1. Net Present Value and Other Investment Criteria (Capital Budgeting)
Chapter 8
Net Present Value and
Other Investment Criteria
(Capital Budgeting)

2. The Capital Budgeting Issue
One of the most important issues in Corporate Finance
Launch a new project
Enter a new market
Determines the nature of the firm’s operations and products for years to come
Fixed asset investments are generally long-lived and not easily reversed once made
Fixed assets define the business of the firm

3. Capital Budgeting *Net Present Value (NPV)
Techniques used to analyze potential business ventures to decide which are worth undertaking:
*Net Present Value (NPV)
Preferred Approach
*Internal Rate of Return (IRR)
Payback Period
Average Accounting Return (AAR)
Profitability Index (PI)

4. Capital Budgeting
Good Capital Budgeting criterion must tell us two things
1. Is a particular project a good investment?
2. If we have more than one good project, but we can only take one of them, which one should we take?
We’ll see that: only the NPV criterion can always provide the correct answer to both questions

5. Net Present Value (NPV)

6. Net Present Value The Basic Idea
The goal of the financial manager is to create value for the stockholders
Potential investments must be examined
A widely used procedure for doing this is the “Net Present Value” approach

7. Net Present Value The Basic Idea
We create value by identifying an investment worth more in the marketplace than it costs us to acquire
Capital Budgeting is about trying to determine whether a proposed investment or project will be worth more than it costs once it’s in place

8. Net Present Value The Basic Idea
The Net Present Value (NPV) – is the difference between an investment’s market value and its costs
A way of assessing the profitability of a proposed investment
The preferred approach in principle and typically in practice
Given the goal of creating value for the stockholders:
Capital budgeting is a search for investments with positive net present values

9. Net Present Value Estimating Net Present Value
Estimate the cost of the project or investment
Estimate the future cash flows
Discount those cash flows to estimate the present value of the future cash flows
NPV = The Present Value of the Future Cash Flows less the initial cost of the project or investment.

10. Net Present Value Net Present Value Rule
If NPV is positive:
Accept the project or investment
Increases the total value of the stock
The greater the NPV, the greater the increase in the value of the stock
If NPV is negative:
Reject the project or investment
Decreases the total value of the stock
If NPV is zero:
Indifferent – between taking or not taking the project or investment
Break-even proposition
Value is neither created nor destroyed

11. Net Present Value Example 8.1, Page 211
Suppose we are asked to decide whether or not a new consumer product should be launched.
Based on projected sales and costs, we expect that the cash flows over the five-year life of the project will be: $2,000 in the first two years, $4,000 in the nest two, and $5,000 in the last year.
It will cost about $10,000 to begin production.
We use a 10% discount rate to evaluate new products.
What should we do here?

12. Net Present Value Example 8.1, Page 211
hp 12C Keystrokes Inst Manual Pg 70, 71,& 72
Use Shift Keys: g – blue f – yellow
CHS g CF = -10,000 Cost to begin project
g CFj = 2, st Yr Cash Flow Amt
g CFj = 2,000 2nd Yr Cash Flow Amt
g CFj = 4, rd Yr Cash Flow Amt
g CFj = 4, th Yr Cash Flow Amt
g CFj = 5, th Yr Cash Flow Amt
i = %
f NPV = 2,313
Based on the NPV Rule: since NPV is positive, we should take on, or “Accept” the project.
Note: When NPV is negative  “Reject” the project.

13. Net Present Value Example: Not in Book
You are going to choose between two investments. Both cost $80,000, but investment A pays $35,000 a year for 4 years while investment B pays $30,000 a year for 5 years. If your required return is 13%, which should you choose?
Answer on following slide

14. Net Present Value Example: Not in Book
Answer to previous slide:
NPV for Investment A = 24,106.50
NPV for Investment B = 25,516.94
Choose Investment B because it has a higher NPV.

15. Net Present Value Example: Problem 10.b. – Page 233
Darby & Davis, LLC, has identified the following two mutually exclusive projects. If the required return is 11 %, what is the NPV for each of these projects? Which project will you choose if you apply the NPV decision rule?
Year Cash Flow (A) Cash Flow (B)
, ,000
, ,000
, ,000
, ,000
, ,500
NPV for Project (A) = $1,520.71
NPV for Project (B) = $1,698.58
Choose Project B  it has the highest NPV

16. Internal Rate of Return (IRR)

17. The Internal Rate of Return
Internal Rate of Return (IRR) – is simply the discount rate that makes the NPV of an investment zero.
Put another way: It’s the rate of return at which the discounted future cash flows = the initial cash outlay
“Internal” rate – only depends on the cash flows of a particular investment, not on rates offered elsewhere
Closely related to NPV
The most important alternative to NPV

18. The Internal Rate of Return
IRR Rule:
Accept: if the IRR exceeds the “required rate of return”
Reject: if the IRR is below (less than) the “required rate of return”
For Example: if your organization decides that it only wants to take on those projects with a return of 10% (10% is the required return), then you would:
“Accept” all projects with an IRR greater than 10%
“Reject” all projects with an IRR less than 10%.

19. The Internal Rate of Return Example 8.3, Page 220
hp 12C Keystrokes Inst Manual Pg 70, 71,& 72
Use Shift Keys: g – blue f – yellow
CHS g CF0 = Up-Front Cost
g CFj = st Yr Cash Flow
g CFj = nd Yr Cash Flow
g CFj = rd Yr Cash Flow
f IRR = 15%
Conclusion:
Since IRR = 15% and the required rate of return is 18%
Reject: the IRR is below the “required rate of return”

20. The Internal Rate of Return Problem 8, Page 233
hp 12C Keystrokes Instructions Pg 70, 71,& 72
Use Shift Keys: g – blue f – yellow
g CF0 = -2,400 Up-Front Cost
g CFj = st Yr Cash Flow Amount
g CFj = nd Yr Cash Flow Amount
g CFj = ,000 3rd Yr Cash Flow Amount
f IRR = %

21. The Internal Rate of Return Problems with IRR
Non-conventional Cash Flows (Page 221):
Multiple Answers (rates of return) – the possibility that more than one discount rate makes the NPV of an investment zero
When cash flows aren’t conventional, strange things start to happen with IRR:
Some computers/calculators just report the first IRR
Others report the smallest IRR
What is the return?....becomes difficult to answer
Read Page 221 and 222

22. The Internal Rate of Return Problems with IRR
Mutually Exclusive Investments – A situation where taking one investment prevents the taking of another (example: own a corner lot – can build a gas station or apartment bldg, but not both)
The IRR can be misleading and may lead to incorrect decisions
The project with the highest IRR may not produce the highest NPV due to:
timing of the cash flows
and the required return rate
Therefore, with “Mutually Exclusive Projects”, do not rank them based on their returns (IRR)
When comparing investments to determine which is best – ALWAYS USE NPV
Which one is best? – the one with the largest NPV

23. The Internal Rate of Return Redeeming Qualities of IRR
IRR can be calculated w/o knowing the appropriate discount rate, NPV can’t.
Easy to understand and communicate.

24. The Payback Rule

25. The Payback Rule Defining the Rule
Payback Period: is the amount of time required for an investment to generate cash flows to recover its initial cost.
How many years do you have to wait until the accumulated cash flows from an investment equal or exceed the cost of the investment?

26. The Payback Rule Defining the Rule
Payback Rule: an investment is acceptable if its calculated payback period is less than some pre-specified number of years.
Accept: if the payback period is less than or equal to the specified number of years
Reject: if the payback period is greater than the specified number of years
Example 8.2, Page 213:
Calculating Payback

27. The Payback Rule Analyzing the Rule
Severe shortcomings as compared to NPV
No discounting: the time value of money is ignored
Projects may be accepted that are worth less than they cost
Considers no risk differences
Calculated the same way for both very risky and very safe projects
Problems with determining the exact cut-off period
Cash flows after the payback period are ignored
Bias toward short term investments
Profitable long term investments may be rejected

28. The Payback Rule Redeeming Qualities of the Rule
Useful for relatively minor decisions
In general: an investment that pays back rapidly and has benefits extending beyond the cutoff period probably has a positive NPV

29. The Payback Rule Summary of the Rule
A kind of “break-even” measure
In an accounting sense
Not an economic sense
because time value is ignored
It determines how long it takes to recover the initial investment, not the impact an investment will have on the value of the stock
Due to its simplicity, it’s a useful simple rule of thumb - as a screen for dealing with many minor investment decisions

30. Average Accounting Return

31. The Average Accounting Return
Average Accounting Return (AAR): An investment’s average net income divided by its average book value:
Average net income
Average book value
AAR Rule:
Accept the project if its average accounting return exceeds a target average account return
Reject: Otherwise
Example in book: Page 216 and 217
Excel Spreadsheet

32. The Average Accounting Return
The AAR Rule has many problems:
AAR is not a true rate of return. It ignores time value.
It’s a ratio of two accounting numbers and not comparable to returns offered in the financial markets.
Based on accounting net income and book values, instead of cash flows and market values
Doesn’t indicate the effect on share price from taking the investment
However, it is easy to calculate and needed info is usually available

33. The Profitability Index

34. The Profitability Index
Profitability Index (PI) – Present Value of an investment’s future cash flows divided by its initial cost. Also called the Benefit-Cost Ratio
PI = PV / Initial Cost
If a project costs $200 and the present value of its future cash flows is $220:
PI = 220 / 200 = 1.10
For every dollar invested $.10 in NPV results
PI measures the value created per dollar invested
Often proposed as a measure of performance for government or other not-for-profit investments
When capital is scarce, it may make sense to allocate it to those projects with the highest PIs

35. The Profitability Index
PI > 1 for projects with a positive NPV
PI < 1 for projects with a negative NPV
Remember: Positive NPV means that the PV of the future cash flows is greater than the initial investment
PI may lead to incorrect decisions when considering mutually exclusive projects
The PI Index cannot be used to rank mutually exclusive projects
Always go with the project with the highest NPV!

36. The Practice of Capital Budgeting
While NPV is considered superior, its calculation involves only “estimated” future cash flows.
The result can be very “soft”.
For this reason firms typically use multiple criteria for evaluating a proposal

37. Chapter 8 Suggested Homework
Know Chapter theories, concepts and definitions
Suggested NPV Homework problems:
Problem 8.1 – Page 229
Problems 6, 9, and 10.b. – Page 233
Problem 16.b & c – Page 235
Problem 19.b & c and 22.b & c – Page 236
Problem 23.b and c – Page 237

38. Chapter 8 Suggested Homework
Suggested IRR Homework problems:
Problem 5 - Page 232-3
Problem 8, 10a - Page 233
Problem 16a - Page 235
Problem 23a - Page 236-7
Problem 25a - Page 237

39. Chapter 8 Suggested Homework
Suggested Payback Rule Homework problems:
Problems 1 - Page 232
Suggested Average Accounting Return Homework problems:
Problem 4, Page 232
Suggested Profitability Index Homework:
Problem 13, Page 234