Chapter 9

Net Present Value

and Other
Investment Criteria

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin
 Key Concepts and Skills
• Be able to compute payback and discounted
payback and understand their shortcomings
• Understand accounting rates of return and
their shortcomings
• Be able to compute internal rates of return
(standard and modified) and understand their
strengths and weaknesses
• Be able to compute the net present value and
understand why it is the best decision
criterion
• Be able to compute the profitability index and
understand its relation to net present value
9-2
 Chapter Outline
• Net Present Value
• The Payback Rule
• The Discounted Payback
• The Average Accounting Return
• The Internal Rate of Return
• The Profitability Index
• The Practice of Capital Budgeting

9-3
 Good Decision Criteria
• We need to ask ourselves the
following questions when evaluating
capital budgeting decision rules:
– 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?

9-4
 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.

9-5
Project Example Information
• You are reviewing a new project and have
estimated the following cash flows:
– Year 0: CF = -165,000
– Year 1: CF = 63,120; NI = 13,620
– Year 2: CF = 70,800; NI = 3,300
– Year 3: CF = 91,080; NI = 29,100
– Average Book Value = 72,000
• Your required return for assets of this risk
level is 12%.

9-6
 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.
• Since our goal is to increase owner
wealth, NPV is a direct measure of how
well this project will meet our goal.

9-7
 Computing NPV for the
Project
• Using the formulas:
– NPV = -165,000 + 63,120/(1.12) +
70,800/(1.12)2 + 91,080/(1.12)3 = 12,627.41
• Using the calculator:
– CF0 = -165,000; C01 = 63,120; F01 = 1; C02 =
70,800; F02 = 1; C03 = 91,080; F03 = 1; NPV;
I = 12; CPT NPV = 12,627.41
• Do we accept or reject the project?

9-8
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 rule?

9-9
 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
NPV

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 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

9-11
 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
– Year 3: 31,080 – 91,080 = -60,000 project
pays back in year 3
• Do we accept or reject the project?

9-12
 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 rule?

9-13
 Advantages and
Disadvantages of Payback
• Advantages • Disadvantages
– Easy to understand – Ignores the time
– Adjusts for value of money
uncertainty of later – Requires an
cash flows arbitrary cutoff point
– Biased toward – Ignores cash flows
liquidity beyond the cutoff
date
– Biased against
long-term projects,
such as research
and development,
and new projects 9-14
Discounted Payback Period
• Compute the present value of each cash
flow and then determine how long it takes
to pay back on a discounted basis
• Compare to a specified required period
• Decision Rule - Accept the project if it
pays back on a discounted basis within
the specified time

9-15
 Computing Discounted Payback
for the Project
• Assume we will accept the project if it pays back
on a discounted basis in 2 years.
• Compute the PV for each cash flow and
determine the payback period using discounted
cash flows
– Year 1: 165,000 – 63,120/1.121 = 108,643
– Year 2: 108,643 – 70,800/1.122 = 52,202
– Year 3: 52,202 – 91,080/1.123 = -12,627 project pays
back in year 3
• Do we accept or reject the project?

9-16
 Decision Criteria Test –
Discounted Payback
• Does the discounted payback rule account for the
time value of money?
• Does the discounted payback rule account for the
risk of the cash flows?
• Does the discounted payback rule provide an
indication about the increase in value?
• Should we consider the discounted payback rule
for our primary decision rule?

9-17
 Advantages and Disadvantages
of Discounted Payback
• Advantages • Disadvantages
– Includes time value – May reject positive
of money NPV investments
– Easy to understand – Requires an
– Does not accept arbitrary cutoff
negative estimated point
NPV investments – Ignores cash flows
when all future beyond the cutoff
cash flows are point
positive – Biased against
– Biased towards long-term projects,
liquidity such as R&D and
new products 9-18
Average Accounting Return
• There are many different definitions for
average accounting return
• The one used in the book is:
– Average net income / average book value
– Note that the average book value depends on
how the asset is depreciated.
• Need to have a target cutoff rate
• Decision Rule: Accept the project if the
AAR is greater than a preset rate

9-19
 Computing AAR for the
Project
• Assume we require an average
accounting return of 25%
• Average Net Income:
– (13,620 + 3,300 + 29,100) / 3 = 15,340
• AAR = 15,340 / 72,000 = .213 =
21.3%
• Do we accept or reject the project?

9-20
Decision Criteria Test - AAR
• Does the AAR rule account for the time
value of money?
• Does the AAR rule account for the risk of
the cash flows?
• Does the AAR rule provide an indication
about the increase in value?
• Should we consider the AAR rule for our
primary decision rule?

9-21
 Advantages and
Disadvantages of AAR
• Advantages • Disadvantages
– Easy to calculate – Not a true rate of
– Needed return; time value
information will of money is
usually be ignored
available – Uses an arbitrary
benchmark cutoff
rate
– Based on
accounting net
income and book
values, not cash
flows and market
9-22
values
 Internal Rate of Return
• This is the most important alternative
to NPV
• It is often used in practice and is
intuitively appealing
• It is based entirely on the estimated
cash flows and is independent of
interest rates found elsewhere

9-23
 IRR – Definition and
Decision Rule
• Definition: IRR is the return that makes the
NPV = 0
• Decision Rule: Accept the project if the
IRR is greater than the required return

9-24
 Computing IRR for the
Project
• If you do not have a financial calculator,
then this becomes a trial and error
process
• Calculator
– Enter the cash flows as you did with NPV
– Press IRR and then CPT
– IRR = 16.13% > 12% required return
• Do we accept or reject the project?

9-25
 NPV Profile for the Project
70,000
60,000 IRR = 16.13%
50,000
40,000
30,000
NPV

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

-20,000
Discount Rate

9-26
 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?

9-27
 Advantages of IRR
• Knowing a 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 return, which
is often a difficult task

9-28
 Calculating IRRs With A
Spreadsheet
• You start with the cash flows the same 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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Summary of Decisions for
the Project
Summary
Net Present Value Accept

Payback Period Reject

Discounted Payback Period Reject

Average Accounting Return Reject

Internal Rate of Return Accept

9-30
 NPV vs. IRR
• NPV and IRR will generally give us
the same decision
• Exceptions
– Nonconventional cash flows – cash flow
signs change more than once
– Mutually exclusive projects
• Initial investments are substantially different
(issue of scale)
• Timing of cash flows is substantially
different
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 IRR and Nonconventional
Cash Flows
• When the cash flows change sign more
than once, there is more than one IRR
• When you solve for IRR you are solving for
the root of an equation, and when you
cross the x-axis more than once, there will
be more than one return that solves the
equation
• If you have more than one IRR, which one
do you use to make your decision?

9-32
 Another Example –
Nonconventional Cash Flows
• Suppose an investment will cost $90,000
initially and will generate the following
cash flows:
– Year 1: 132,000
– Year 2: 100,000
– Year 3: -150,000
• The required return is 15%.
• Should we accept or reject the project?

9-33
 NPV Profile
$4,000.00
IRR = 10.11% and 42.66%

$2,000.00

$0.00
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55
($2,000.00)
NPV

($4,000.00)

($6,000.00)

($8,000.00)

($10,000.00)
Discount Rate

9-34
Summary of Decision Rules
• The NPV is positive at a required
return of 15%, so you should Accept
• If you use the financial calculator, you
would get an IRR of 10.11% which
would tell you to Reject
• You need to recognize that there are
non-conventional cash flows and look
at the NPV profile

9-35
IRR and Mutually Exclusive
Projects
• Mutually exclusive projects
– If you choose one, you can’t choose the other
– Example: You can choose to attend graduate
school at either Harvard or Stanford, but not
both
• Intuitively, you would use the following
decision rules:
– NPV – choose the project with the higher NPV
– IRR – choose the project with the higher IRR

9-36
 Example With Mutually
Exclusive Projects
Period Project Project The required return
A B for both projects is
0 -500 -400 10%.
1 325 325

2 325 200 Which project

should you accept
IRR 19.43 22.17 and why?
% %
NPV 64.05 60.74
9-37
 NPV Profiles
$160.00 IRR for A = 19.43%
$140.00
IRR for B = 22.17%
$120.00
$100.00 Crossover Point = 11.8%
$80.00
NPV

A
$60.00
B
$40.00
$20.00
$0.00
($20.00) 0 0.05 0.1 0.15 0.2 0.25 0.3
($40.00)
Discount Rate

9-38
Conflicts Between NPV and
IRR
• NPV directly measures the increase in
value to the firm
• Whenever there is a conflict between NPV
and another decision rule, you should
always use NPV
• IRR is unreliable in the following situations
– Nonconventional cash flows
– Mutually exclusive projects

9-39
 Modified IRR
• Calculate the net present value of all
cash outflows using the borrowing
rate.
• Calculate the net future value of all
cash inflows using the investing rate.
• Find the rate of return that equates
these values.
• Benefits: single answer and specific
rates for borrowing and reinvestment
9-40
 Profitability Index
• Measures the benefit per unit cost,
based on the time value of money
• 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 in which we have limited
capital

9-41
 Advantages and Disadvantages
of Profitability Index
• Advantages • Disadvantages
– Closely related to – May lead to
NPV, generally incorrect decisions
leading to identical in comparisons of
decisions mutually exclusive
– Easy to understand investments
and communicate
– May be useful when
available investment
funds are limited

9-42
 Capital Budgeting In
Practice
• We should consider several
investment criteria when making
decisions
• NPV and IRR are the most
commonly used primary investment
criteria
• Payback is a commonly used
secondary investment criteria

9-43
 Summary – DCF Criteria
• Net present value
– Difference between market value and cost
– Take 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 nonconventional 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

9-44
 Summary – Payback
Criteria
• Payback period
– Length of time until initial investment is recovered
– Take the project if it pays back within some specified
period
– Doesn’t 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

9-45
 Summary – Accounting
Criterion
• Average Accounting Return
– Measure of accounting profit relative to
book value
– Similar to return on assets measure
– Take the investment if the AAR exceeds
some specified return level
– Serious problems and should not be
used

9-46
 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 required payback 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 decision rule should be the primary
decision method?
• When is the IRR rule unreliable?
9-47
 Ethics Issues
• An ABC poll in the spring of 2004 found that one-
third of students age 12 – 17 admitted to cheating
and the percentage increased as the students got
older and felt more grade pressure. If a book
entitled “How to Cheat: A User’s Guide” would
generate a positive NPV, would it be proper for a
publishing company to offer the new book?
• Should a firm exceed the minimum legal limits of
government imposed environmental regulations
and be responsible for the environment, even if this
responsibility leads to a wealth reduction for the
firm? Is environmental damage merely a cost of
doing business?

• Should municipalities offer monetary incentives to

induce firms to relocate to their areas? 9-48
 Comprehensive Problem
• An investment project has the following
cash flows: CF0 = -1,000,000; C01 – C08 =
200,000 each
• If the required rate of return is 12%, what
decision should be made using NPV?
• How would the IRR decision rule be used
for this project, and what decision would be
reached?
• How are the above two decisions related?

9-49
End of Chapter

9-50