Principles of

Corporate Finance
Chapter 5 Eighth Edition

Why Net Present

Value Leads to
Better Investment
Decisions Than
Slides by
Other Criteria Matthew Will

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 5- 2

Topics Covered
 A Review of The Basics
– NPV and its Competitors
 The Payback Period
– The Book Rate of Return
 Internal Rate of Return
 Capital Rationing

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 5- 3

NPV and Cash Transfers

 Every possible method for evaluating projects
impacts the flow of cash about the company
as follows.
Cash

Investment Investment
opportunity (real Firm Shareholder opportunities
asset) (financial assets)

Invest Alternative: Shareholders invest

pay dividend for themselves
to shareholders

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 5- 4

CFO Decision Tools

Survey Data on CFO Use of Investment Evaluation Techniques

NPV, 75%

IRR, 76%

Payback, 57%

Book rate of
return, 20%

Profitability
Index, 12%

0% 20% 40% 60% 80% 100%

SOURCE: Graham and Harvey, “The Theory and Practice of Finance: Evidence from the Field,”
Journal of Financial Economics 61 (2001), pp. 187-243.

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 5- 5

Book Rate of Return

Book Rate of Return - Average income divided by average book value over project life. Also called accounting rate of return.

Managers rarely use this measurement to make decisions. The components reflect tax and accounting figures, not market values or cash
flows.

book income
Book rate of return 
book assets

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 5- 6

Payback
 The payback period of a project is the number of
years it takes before the cumulative forecasted
cash flow equals the initial outlay.

 The payback rule says only accept projects that

“payback” in the desired time frame.

 This method is flawed, primarily because it

ignores later year cash flows and the the present
value of future cash flows.

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 5- 7

Payback
Example
Examine the three projects and note the mistake
we would make if we insisted on only taking
projects with a payback period of 2 years or less.

Payback
Project C0 C1 C2 C3 NPV@ 10%
Period
A - 2000 500 500 5000
B - 2000 500 1800 0
C - 2000 1800 500 0

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 5- 8

Payback
Example
Examine the three projects and note the mistake
we would make if we insisted on only taking
projects with a payback period of 2 years or less.

Payback
Project C0 C1 C2 C3 NPV@ 10%
Period
A - 2000 500 500 5000 3  2,624
B - 2000 500 1800 0 2 - 58
C - 2000 1800 500 0 2  50

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 5- 9

Internal Rate of Return

Example
You can purchase a turbo powered machine tool
gadget for $4,000. The investment will generate
$2,000 and $4,000 in cash flows for two years,
respectively. What is the IRR on this investment?

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 5- 10

Internal Rate of Return

Example
You can purchase a turbo powered machine tool gadget for $4,000.
The investment will generate $2,000 and $4,000 in cash flows for two
years, respectively. What is the IRR on this investment?

2,000 4,000
NPV  4,000   0
(1  IRR ) (1  IRR )
1 2

IRR  28.08%

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Internal Rate of Return

2500
2000
1500
IRR=28%
1000
NPV (,000s)

500
0
-500
10

20

30

40

50

60

70

80

90

0
10
-1000
-1500
-2000
Discount rate (%)

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Internal Rate of Return

Pitfall 1 - Lending or Borrowing?
 With some cash flows (as noted below) the NPV of the
project increases s the discount rate increases.
 This is contrary to the normal relationship between NPV and
discount rates.

Project C0 C1 IRR NPV @ 10%

A  1,000  1,500  50%  364
B  1,000  1,500  50%  364

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Internal Rate of Return

Pitfall 2 - Multiple Rates of Return
 Certain cash flows can generate NPV=0 at two different discount
rates.

 The following cash flow generates NPV=$A 3.3 million at both IRR
% of (-44%) and +11.6%.

Cash Flows (millions of Australian dollars)

C0 C1...... ......C9 C10

 60 12 12  15

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 5- 14

Internal Rate of Return

Pitfall 2 - Multiple Rates of Return
 Certain cash flows can generate NPV=0 at two different discount rates.

 The following cash flow generates NPV=$A 3.3 million at both IRR% of
(-44%) and +11.6%.

NPV
600

IRR=11.6%
300

0 Discount
Rate

-30 IRR=-44%

-600

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 5- 15

Internal Rate of Return

Pitfall 2 - Multiple Rates of Return
 It is possible to have a zero IRR and a positive NPV

Project C0 C1 C2 IRR NPV @ 10%

C  1,000  3,000  2,500 None  339

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 5- 16

Internal Rate of Return

Pitfall 3 - Mutually Exclusive Projects
 IRR sometimes ignores the magnitude of the project.
 The following two projects illustrate that problem.

Project C0 C1 IRR NPV @ 10%

D  10,000  20,000 100%  8,182
E  20,000  30,000  75%  11,818

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 5- 17

Internal Rate of Return

Pitfall 3 - Mutually Exclusive Projects

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 5- 18

Internal Rate of Return

Pitfall 4 - Term Structure Assumption
 We assume that discount rates are stable during the term of the project.
 This assumption implies that all funds are reinvested at the IRR.
 This is a false assumption.

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 5- 19

Internal Rate of Return

Calculating the IRR can be a laborious task. Fortunately,
financial calculators can perform this function easily.

HP-10B EL-733A BAII Plus

-350,000 CFj -350,000 CFi CF
16,000 CFj 16,000 CFfi 2nd {CLR Work}
16,000 CFj 16,000 CFi -350,000 ENTER
466,000 CFj 466,000 CFi 16,000 ENTER
{IRR/YR} IRR 16,000 ENTER
466,000 ENTER
All produce IRR=12.96 IRR CPT
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 5- 20

Profitability Index
 When resources are limited, the profitability index
(PI) provides a tool for selecting among various
project combinations and alternatives

 A set of limited resources and projects can yield

various combinations.

 The highest weighted average PI can indicate

which projects to select.

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 5- 21

Profitability Index

Cash Flows ($ millions)

Project
Project CC00 CC11 CC2 NPV
NPV@@ 10%
10%
2
AA 10
10 30
30 55 21
21
BB 55 55 20
20 16
16
CC 55 55 15
15 12
12

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 5- 22

Profitability Index

Cash Flows ($ millions)

Project
Project Investment
Investment($)
($) NPV
NPV($)
($) Profitabil
Profitability
ityIndex
Index
AA 10
10 21
21 2.1
2.1
BB 55 16
16 3.2
3.2
CC 55 12
12 2.4
2.4

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 5- 23

Profitability Index

NPV
Profitability Index 
Investment
Example
We only have $300,000 to invest. Which do we select?

Proj NPV Investment PI

A 230,000 200,000 1.15
B 141,250 125,000 1.13
C 194,250 175,000 1.11
D 162,000 150,000 1.08

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 5- 24

Profitability Index
Example - continued
Proj NPV Investment PI
A 230,000 200,000 1.15
B 141,250 125,000 1.13
C 194,250 175,000 1.11
D 162,000 150,000 1.08

Select projects with highest Weighted Avg PI

WAPI (BD) = 1.13(125) + 1.08(150) + 0.0 (25)
(300) (300) (300)
= 1.01

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 5- 25

Profitability Index
Example - continued
Proj NPV Investment PI
A 230,000 200,000 1.15
B 141,250 125,000 1.13
C 194,250 175,000 1.11
D 162,000 150,000 1.08

Select projects with highest Weighted Avg PI

WAPI (BD) = 1.01
WAPI (A) = 0.77
WAPI (BC) = 1.12

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 5- 26

Linear Programming

 Maximize Cash flows or NPV

 Minimize costs

Example
Max NPV = 21Xn + 16 Xb + 12 Xc + 13 Xd
subject to
10Xa + 5Xb + 5Xc + 0Xd <= 10
-30Xa - 5Xb - 5Xc + 40Xd <= 12

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 5- 27

Vegetron Case
Table 5.2

YEAR
1 2 3 4 5
1.Revenue 180 180 180 180 180
2. Operating costs 70 70 70 70 70
3. Depreciation a 80 80 80 80 80
4. Net income 30 30 30 30 30
5. Start-of-year book value 400 320 240 160 80

Book rate of return 7.50% 9.40% 12.50% 18.75% 37.50%

(4÷5)

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Vegetron Case
Table 5.3

YEAR
1 2 3 4 5 6 7
1.Reyenue 140 140 140 140 140 140 140
2. Operating costs 55 55 55 55 55 55 55
3. Depreciation a 57 57 57 57 57 57 57
4. Net income 28 28 28 28 28 28 28
5. Start-of-year book value 400 343 286 229 171 114 57

6. Book rate of return 7.00% 8.20% 9.80% 12.20% 16.40% 24.60% 49.10%
(4÷5)

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Web Resources
Click to access web sites
Internet connection required

www.invest-faq.com/articles/analy-int-rate-return.html
www.rebuild.org/lawson/irr.asp
www.hud.gov/offices/cpd/affordablehousing/training/ener
gy/cost/payback.cfm
www.unix.mcs.anl.gov/otc/Guide/faq/linear-programming-
faq.html
www.faqs.org/faqs/linear-programming-faq/

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