Chapter 7

Net Present Value and Other

Investment Criteria
Learning Objectives
• Understand the Payback, Discounted Payback, and
Average Accounting Return Rules and their
shortcomings
• Understand the Net Present Value Rule and why it is
the best decision criteria
• Understand the Internal Rate of Return Rule and its
strengths and weaknesses
• Understand the Profitabilty Index Rule and its
weakness
• Understand the difference between mutually
exclusive projects, independent projects, and
1
interdependent projects.
Good Decision Criteria

• We need to ask ourselves the following

questions when evaluating decision
criteria
• Does the decision rule adjust for the time value
of money?
• Does the decision rule adjust for risk?
• Does the decision rule provide information on
whether we are creating value for the firm
(shareholders)?
2
Project Example Information
• You are looking at a new project and you
have estimated the following cash flows:
Time Cash Flow
0 -$165,000 (initial investment)
1 63,120
2 70,800
3 91,080
• According to CAPM (how?), the required rate
of return for assets of this risk is 12%.

3
 Payback and
Discounted Payback Rule
Payback Period

• How long does it take to get the initial cost

back in a nominal sense?
• Computation
• Estimate the cash flows
• Subtract the future cash flows from the initial
cost until the initial investment has been
recovered
• Decision Rule – Accept if the payback
period is less than some preset limit
5
Computing Payback For The Project

• Assume we will accept the project if it pays

back within two years.

• Year 1: 165,000 – 63,120 = 101,880 still to recover

• Year 2: 101,880 – 70,800 = 31,080 still to recover
• Payback Period = 2 years + 31,080/91,080 = 2.34 years

• Do we accept or reject the project?

Reject

6
Decision Criteria Test - Payback

• Does the payback rule account for the

time value of money?
• Does the payback rule account for the risk
of the cash flows?
• Does the payback rule provide an
indication about the increase in value?
• Should we consider the payback rule for
our primary decision criteria?
7
Advantages and Disadvantages of
Payback
• Advantages • Disadvantages
• Simple -- easy to • Ignores the time value of
understand money
• Biased towards liquidity • Requires an arbitrary
cutoff point
• Ignores cash flows
beyond the cutoff date
• Biased against long-term
projects, such as
research and
development, and new
projects
8
Discounted Payback
• To address the deficiency of ignoring time
value of money, sometimes companies will
modify the Payback Method with
Discounted Payback Method
• The modification is simple: the calculation
of the payback is based on the properly
“discounted” CF’s
• For our example, here are the discounted
CFs
9
Discounted Payback Example
Time DCF
0 -$165,000
1 $63,120/1.12 = $56,357.14
2 $70,800/1.122 = $56,441.33
3 $91,080/1.123 = $64,828.95

• The Discounted PB is computed based on

the discounted CF’s
•  Discounted PB = 2.81 Years (verify)
10
Discounted Payback Example (contd)

• Assume we will accept the project if it pays

back within two years.

• Year 1: 165,000 – 56,357.14=108,642.86 still to recover

• Year 2: 108,642.86– 56,441.33=52,201.53 still to recover
• Payback = 2 years + 52,201.53/64,828.95=2.8052=2.81yrs

• Do we accept or reject the project?

Reject

11
The Average Accounting Return
Rule
Average Net Income
AAR =
Average Book Value of Investment
Another attractive but fatally flawed approach.
Ranking Criteria and Minimum Acceptance Criteria set by
management
Disadvantages:
Ignores the time value of money
Uses an arbitrary benchmark cutoff rate
Based on book values, not cash flows and market
values
Advantages:
The accounting information is usually available
Easy to calculate 12
The Average Accounting Return Rule:
Example
• You want to invest in a machine that produces
squash balls
• The machine costs $90,000
• The machine has a 3 year life.
• Assuming straight line depreciation, the annual
depreciation is $30,000

13
The Average Accounting Return Rule:
Example (cont.)
• Projected Net Income from the project:
Year 1 Year 2 Year 3
Sales 140 160 200
Expenses -120 -100 -90
E.B.D. 20 60 110
Depreciation -30 -30 -30
E.B.T. 10 30 80
Taxes (40%) -4 -12 -32
NI: -6 18 48
14
The Average Accounting Return Rule:
Example (cont.)
We calculate:

− 6 + 18 + 48
(i) Average NI = = 20
3

(ii) Average book value (BV) of the investment

(machine):
Time 0 1 2 3
BV of investment: 90 60 30 0
90 + 60 + 30 + 0
Average BV = = 45
4 15
The Average Accounting Return Rule:
Example (cont.)
(iii) The Average Accounting Return:

20
AAR = = .4444
45

• Conclusion
If target AAR < 44.44% => accept
If target AAR > 44.44% => reject

16
NPV – Net Present Value
Net Present Value
• The difference between the market value of a
project and its cost
• How much value is created from undertaking
an investment?
• The first step is to estimate the expected future cash
flows.
• The second step is to estimate the required return for
projects of this risk level.
• The third step is to find the present value of the cash
flows and subtract the initial investment.

18
Computing NPV for the Project

Using the formulas:

n
Ct
NPV = ∑ t
t = 0 (1 + r )

63,120 70,800 91, 080

−$165, 000 +
= + 2
+
1.12 1.12 1.123
−$165, 000 + 177, 627.42 =
= $12, 627.42

Do we accept or reject the project?

19
NPV Decision Rule
• If the NPV is positive, accept the
project
• A positive NPV means that the project is
expected to add value to the firm and will
therefore increase the wealth of the
owners. (What about stock price?)
• Since our goal is to increase shareholders’
(owners’) wealth, NPV is a direct measure
of how well this project will meet our goal.
20
Decision Criteria Test - NPV

• Does the NPV rule account for the time

value of money?
• Does the NPV rule account for the risk of
the cash flows?
• Does the NPV rule provide an indication
about the increase in value?
• Should we consider the NPV rule for our
primary decision criteria?
21
Calculating NPVs with a Spreadsheet
• 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
• Subtract the initial investment after computing
the PVs
22
IRR – Internal Rate of Return
Internal Rate of Return

• IRR is the most important alternative to

NPV
• It is often used in practice and is intuitively
appealing

24
Calculation of IRR

63,120 70,800 91, 080

0=
NPV =−$165, 000 + + +
1 + IRR (1 + IRR ) (1 + IRR )3
2

16.13%
∴ IRR =

25
 NPV Profile For The Project
IRR = 16.13%
70,000
60,000
50,000
40,000
30,000
NPV

20,000
10,000
0
-10,000
-20,000
0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22
Discount Rate

26
IRR – Definition and Decision Rule
• Definition: IRR is the required rate of return that
makes the NPV of the Project = 0

• Decision Rule: With conventional cash flows

(negative first and positive later), accept the
project if the IRR is greater than the required
rate of return of the project

27
Computing IRR For The Project
• Financial calculator or EXCEL spreadsheet can
be used to calculate IRR.
• If you do not have a financial calculator or
EXCEL then this becomes a trial-and-error
process
• Therefore, IRR will not be asked in the exam
for multiple cash flows

28
Decision Criteria Test - IRR

• Does the IRR rule account for the time

value of money?
• Does the IRR rule account for the risk of
the cash flows?
• Does the IRR rule provide an indication
about the increase in value?
• Should we consider the IRR rule for our
primary decision criteria?
29
Advantages of IRR
• Knowing an “internal” return is intuitively
appealing
• It is a simple way to communicate the value of a
project to someone who doesn’t know all the
estimation details
• If the IRR is high enough, you may not need to
estimate a required rate of return, which is often
a difficult task. (But without the required return,
you don’t know the exact PV contribution of the
project, even though you know it is positive
intuitively in view of the very high IRR.)
30
 Problems of IRRs
• NPV and IRR will generally give us the
same decision
• But IRR may have the following problems:
• Does not distinguish between investing and
borrowing (what if the cash flows are not
conventional?)
• There may be multiple IRRs
• Problems with mutually exclusive investments
• Reinvestment assumption: IRR assumes
reinvestment of future cash flows at IRR, which
may be unrealistic in case of a high IRR 31
IRR & Non-conventional CF’s:
Lending or Borrowing?

• Consider the following two projects

• Project A: CF = -100
0

CF1 = 120
• Project B: CF = 100
0

CF1 = -120
• What is the IRR for Project A and B?
• At what discount rate should Project A be
accepted? How about Project B?
32
 Multiple IRRs

• When the cash flows change signs more

than once, there is more than one IRR

• If you have more than one IRR, which

one do you use to make your decision?

33
Example – Multiple IRRs

• Suppose an investment has the following

cash flows:
Time Cash Flow
0 -$90,000
1 132,000
2 100,000
3 -150,000
The required return is 15%.
• Should we accept or reject the project?
34
NPV Profile
IRR = 10.11% and 42.66%
$4,000.00
$2,000.00

$0.00

($2,000.00)
NPV

($4,000.00)

($6,000.00)

($8,000.00)

($10,000.00)
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55
Discount Rate

35
Mutually Exclusive Projects
• Mutually exclusive projects
• If you choose one, you can’t choose the other;
• Therefore, companies have to rank all projects according to
certain decision rule(s);
• Example: The company chooses one of the two types of
equipment for manufacturing of its products
• According to the decision rules, you would:
• By NPV: choose the project with the higher NPV
• By IRR: choose the project with the higher IRR
• But the two rules might give conflicting decisions with mutually
exclusive projects
• The Scale Problem
• The Timing Problem

36
 The scale problem
• Consider the following (mutually exclusive)
projects
• Project 1: -$1 $2

0 1

-$10 $19
• Project 2:
0 1

• IRR1 = 100%, IRR2 = 90%

• Using a 50% discount rate, NPV1 = $0.33 and NPV2 =
$2.76
• IRR rule: Pick Project 1 Vs. NPV rule: Pick Project 2
37
The Timing Problem
Time CFProject A CFProject B
0 -$50,000 -$50,000
1 $50,000 $5,000
2 $5,000 $5,000
3 $5,000 $60,000
IRR 16.04% 12.94%
NPV @ 0% $10,000 $20,000
NPV @ 10% $3,343 $3,757
NPV @ 15% $546.6 -$2,420
38
How to solve this problem?
• The conflict of decisions between the NPV
and IRR reflects the “timing problem” in the
example.
• IRR usually gives a higher weight on earlier
cash flows;
• Is there a remedy?

39
 NPV Profiles
$25,000

$20,000

$15,000

$10,000
Cross-over rate
Project A
Project B
$5,000

$0
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%

($5,000)

($10,000)
40
NPV of Incremental Project “B-A”

• CF’s of “Incremental” Project (B-A)

• CF0 = 0
• CF1 = -$45,000
• CF2 = 0
• CF3 = $55,000
• The cross-over rate is, in fact, the IRR of the
“incremental cash flows” (B-A)
• IRR of Incremental Project (B-A) = 10.55%
• Accept B over A if discount rate <10.55%
• Check that in the graph
• NPV(B-A) @ 10% = $413.2
• NPV(B-A) @ 15% = -$2,967
41
PI – Profitability Index
Profitability Index
• PI is defined as the PV of the future cash flows
divided by initial investment, i.e.
PI = PV(future CFs)/CF0
• We accept the project if PI>1
• A profitability index of 1.1 implies that for every
$1 of investment, we create an additional $0.10
in value
• This measure can be very useful in situations
when companies have limited capital.

43
In our example:
Recall the discounted CFs of the project
Time DCF
0 -$165,000
1 $63,120/1.12 = $56,357.14
2 $70,800/1.122 = $56,441.33
3 $91,080/1.123 = $64,828.95

Sum of DCF (t=1 to 3) = $ 177,627.42

Hence the PI of the project is:
$177,627.42/165,000 = 1.0765
44
 Advantages and Disadvantages of
Profitability Index

• Advantages • Disadvantages
• Closely related to NPV, • May lead to incorrect
generally leading to decisions in
identical decisions comparisons of
• Easy to understand and mutually exclusive
communicate investments
• scale problem

45
Capital Budgeting In Practice
• Because project evaluations are based on
estimates, companies use several
investment criteria when considering
investment projects (see Table on next
page)
• NPV and IRR are the most commonly
used primary investment criteria
• Payback is a commonly used secondary
investment criterion
46
Capital Budgeting in Practice (Cont)
Evaluation Technique % CFOs who Always or Almost Always Use
the Technique (A survey of 320 CFOs)
IRR 75.6%
NPV 74.9%
PB 56.7%
Discounted PB 29.5%
PI 11.90%

 Source: Figure 2 from JR Graham and CR Harvey, “The Theory and

Practice of Corporate Finance: Evidence from the Field,” Journal of
Financial Economics, 60 (2001).
47
 Independent vs.
Interdependent Projects
NPV of Repeated Projects with
Different Investment Horizons
Independent vs. Interdependent Projects

• Independent projects: the decision of this

project has nothing to do with firms’
decision to accept/reject other projects.
• Interdependent projects
• Example: Contingent projects
• If you choose Windows system in your computer, you
probably can only choose Microsoft Office;
• If a company chooses to buy one equipment, it also
implies that it has chosen the maintenance of this
equipment.
49
Repeated Investments of unequal lives
• When two investments have different horizons and
can be repeated, the direct application of the NPV rule
can lead to the wrong decision
• Why?
• Example: Consider a factory that must have an air
cleaner (mandated by law)
• There are two choices
• The Cleaner A costs $4,000 today, has annual operating
costs of $100, and lasts for 10 years
• The Cleaner B costs $1,000 today, has annual operating
costs of $500 and lasts for 5 years
• Which one should we choose?
50
Repeated Investments of unequal lives (1)

• At first glance, the cheap cleaner has the higher NPV

(r = 10%)
10
$100
−$4, 000 − ∑
NPVA = t
−$4, 614.46
=
t =1 (1.10)
5
$500
−$1, 000 − ∑
NPVB = t
−$2,895.39
=
t =1 (1.10)

• Shall we choose cleaner B since its cost is lower?

• This overlooks the fact that the Cleaner A lasts
twice as long
51
Repeated Investments of unequal lives (2)

• There are 2 methods to solve this problem:

• The chain replication method
• Repeat projects until they begin and end at
the same time
• Compute NPV for the “repeated projects”
• The equivalent annual NPV (EANPV) method
• Calculate the annuity corresponding to the
NPV of the project over its lifetime for each
project

52
 The chain replication approach
 The Cleaner A’s time line of cash flows

-$4,000 –100 -100 -100 -100 -100 -100 -100 -100 -100 -100

0 1 2 3 4 5 6 7 8 9 10

$10010
−$4, 000 − ∑
NPVA = t
−$4, 614.46
=
t =1 (1.10)

or
 1 
 1 − (1.10)10 
−4, 000 − 100 
NPVA = =−$4614.46
 0.10 
 
  53
 The chain replication approach
• The Cleaner B’s time line of cash flows over 10 yrs
-$1,000 –500 -500 -500 -500 -1,500 -500 -500 -500 -500 -500

0 1 2 3 4 5 6 7 8 9 10

$500 $1, 000 10 $500

5
−$1, 000 − ∑
NPVB = t
− 5
−∑ t
−$4, 693.20
=
=t 1 = (1.10) (1.10) t 6 (1.10)
or
 1    1 
 1− 5    1− 
( )  − $1, 000 + 500  ( )
5
1.10 1.10   ÷ (1.10 )5
NPVB = −$1, 000 − 500 
 0.10    0.10 
    
     
=−$2,895.39 − 1, 797.81 = −$4, 693.20

• Now we find that NPVA > NPVB ! 54

The equivalent annual NPV approach
• The Equivalent Annual NPV approach (EANPV)
• The EANPV is the value of the payment of an
annuity that has the same PV as our original set
of cash flows 
1−
1 
 (1 + r ) n 
NPV
= EANPV ×  
 r 

 

• It is more computationally efficient than the chain
replication approach
• Suppose we need to compare a 5-year project with a 7-
year project.
• Chain replication approach: look at the cash flows for
35 years!
• EANPV is easier and it leads to the same decision. 55
 EANPV – example
• Cleaner A
 1 
1 − (1 + 0.10)10 
−$4, 614.46 =
NPVA = EANPV ×  
 0.10 
 
→ EANPVA = −$750.98

• Cleaner B
 1 
1 − (1 + 0.10)5 
−$2,895.39 =
NPVB = EANPV ×  
 0.10 
 
→ EANPVB =−$763.80
• EANPVA > EANPVB → Choose Cleaner A!
(EANPV<0, it can be interpreted as equivalent annual cost) 56
Summary
• Understand the advantages and
disadvantages of decision rules
• Payback Rule
• NPV
• IRR
• PI
• Understand the difference between
mutually exclusive projects, independent
and interdependent projects
• Evaluation of Repeated Projects 57