Chapter 8

Net Present Value

and Other
Investment Criteria

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McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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Key Concepts and Skills

• Understand the payback rule and its
shortcomings
• Understand accounting rates of return and
their problems
• Understand the internal rate of return and
its strengths and weaknesses
• Understand the net present value rule and
why it is the best decision criteria
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Chapter Outline
• Net Present Value
• The Payback Rule
• The Average Accounting Return
• The Internal Rate of Return
• The Profitability Index
• The Practice of Capital Budgeting

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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?

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Project Example Information

• You are looking at a new project and you
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 is 12%.

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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.
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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.
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Computing NPV for the Project

• Using the formulas:
– NPV = 63,120/(1.12) + 70,800/(1.12)2 +
91,080/(1.12)3 – 165,000 = $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?

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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?
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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
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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
during year 3
– Payback = 2 years + 31,080/91,080 = 2.34 years
• Do we accept or reject the project?

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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?
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Advantages and Disadvantages
of Payback
• Advantages • Disadvantages
– Easy to understand – Ignores the time value
– Adjusts for uncertainty of money
of later cash flows – 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
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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.
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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?

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Advantages and Disadvantages
of AAR
• Disadvantages
• Advantages
– Not a true rate of
– Easy to calculate return; time value of
– Needed information money is ignored
will usually be – Uses an arbitrary
available benchmark cutoff
rate
– Based on accounting
net income and book
values, not cash
flows and market
values
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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

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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

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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?
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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

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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?
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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

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Summary of Decisions For the
Project
Summary

Net Present Value Accept

Payback Period Reject

Average Accounting Return Reject

Internal Rate of Return Accept

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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
• Timing of cash flows is substantially different

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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 next year 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
(Use incremental Rate of Return)
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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
– Non-conventional cash flows
– Mutually exclusive projects

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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 receive $1.10
worth of benefits, so we create an
additional $0.10 in value
• This measure can be very useful in
situations in which we have limited capital

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

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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

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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 the required
payback is 4 years.
– What is the payback period?
– What is the NPV?
– What is the IRR?
– Should we accept the project?
• What should be the primary decision method?
• When is the IRR rule unreliable?

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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?

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