10,000 10,000
3 10,000 20,000
4 5,000 250,000

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T9.16 Solution to Problem 9.3 (concluded)

! Project A:
Payback period = 1 + 1 + ($30,000 - 25,000)/10,000
= 2.50 years

! Project B:
Payback period = 1 + 1 + 1 + ($45,000 - 35,000)/$250,000
= 3.04 years

! Project A’s payback period is 2.50 years and project B’s

payback period is 3.04 years. Since the maximum acceptable
payback period is 3 years, the firm should accept project A and
reject project B.

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T9.17 Solution to Problem 9.7

! A firm evaluates all of its projects by applying the IRR

rule. If the required return is 18 percent, should the firm
accept the following project?

Year Cash Flow

0 -$30,000
1 25,000
2 0
3 15,000

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T9.17 Solution of Problem 9.7 (concluded)

! To find the IRR, set the NPV equal to 0 and solve for the
discount rate:

NPV = 0 = -$30,000 + $25,000/(1 + IRR)1 + $0/(1 + IRR) 2

+$15,000/(1 + IRR)3

! At 18 percent, the computed NPV is ____.

! So the IRR must be (greater/less) than 18 percent. How did

you know?

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T9.17 Solution of Problem 9.7 (concluded)

! To find the IRR, set the NPV equal to 0 and solve for the
discount rate:

NPV = 0 = -$30,000 + $25,000/(1 + IRR)1 + $0/(1 + IRR)2

+$15,000/(1 + IRR)3

! At 18 percent, the computed NPV is $316.

! So the IRR must be greater than 18 percent. We know this

because the computed NPV is positive.

! By trial-and-error, we find that the IRR is 18.78 percent.

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