CORPORATE FINANCE

CHAPTER 4

INVESTMENT APPRAISALS

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 Chapter content

1. Net present value - NPV

2. Internal Rate of returns - IRR

3. Other appraisal approaches:

• Payback period

• Accounting rate of return

• Profitability index

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Percentage of CFOs Who Use a Given Technique

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 Frequency of Use of Capital Budgeting Methods

*Firms indicate frequency of use on a scale from 0 (never) to 4 (always).

Numbers in table are averages across respondents

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 PART 1

NET PRESENT VALUE - NPV

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 NPV

Net present value (NPV) is the difference between the

present value of cash inflows and the present value of
cash outflows.

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 NPV RULE

 All projects which have a positive NPV should be accepted

while those that are negative should be rejected.

 If funds are limited and all positive NPV projects cannot be

initiated, those with the high discounted value should be
accepted.

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 NPV examples

Assume Newco is deciding between two machines (Machine A and Machine

B) in order to add capacity to its existing plant. Using the cash flows in the
table below, let's calculate the NPV for each machine and decide which
project Newco should accept. Assume Newco's cost of capital is 8.4%.

Expected after-tax cash flows for the new machines:

Year Machine A Machine B
0 -5000 -2000
1 500 500
2 1000 1500
3 1000 1500
4 1500 1500
5 2500 1500
6 1000 1500
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 PART 2
INTERNAL RATE OF
RETURN - IRR

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 IRR

 The IRR is the interest rate (also known as the discount rate) that will
bring a series of cash flows to a net present value (NPV) of zero.

 The IRR formula can be very complex depending on the timing and
variances in cash flow amounts. Without a computer or financial
calculator, IRR can only be computed by trial and error.

N
CFn
NPV   n
0
n 1 (1  IRR )

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 Calculating IRR

Assume an initial mortgage amount of $200,000 and monthly payments of

$1,050 for 30 years. The IRR (or implied interest rate) on this loan annually
is 4.8%.

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 IRR RULE

IRR > cost of capital  accept project

IRR < cost of capital  reject project

In the example below, the IRR is 15%. If the firm's actual discount rate for
discounted cash flow models is less than 15%, the project should be accepted.

Investment Inflows

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

-1,000,000 300,00 300,000 300,000 300,000 300,000

NPV and IRR are formally equivalent, however, the IRR rule contains several pitfalls

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 IRR pitfall 1: Lending or Borrowing?

Not all cash-flow streams have NPVs that decline as the discount rate increases.

Consider the following projects A and B:

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 IRR pitfall 2: Multiple rates of return

Helmsley Iron is proposing to develop a new strip mine in Western Australia. The mine involves
an initial investment of A$30 billion and is expected to produce a cash inflow of A$10 billion a
year for the next 9 years. At the end of that time the company will incur A$65 billion of
cleanup costs. Thus the cash flows from the project are:

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 IRR pitfall 2: Multiple rates of return

As the discount rate increases, NPV initially rises and then declines.
The reason for this is the double change in the sign of the cash-flow stream.
 There can be as many IRR for a project as there are changes in the sign of the cash flows.

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 IRR pitfall 2: Multiple rates of return

There are also cases in which no IRR exists.

For example, project C has a positive NPV at all discount rates:

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 IRR pitfall 3: Mutually exclusive projects

Firms often need to choose from among mutually exclusive projects: choose
from among several alternative ways of doing the same job or using the same
facility  IRR rule can be misleading.

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 IRR pitfall 3: Mutually exclusive projects

 looking at the IRR on the incremental flows.

• First, consider the smaller project (D). It has an IRR of 100% > 10% opportunity cost of
capital  D is acceptable.
• Second, is it worth making the additional $10,000 investment in E?
The incremental flows from undertaking E rather than D are as follows:

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 IRR pitfall 3: Mutually exclusive projects

IRR is also unreliable in ranking projects that offer different patterns of cash
flow over time. For example, suppose the firm can take project F or project G
but not both:

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IRR pitfall 3: Mutually exclusive projects

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 IRR pitfall 4: More than One Opportunity Cost of Capital

The most general formula for calculating net present value:

The IRR rule tells us to accept a project if the IRR is greater than the opportunity cost
of capital. But what do we do when we have several opportunity costs? Do we
compare IRR with r1, r2, r3, . . .?
we would have to compute a complex weighted average of these rates to obtain a
number comparable to IRR  too complicated!!!
Many firms use the IRR assuming that there is no difference between short-term
and long-term discount rates.

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 PART 3
OTHER INVESTMENT
CRITERIAS

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 1. Payback period

A project’s payback period is found by counting the number of years it takes

before the cumulative cash flow equals the initial investment.

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 Example

NPVA = +$2,624
NPVB = -2$58
NPVc = +$50

How rapidly each project pays back its initial investment?

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 Payback rule

 All other things being equal, the better investment is the one with
the shorter payback period.

 Normally, a project should be accepted if its payback period is less

than some specified cut-off period.

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 Payback drawbacks

While the payback rule appears very straightforward, there are 2 significant
problems with this method:

1. It ignores the time value of money.

2. It ignores any benefits that occur after the payback period and therefore
does not measure profitability.

 The payback method is often used by large, sophisticated companies

when making relatively small decisions. Exp: the decision to build a small
warehouse…

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 Discounted Payback

Occasionally companies discount the cash flows before they compute the
payback period.

The discounted payback rule asks, how many years does the project have to
last in order for it to make sense in terms of net present value?

 the discounted payback rule will never accept a negative-NPV

project.

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 Discounted Payback example

Going back to our earlier example of Newco and the decision about which machine to purchase, let's
determine the discounted payback period for Machine A and Machine B, and determine which project Newco
should accept. Recall that Newco's cost of capital is 8.4%.

Discounted Cash Flows for Machine A and Machine B

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 2. Accounting Rate of Return - ARR

Average accounting return or accounting rate of return or ARR, is an accounting

method used for the purposes of comparison with other capital budgeting calculations,
such as NPV, PB period and IRR.

ARR = Average Profit / Average Investment

 ARR compares the amount invested to the profits earned over the course of a
project's life. The higher the ARR, the better.

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 ARR drawbacks

The major drawbacks of ARR are as follows:

 It uses operating profit rather than cash flows. Some capital investments have high
upkeep and maintenance costs, which bring down profit levels.

 Unlike NPV and IRR, it does not account for the time value of money. By ignoring the
time value of money, the capital investment under consideration will appear to have
a higher level of return than what will occur in reality.

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 3. Profitability Index

A profitability index attempts to identify the relationship between the costs and
benefits of a proposed project.

The PI ratio =

PI > 1  profitability is positive

PI < 1  the project's PV is less than the initial investment  the project should
be rejected or abandoned.

The profitability index rule states that the ratio must be greater than 1.0 for the
project to proceed.

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 PI vs NPV

 The profitability index rule is a variation of the NPV rule.

if NPV > 0, the PI > 1
if NPV < 0, the PI < 1
 calculations of PI and NPV would both lead to the same decision

 However, the profitability index differs from NPV in one important respect:
being a ratio, it ignores the scale of investment and provides no indication
of the size of the actual cash flows.

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 CHAPTER SUMMARY

1. Net present value - NPV

2. Internal Rate of returns - IRR

3. Other criterias:

• Payback period

• Accounting rate of return

• Profitability index

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