Net Present Value and Other Investment Criteria: Ross, Essentials of Corporate Finance, 5e

Chapter 8
NET PRESENT VALUE

AND OTHER
INVESTMENT CRITERIA
Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd

Ross, Essentials of Corporate Finance, 5e 8-1
Learning objectives
LO8.1 Summarise the payback rule and some
of its shortcomings.
LO8.2 Describe accounting rates of return and
some of the problems with them.
LO8.3 Describe the internal rate of return
criterion and its strengths and
weaknesses.
LO8.4 Explain why the net present value
criterion is the best way to evaluate
proposed investments.
continued
Learning objectives
LO8.5 Apply the modified internal rate of return.
LO8.6 Calculate the profitability index and
understand its relation to net present
value.

Chapter outline
8.1 Net present value
8.2 The payback rule
8.3 The average accounting return
8.4 The internal rate of return
8.5 The profitability index
8.6 The practice of capital budgeting

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?
Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 8-5

Net present value
• The difference between the present value of the
future cash flows and the cost of the investment.
• It is called discounted cash flow (DCF)
Step 1: Estimate the expected future cash flows.
Step 2: Estimate the required return for projects of
this risk level.
Step 3: Find the present value of the cash flows and
subtract the initial investment to arrive at the
net present value.
n CFt n CFt
NPV = ∑ (1 + R)t = NPV = ∑
(1 + R)t
– CF0
t=0 t=1
NPV: decision rule
• NPV = net gain in shareholder wealth
• NPV > 0 means:
- Accept the project
- Project is expected to add value to the firm.
- Project will increase the wealth of the owners.
• NPV = 0 means:
- Project’s inflows are exactly sufficient to repay
the invested capital and provide the required rate
of return.

Computing NPV for the project:
Example 8.1
• We expect that the cash flows over the five-year
life of the project will be $2000 in the first two
years, $4000 in the next two and $5000 in the
last year. It will cost about $10 000 to begin
production. We use a 10% discount rate to
evaluate new products. Should we accept or
reject the project?
- Formula:
 NPV = –10 000 + 2000/(1.10)1 + 2000/(1.10)2 +
4000/(1.10)3 + 4000/(1.10)4 + 5000/(1.10)5 = $2313
- Excel
 NPV(rate, CF1: CFn) – CF0
NPV method
• Meets all desirable criteria
- Considers all CFs
- Considers TVM
- Adjusts for risk
- Can rank mutually exclusive projects
• Directly related to increase in VF
• Dominant method; always prevails

Payback period
• How long does it take to recover the initial
cost of a project?
• Computation
- Estimate the cash flows.
- Subtract the future cash flows from the initial
cost until initial investment is recovered.
- A ‘break-even’ type of measure
• Decision rule: accept if the payback period is
less than some preset limit.

Computing PBP for the project:
Example 8.2
• The projected cash flows from a proposed
investment are:
• Year 1 2 3
• Cashflow 100 200 500
• This project costs $500. What is the payback
period for this investment?
Year
•` 0 1 2 3
Cashflow -500 100 200 500
Cum. Cashflow -500 -400 -200 300
• PBP = 2 + 200/500 = 2.4 years

Advantages and
disadvantages of payback

Average accounting return
(AAR)
• Many different definitions for average
accounting return (AAR)
• In this book: Average Net Income
AAR 
Average Book Value
- Note: Average book value depends on how the
asset is depreciated.
• Requires a target cut-off rate.
• Decision rule: accept the project if the AAR is
greater than target rate.

Computing ARR for the project:
Example
• The required investment to fit out the shop is
$500 000. The store would have a four-year
life. The required investment would be 100%
depreciated (straight-line) over four years.
Year 1 2 3 4
Profit for the year 40 000 50 000 60 000 70 000
- The average profit for the year

=(40 000 + 50 000 + 60 000 + 70 000)/ 4
= 55 000
- Average book value = (500 000 + 0)/2 = 250 000
- ARR = 55 000/ 250 000 = 22%
Advantages and
disadvantages of AAR

Internal rate of return (IRR)
• IRR = discount rate that makes the NPV = 0

• Most important alternative to NPV
• Widely used in practice
• Intuitively appealing
• Based entirely on the estimated cash flows
• Independent of interest rates
• Decision rule:
- Accept the project if the IRR is greater than the
required return.
Computing IRR for the project:
Example
• We expect that the cash flows over the five-
year life of the project will be $2000 in the first
two years, $4000 in the next two and $5000 in
the last year. It will cost about $10 000 to
begin production.
• Estimate the IRR for this project? We use a
10% discount rate to evaluate new products.
Should we accept or reject the project?
- Excel
 IRR(CF0: CFn) = 17.30%
 IRR > discount rate = accept the project
An NPV profile: Figure 8.4

NPV versus IRR
• NPV and IRR will generally give the same
decision.
• Exceptions
- Non-conventional cash flows
 Cash flow sign changes more than once
- Mutually exclusive projects
 Initial investments are substantially different.
 Timing of cash flows is substantially different.
 Will not reliably rank projects.

IRR and non-conventional cash
flows
• Cash flows change sign more than once.
• Most common:
- Initial cost (negative CF)
- A stream of positive CFs
- Negative cash flow to close project
- For example, nuclear power plant or strip mine
• More than one IRR … Which one do you use
to make your decision?

Non-conventional cash flows:
Example
• Suppose we have a strip-mining project that
requires a $60 investment. Our cash flow in the
first year will be $155. In the second year, the
mine is depleted, but we have to spend $100 to
restore the terrain.
• To find the IRR on this
project, we can calculate
the NPV at various rates:
• NPV is zero when the discount rate is 25%, so
this is the IRR. The NPV is also zero at 33.33%.
Which of these is correct?
NPV profile: Figure 8.6

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.

Mutually exclusive projects:
Example
• The IRR for A is 24%, and the IRR for B is
21%.
• The NPV and IRR rankings conflict for some
discount rates.
• Which investment has the higher NPV
depends on the required return.
continued
Mutually exclusive projects:
Example
• If the required return is 10%, for instance,
then B has the higher NPV, even though A
has the higher return.
• If our required return is 15%, then there is no
ranking conflict: Investment A is better.

NPV profiles: Figure 8.7

Two reasons NPV profiles
cross
• Size (scale) differences
- Smaller project frees up funds sooner for
investment.
- The higher the opportunity cost, the more
valuable these funds, so a high discount rate
favours small projects.
• Timing differences
- Project with faster payback provides more CF in
early years for reinvestment.
- If discount rate is high, early CF are especially
good.

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

Advantages and
disadvantages of IRR

Modified internal rate of return
(MIRR)
• Controls for some problems with IRR
• Three methods:
- Discounting approach = Discount future outflows
to present and add to CF0.
- Reinvestment approach = Compound all CFs
except the first one forward to end.
- Combination approach = Discount outflows to
present; compound inflows to end.
• MIRR will be unique number for each method.
• Discount (finance)/compound (reinvestment)
rate externally supplied
MIRR vs IRR
• Different opinions about MIRR and IRR
• MIRR avoids the multiple IRR problem.
• Managers like rate-of-return comparisons,
and MIRR is better for this than IRR.
• Problem with MIRR: different ways to
calculate with no evidence of the best method
• Interpreting a MIRR is not obvious.

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
where we have limited capital.
• Decision rule:
If PI > 1.0  Accept

Advantages and disadvantages
of profitability index

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.
• All provide valuable information.


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Chapter 8

NET PRESENT VALUE

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 8-5

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• PBP = 2 + 200/500 = 2.4 years

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- The average profit for the year

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• IRR = discount rate that makes the NPV = 0

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