Chapter 5

Net Present Value and Other Investment Rules

McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
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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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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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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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
 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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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.

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 5.4 The Internal Rate of Return
 IRR: the discount rate that sets NPV to be
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.
0% $100.00 $150.00
4% $73.88
8% $51.11 $100.00
12% $31.13
16% $13.52 $50.00 IRR = 19.44%
NPV

20% ($2.08)
24% ($15.97) $0.00
28% ($28.38) -1% 9% 19% 29% 39%
32% ($39.51) ($50.00)
36% ($49.54)
40% ($58.60) ($100.00)
44% ($66.82) Discount rate

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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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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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Borrowing and Lending

investing

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Borrowing and Lending

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Multiple IRRs

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Modified IRR
 Discount and combine the later cash flows
until only one change in sign remains.

Discount C2 back to Date 1 at 14%:

-132/1.14 = -115.79
C1 = 230 – 115.79 = 114.21
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Modified IRR
 The adjusted stream of cash flows:
(-100,114.21)
❑ Determine IRR of this cash flow stream
IRR = 14.21 % -> MIRR = 14.21%
❑ MIRR > 14% -> Accept

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Modified IRR
MIRR does correct for multiple IRRs. How
about NPV?

Get back to the project C, assuming that the

appropriate discount rate, say, is 14%. Using the
NPV rule, should you accept this project?
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Modified IRR
MIRR does correct for multiple IRRs. How
about NPV?

NPV = 0.18 > 0

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IRR vs NPV

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Problems Specific to Mutually
Exclusive Projects
❑ Scale Problem
❑ Timing Problem

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The Scale Problem
Would you rather a rate of return 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 Scale Problem

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The Scale Problem

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The Scale Problem

IRR = 66.67% > 25% -> accept the large

project
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The Scale Problem

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Solution to Scale Problem
❑ Compare the NPVs of two choices
❑ Calculate the incremental NPV from
choosing the large project instead of the
small project
❑ Compare the incremental IRR to the
discount rate

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The Timing Problem

❑ For the two mutually exclusive projects, you

can not compare their IRRs to each other in
order to select the best one. Instead, you
should compare NPVs of the two projects
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The Timing Problem
❑ Compare the NPVs of the two projects

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The Timing Problem
❑ Compare incremental IRR to discount rate

❑ Calculate NPV on incremental cash flows

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Solution to Timing Problem
❑ Compare the NPVs of two projects
❑ Calculate the incremental NPV
❑ Compare the incremental IRR to the
discount rate

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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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NPV versus IRR
 Generally, NPV is the best measure to evaluate
the project but IRR is still used commonly.
Why?

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5-37
5.6 The Profitability Index (PI)

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5-39
Independent Projects

 Assuming that Project 1 and Project 2 are

independent of each other, should they be
accepted using PI?

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Mutually Exclusive Projects

 What is your decision if they are mutually

exclusive?

5-41
Mutually Exclusive Projects

 Scale problem -> incremental analysis

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Mutually Exclusive Projects

 Incremental PI -> Project 1

 NPV -> Project 1

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 Capital Rationing

 Limited funds: 20
 Assuming that these projects are independent
of each other
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 Capital Rationing

 Rank the projects using PI

 Choose the positive projects until the capital
is rationed
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 Capital Rationing

 Capital rationing over multiple time periods

 Indivisiblities

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 Capital Rationing

 Limited funds: 30
 Assuming that these projects are independent
of each other
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 Capital Rationing

 Rank the projects

 2, 3 and a part of Project 1

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The Profitability Index
 Disadvantages:
◼ Problems with mutually exclusive investments
◼ Problems with capital rationing:
- Limited funds over multiple time periods
- Indivisibilities of a project

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The Profitability Index
 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 use payback, others use accounting
rate of return.
 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
$400
NPV

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

$100

$0
-15% 0% 15% 30% 45% 70% 100% 130% 160% 190%
($100)

($200)
Project A
Discount rates
Cross-over Rate Project B
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Summary – Discounted Cash Flow
 Net present value
◼ Difference between market 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
 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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