Chapter 8

Net Present Value and

Other Investment Criteria

Financial Management (MGCM10018)

Preview
• The investment decision (a.k.a. capital
budgeting) is central to the success of the
company.
▫ A company’s shareholders want the firm to invest
in every project that is worth more than it costs.
▫ The difference between a project’s value and its
cost is termed the net present value (NPV).
• This chapter presents multiple valuation
techniques in the capital budgeting process.
2
Outline
• Net Present Value
• The Internal Rate of Return Rule
• The Profitability Index
• The Payback Rule
• Mutually Exclusive Projects
• A Last Look

3
Net Present Value (8.1)

• Assume we are in real estate business and we’re

considering to build an office block.
▫ The land would cost $50,000, and the
construction would cost $300,000.
▫ We foresee a shortage of office space in a year and
predict that we’ll be able to sell the building for
$400,000.
▫ Suppose Treasury notes offer interest of 7%,
would you committee to such project?
▫ What would be the net present value of the project?
4
Net Present Value (continued)

• The present value of $400,000 would be

400,000
PV = = $373,832
1.07
▫ This is also known as the market price or market
value of project.
▫ The discount rate of 7% is also known as the
opportunity cost of capital.
 The expected rate of return given up by investing in
a project

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Net Present Value (continued)

• The net present value (NPV) of this project

would be
NPV = PV − Required Investment
= $373,832 − $350,000 = $23,832

▫ That is, the NPV is present value of cash flows

minus initial investment.
▫ Thus, we should take this project since it earns
higher return than the alternative investment.
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Net Present Value (continued)

• The net present value rule states that managers

increase shareholder’s wealth by accepting
projects that are worth more than they cost.
• Therefore, managers should accept all projects
with a positive NPV.
• In the last example, we may think that the
project is riskier than Treasury note.
▫ Suppose we forecast 12% return in stock market.

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NPV General Formula

C1 C2 Ct
NPV = C0 + 1
+ 2
+ ... +
(1 + r ) (1 + r ) (1 + r ) t

Terminology
C0 = Initial Cash Flow (often negative)
Cl = Cash Flow at time 1
C2 = Cash Flow at time 2
Ct = Cash Flow at time t?
t ime
= period of the investment?
r pportunity
= cost of capital
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NPV: Example 1
Assume you plan to invest $1,000 today and will
receive $600 each year for two years (assume the cash
is received at the end of the year). What is the net
present value if there is a 10% opportunity cost of
capital?

9
NPV: Example 2
Assume you invest $1,000 today and will receive $1,200
in two years (assume the cash is received at the end of
the 2nd year). What is the net present value if there is a
10% opportunity cost of capital?

10
 Forecast cash flows and present values in
1986 for the Channel Tunnel project.

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The Internal Rate of Return (8.2)

• The companies often ask whether the project’s

return is higher or lower than the opportunity
cost of capital.
▫ As the earlier example, we planned to invest
$350,000 to get back a cash flow of C1 =
$400,000 in one year.
 The rate of return = (400 – 350)/350 = 14.3%
 This is higher than the alternative return on
Treasury note of 7%.

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The Rate of Return Rule
• Thus, the rate of return rule states that
managers should invest in any project offering a
rate of return that is higher than the opportunity
cost of capital.
▫ Note that the rate of return is the discount rate of
all cash flows at which NPV equals zero.
▫ Such rate is known as the project’s internal rate of
return (IRR).
 It is also known as discounted cash-flow rate of
return.
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The IRR Formula

C1 C2 Ct
0 = C0 + 1
+ 2
+ ... +
(1 + IRR ) (1 + IRR ) (1 + IRR )t

• The C0 is first cash flow

▫ It is often the initial investment.
▫ It is typically negative.

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Internal Rate of Return: Example
Cash Flows
NPV
Project C0 C1 C2 (@ 10%)
Project 1 - $1,000 $700 $500 $49.59
Project 2 - $1,000 $500 $700 $33.06

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NPV and Internal Rate of Return

16
The IRR Rule
• When used properly, the NPV and internal rate
of return rules lead to the same decision.
• Some examples show the pitfalls of IRR rule.
▫ Lending or borrowing?
▫ Mutually exclusive projects
▫ Multiple rates of return

17
IRR vs. NPV
Lending or Borrowing?

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IRR vs. NPV:
Mutually Exclusive Projects
• Suppose we invested $375,000 to build the
office and rent it for 3 years.
▫ We’ll be able to sell it for $450,000.

▫ If we follow IRR rule, we earn more with initial

project.
 By NPV rule, we’ll be nearly $58,000 richer.
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NPV vs. IRR Rules

20
IRR vs. NPV:
Mutually Exclusive Projects (continued)

• Note that we want projects that increase the

value of the firm.
▫ Projects that earn a good rate of return for a long
time often have higher NPVs than those that offer
high percentage rates of return but die young.

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IRR vs. NPV
Multiple Rates of Return
• A coal firm is considering a project to strip-mine
coal, and the project requires an investment of
$210 million.
▫ It will produce cash inflow of $125 million in first
2 years and of $175 million in years 3 and 4.
▫ The firm is obliged in year 5 to reclaim the land at
cost of $400 million.
▫ At a 20% opportunity cost, its NPV = $5.9 million.
• What would be the IRR?
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IRR vs. NPV
Multiple Rates of Return (continued)
• There would be two IRRs!

125 125 175 175 400

NPV = −210 + + 2
+ 3
+ 4
− 5
=0
1.03 1.03 1.03 1.03 1.03

125 125 175 175 400

NPV = −210 + + 2
+ 3
+ 4
− 5
=0
1.25 1.25 1.25 1.25 1.25

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Multiple rates of return

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The Profitability Index (8.3)

• The profitability index measures the net present

value of a project per dollar of investment.
NPV
Profitability Index =
Initial Investment
▫ For instance, the office building example has
profitability index as 23,832 / 350,000 = 0.068
• Any project with positive profitability index
must also have a positive NPV.
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Profitability Index: Example

Cash Flows
NPV (@
Project C0 C1 C2 10%)
Project 1 - $1,000 $700 $500 $49.59
Project 2 - $1,000 $500 $700 $33.06

26
The Profitability Index (continued)

• Why do we use profitability index?

▫ When there is a limit on the firm’s budgeting, we
can concentrate on getting the biggest return for
each investment.

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The Profitability Index (continued)

• Economists use the term capital rationing to

refer to a shortage of funds available for
investment.
▫ Profitability index provides a measure of which
project to accept under capital rationing.
▫ Soft rationing: limits on funds imposed by
management.
▫ Hard rationing: limits on funds imposed by the
lack of available funds in the capital market.
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The Payback Rule (8.4)

• A project’s payback period is the length of time

before we recover our initial investment.
▫ The payback rule says that a project should be
accepted if its payback period is less than a
specified cutoff period.

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Payback Method: Example

The three projects below are available. The company

accepts all projects with a 2 year or less payback period.
Show how this will impact your decision.
Cash Flows
Payback
Project C0 C1 C2 C3 Period
Project 1 - $1,000 $700 $500 1.6 years
Project 2 - $1,000 $500 $700 1.7 years
Project 3 - $1,000 $500 $700 $700 1.7 years

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The Payback Rule (continued)

• Drawbacks of payback rule.

▫ Though Projects 1, 2 and 3 have payback periods
less than 2 years, notice the differences in NPV.
▫ The Payback Rule ignores the time value of money.
• Sometimes managers calculate the discounted
payback period.
▫ This is the number of periods before the present
value of prospective cash flows equals or exceeds
the initial investment.
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Mutually Exclusive Projects (8.5)

• The previous examples are mostly take-it-or-

leave-it decisions.
▫ Real world decisions entail either-or choices.
▫ For example, we could build an apartment block.
Or, a 7-story office building instead of 10-story.
• When choosing among mutually exclusive
projects, calculate their NPV and choose the one
with highest positive NPV.

32
Using the NPV Rule to Choose
among Projects
Example: Consider two projects, assuming a 10% opportunity
cost of capital. Which project should be selected?

Cash Flows

Project C0 C1 C2 NPV
Project 1 - $1,000 $700 $500 $49.59
Project 2 - $1,000 $500 $700 $33.06

33
Using the NPV Rule to Choose
among Projects (continued)
• Challenges to the NPV rule:
▫ The investment timing decision
▫ The choice between long and short-lived
equipment
▫ When to replace an old machine

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Investment Timing
Sometimes you have the ability to defer an investment and
select a time that is more ideal at which to make the
investment decision.
Example: A common example involves a tree farm. You may
defer the harvesting of trees. By doing so, you defer the receipt
of the cash flow, yet increase the cash flow. Assume an
opportunity cost of capital of 10%.
Year Cost Sales Value NPV
0 50 70 20 20.0
1 55 80 25 22.7
2 60 88 28 23.1
3 64 95 31 23.3
4 68 102 34 23.2
5 70 105 35 21.7 35
Investment Timing: Example

• Obsolete Technologies: The gain from purchase of a

computer is rising, but the NPV today is highest if the
computer is purchased in 3 years.

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Long- vs. Short-Lived Equipment:
Equivalent Annual Annuity
• Suppose the firm is forced to choose between
two machines, A and B.
▫ The two machines do the same job but cost
differently.

▫ So, should we choose B because of lower PV of

costs?
37
Long- vs. Short-Lived Equipment:
Equivalent Annual Annuity (continued)
• Not necessarily. We need to find the equivalent
annual annuity.
▫ The cash flow per period with the same present
value as the cost of buying and operating a
machine.
present value of cash flows PVCash Flows
EAA = =
annuity factor  1r − 1 t 
 r×(1+ r ) 

38
Long- vs. Short-Lived Equipment:
Equivalent Annual Annuity (continued)

▫ We now see that machine A is better choice,

because its equivalent annual annuity is less.
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When to Replace an Old Machine
• We are operating an old machine that will last 2
more years.
▫ It costs $12,000 each year to operate.
▫ We can replace it with new machine that costs
$25,000 with $8,000 per year in operating costs.
 The new machine will last 5 years.

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A Last Look (8.6)

• We’ve seen several investment criteria. Clearly,

NPV is the gold standard.
• For managers in the field, discounted cash-flow
analysis is in fact the dominant tool for project
evaluation.

41
A comparison of investment decision rules

42
Capital budgeting techniques used in practice

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