1. Net Present Value and Other Investment Criteria
Chapter 9
Net Present Value and Other Investment Criteria
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin

2. 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
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3. 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
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4. 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?
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5. 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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6. 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%.
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7. 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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8. Computing NPV for the Project
Using the formulas:
NPV = -165, ,120/(1.12) + 70,800/(1.12)2 + 91,080/(1.12)3 = 12,627.41
Do we accept or reject the project?
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9. 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?
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10. 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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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?
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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?
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13. 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
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14. 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?
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15. 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?
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16. 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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17. Computing AAR for the Project
Assume we require an average accounting return of 25%
Average Net Income:
(13, , ,100) / 3 = 15,340
AAR = 15,340 / 72,000 = .213 = 21.3%
Do we accept or reject the project?
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18. 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?
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19. 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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20. IRR – Definition and Decision Rule
Decision Rule: Accept the project if the IRR is greater than the required return
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21. Computing IRR for the Project
A project requiring an initial outlay of £15000 is guaranteed to produce a return of £20000 in 3 years’ time.
Use the internal rate of return method to decide whether this investment is worthwhile if the prevailing market rate is 5% compounded annually.

22. Computing IRR for the Project
Rearrange the basic FV equation and solve for r
FV = PV(1 + r)t
r = (FV / PV)1/t – 1
r = (20,000 / 15,000)1/3 – 1 = IRR = 10%
The project is to be recommended because 10% exceeds the market rate of 5%

23. 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?

24. NPV and IRR (1) A firm needs to choose between two projects, A and B.
Project A involves an initial outlay of £13,500 and yields £18,000 in 2 years’ time.
Project B involves an initial outlay of £9,000 and yields £13,000 in 2 years’ time.
Which of these projects would you advise the firm to invest in if the annual market rate of interest is 7%?
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25. NPV and IRR (2)
NPV
Project A: NPVA = [18000 / (1.07)2] – = £2221.9
Project B: NPVB = [13000 / (1.07)2] – 9000 = £
Both projects are viable as they produce positive NPVs.
Project B is preferred, as it has higher NPV.

26. NPV and IRR (3) IRR (Project A) r = (FV / PV)1/t – 1
The project is to be recommended because
15.5% exceeds the market rate of 7%

27. NPV and IRR (4) IRR (Project B) r = (FV / PV)1/t – 1
The project is to be recommended because 20.2% exceeds the market rate of 7%

28. NPV and IRR (5)
In previous two slides, both IRR exceed the market rate 7%.
Project B however gives the higher internal rate

29. IRR or NPV? (1)
It may appear at the first sight that the IRR method is the preferred approach compared to the NPV.
But it not usually the case.
The IRR method can give wholly misleading advice when comparing two or more projects.
You need to be careful when interpreting the results of the IRR method.

30. IRR or NPV? (2)
IRR method is unreliable way of comparing investment opportunities when there are significant differences between the amount involved.
IRR method compares percentages
A large percentage of a small sum could give a smaller profit than a small percentage of a large sum.

31. IRR or NPV? Example
Which of the following projects would you choose to invest in when the market rate is 3% compounded annually:
Project A: requires an initial outlay of £1,000 and yield £1,200 in 4 years’ time.
Project B: requires an outlay of £30,000 and yields £35,000 after 4 years.

32. IRR or NPV? (Example) NPV Project A:
Project B:
NPV = [35,000 / (1.03)4] – 30,000 =
NPV = [35,000 / ] – 30,000 = £1,097.39
Both projects are viable as they produce positive NPVs.
The second project is preferred, as it has higher NPV.

33. IRR or NPV? (Example)
IRR Project A: r = (FV / PV)1/t – 1 r = (1,200 / 1,000)1/4 – 1 = IRRA = 4.7% Project B: r = (35,000 / 30,000)1/4 – 1 = IRRB = 3.9% Project A gives the higher internal rate. We have seen that project B is the preferred choice per NPV.

34. Profitability Index
Measures the benefit per unit cost, based on the time value of money
If the index is greater the one, the project must proceed since it is profitable.
If the index is less than 1, the project must be rejected.
The formula is NPV divided by initial investment.
A initial investment of $1 million and NPV of $1.1 million, would have a profitability index of 1.1
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 in which we have limited capital
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35. 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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36. 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?
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37. End of Chapter
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