Chapter 5

Net Present Value and Other Investment Rules

Key Concepts and Skills
Be able to compute payback and discounted payback
and understand their shortcomings
Be able to compute the internal rate of return and
profitability index, understanding the strengths and
weaknesses of both approaches
Be able to compute net present value and understand
why it is the best decision criterion

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Chapter Outline
5.1 Why Use Net Present Value?
5.2 The Payback Period Method
5.3 The Discounted Payback Period Method
5.4 The Internal Rate of Return
5.5 Problems with the IRR Approach
5.6 The Profitability Index
5.7 The Practice of Capital Budgeting

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5.1 Why Use Net Present Value?
Accepting positive NPV projects benefits
shareholders.
✔ NPV uses cash flows
✔ NPV uses all the cash flows of the project
✔ NPV discounts the cash flows properly

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The Net Present Value (NPV) Rule
Net Present Value (NPV) =
Total PV of future CF’s - Initial Investment
Estimating NPV:
1. Estimate future cash flows: how much? and when?
2. Estimate discount rate
3. Estimate initial costs
Minimum Acceptance Criteria: Accept if NPV > 0
Ranking Criteria: Choose the highest NPV

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Calculating NPV with Spreadsheets
Spreadsheets are an excellent way to compute NPVs,
especially when you have to compute the cash flows
as well.
Using the NPV function:
◦ The first component is the required return entered as a
decimal.
◦ The second component is the range of cash flows beginning
with year 1.
◦ Add the initial investment after computing the NPV.

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Problem for practice
1. What is the net present value of a project with the following cash flows and a
required return of 12%?
Year Cash flows ($)
0 -28900
1 12450
2 19630
3 2750
2.

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5.2 The Payback Period Method
How long does it take the project to “pay back” its initial
investment?
Payback Period = number of years to recover initial costs
What is the pay back period of the cash flow?:
Initial investment = 500
Cash flows from year 1 onwards = (250,250,100)

Minimum Acceptance Criteria:

◦ Set by management
Ranking Criteria:
◦ Set by management

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The Payback Period Method
Disadvantages:
◦ Ignores the time value of money
◦ Ignores cash flows after the payback period
◦ Biased against long-term projects
◦ Requires an arbitrary acceptance criteria
◦ A project accepted based on the payback criteria may not
have a positive NPV
Advantages:
◦ Easy to understand
◦ Biased toward liquidity

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1. It will cost $3,000 to acquire a small Taco stall. Cash flows are
expected to be $1,400 a year for three years. After the three
years, the cart is expected to be worthless as that is the expected
remaining life of the cooling system. What is the payback period
of the Taco stall?

2. Jay Z is considering adding toys to his general store. He

estimates that the cost of inventory will be $4,200. The
remodeling and shelving costs are estimated at $1,500. Toy sales
are expected to produce net cash inflows of $1,200, $1,500,
$1,600, and $1,750 over the next four years, respectively.
Should Jay Z add toys to his store if he assigns a three-year
payback period to this project?

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5.3 The Discounted Payback Period
How long does it take the project to “pay back” its initial
investment, taking the time value of money into account?
Decision rule: Accept the project if it pays back on a
discounted basis within the specified time.
By the time you have discounted the cash flows, you might as
well calculate the NPV.

What is the discounted payback period in the previous

example? R=10%

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1. A project has an initial cost of $8,600 and produces
cash inflows of $3,200, $4,900, and $1,500 over the
next three years, respectively. What is the discounted
payback period if the required rate of return is 8%?

2. A project which will produce cash inflows of $950 a

year for 4 years. The project has a 9% required rate of
return and an initial cost of $2,900. What is the
discounted payback period?

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5.4 The Internal Rate of Return

IRR: the discount rate that sets NPV to zero

Minimum Acceptance Criteria:
◦ Accept if the IRR exceeds the required return
Ranking Criteria:
◦ Select alternative with the highest IRR
Reinvestment assumption:
◦ All future cash flows are assumed to be reinvested at the
IRR

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Internal Rate of Return (IRR)
Disadvantages:
◦ Does not distinguish between investing and borrowing
◦ IRR may not exist, or there may be multiple IRRs
◦ Problems with mutually exclusive investments

Advantages:
◦ Easy to understand and communicate

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IRR: Example
Consider the following project:
$50 $100 $150

0 1 2 3
-$200
The internal rate of return for this project is 19.44%

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NPV Payoff Profile
If we graph NPV versus the discount rate, we can see the IRR
as the x-axis intercept.

IRR = 19.44%

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Calculating IRR with Spreadsheets
You start with the same cash flows as you did for the
NPV.
You use the IRR function:
◦ You first enter your range of cash flows, beginning with the
initial cash flow.
◦ You can enter a guess, but it is not necessary.
◦ The default format is a whole percent – you will normally
want to increase the decimal places to at least two.

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1. What is the IRR of the following cash flow?
-123,400
36,200
54,800
48100
2.

Given above cashflows of two projects, what would

be your decision, Accept A, B or both A and B?

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5.5 Problems with IRR

❑ Multiple IRRs
❑ Are We Borrowing or Lending
❑ The Scale Problem
❑ The Timing Problem

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Mutually Exclusive vs. Independent
Mutually Exclusive Projects: only ONE of several
potential projects can be chosen, e.g., acquiring an
accounting system.
◦ RANK all alternatives, and select the best one.

Independent Projects: accepting or rejecting one

project does not affect the decision of the other
projects.
◦ Must exceed a MINIMUM acceptance criteria

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Multiple IRRs
There are two IRRs for this project:
$200 $800 Which one should
we use?
0 1 2 3
-$200 - $800

100% = IRR2

0% = IRR1

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Borrowing or lending
Consider two cash flows
Project A -$500 -$1000

0 1 2 3
$1200 0
$500 $1000
Project B
0 1 2 3
-1200 0

What are the IRRs?

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The Scale Problem

Would you rather make 100% or 50% on your

investments?
What if the 100% return is on a $1 investment, while
the 50% return is on a $1,000 investment?

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The Timing Problem

$10,000 $1,000 $1,000

Project A
0 1 2 3
-$10,000

$1,000 $1,000 $12,000

Project B
0 1 2 3
-$10,000

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The Timing Problem

10.55% = crossover rate

12.94% = IRRB 16.04% = IRRA

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Calculating the Crossover Rate
Compute the IRR for either project “A-B” or “B-A”

10.55% = IRR

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NPV versus IRR
NPV and IRR will generally give the same decision.
Exceptions:
◦ Non-conventional cash flows – cash flow signs change
more than once
◦ Mutually exclusive projects
● Initial investments are substantially different
● Timing of cash flows is substantially different

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5.6 The Profitability Index (PI)

Minimum Acceptance Criteria:

◦ Accept if PI > 1

Ranking Criteria:
◦ Select alternative with highest PI

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The Profitability Index
Disadvantages:
◦ Problems with mutually exclusive investments – scale problem

Advantages:
◦ May be useful when available investment funds are limited
◦ Easy to understand and communicate
◦ Correct decision when evaluating independent projects

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5.7 The Practice of Capital Budgeting

Varies by industry:
◦ Some firms may use payback, while others choose an
alternative approach.

The most frequently used technique for large

corporations is either IRR or NPV.

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Example of Investment Rules
Compute the IRR, NPV, PI, and payback period for the
following two projects. Assume the required return is
10%.
Year Project A Project B
0 -$200 -$150
1 $200 $50
2 $800 $100
3 -$800 $150

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Example of Investment Rules

Project A Project B
CF0 -$200.00 -$150.00
PV0 of CF1-3 $241.92 $240.80

NPV = $41.92 $90.80

IRR = 0%, 100% 36.19%
PI = 1.2096 1.6053

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Example of Investment Rules
Payback Period:
Project A Project B
Time CF Cum. CF CF Cum.CF
0 -200 -200 -150 -150
1 200 0 50 -100
2 800 800 100 0
3 -800 0 150 150

Payback period for project B = 2 years.

Payback period for project A = 1 or 3 years?

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NPV and IRR Relationship

Discount rate NPV for A NPV for B

-10% -87.52 234.77
0%0.00 150.00 20% 59.26 47.92
40% 59.48 -8.60
60% 42.19 -43.07
80% 20.85 -65.64
100% 0.00 -81.25
120% -18.93 -92.52

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NPV Profiles
NPV

$400

$300
IRR 1(A) IRR IRR 2(A)
$200 (B)

$100

$0
-15% 0% 15% 30% 45% 70% 100% 130% 160% 190%
($100) Discount
rates
($200)
Project A
Cross-over Project B
Rate
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Summary – Discounted Cash Flow
Net present value
◦ Difference between present value and cost
◦ Accept the project if the NPV is positive
◦ Has no serious problems
◦ Preferred decision criterion
Internal rate of return
◦ Discount rate that makes NPV = 0
◦ Take the project if the IRR is greater than the required return
◦ Same decision as NPV with conventional cash flows
◦ IRR is unreliable with non-conventional cash flows or mutually exclusive projects with
different scales
Profitability Index
◦ Benefit-cost ratio
◦ Take investment if PI > 1
◦ Cannot be used to rank mutually exclusive projects
◦ May be used to rank projects in the presence of capital rationing

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Summary – Payback Criteria
Payback period
◦ Length of time until initial investment is recovered
◦ Take the project if it pays back in some specified period
◦ Does not account for time value of money, and there is an
arbitrary cutoff period
Discounted payback period
◦ Length of time until initial investment is recovered on a
discounted basis
◦ Take the project if it pays back in some specified period
◦ There is an arbitrary cutoff period

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Quick Quiz
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?
When is the IRR rule unreliable?

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