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NPV and Other Investment
Criteria
P.V. Viswanath
For an Introductory Course in Finance
Key Concepts and Skills
 The NPV Rule
 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
P.V. Viswanath
2
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
P.V. Viswanath
3
Sources of Investment Ideas
 Three categories of projects:



New Products
Cost Reduction
Replacement of Existing assets
 Sources of Project Ideas:




Existing customers
R&D Department
Competition
Employees
P.V. Viswanath
4
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?
 The Net Present Value rule satisfies these three
criteria, and is, therefore, the preferred decision
rule.
P.V. Viswanath
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.
P.V. Viswanath
6
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.
 NPV is an additive measure:

If there are two projects A and B, then NPV(A and B) = NPV(A) +
NPV(B).
P.V. Viswanath
7
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: 70,800; NI = 3,300
Year 3: 91,080; NI = 29,100
Average Book Value = 72,000
 Your required return for assets of this risk is 12%.
P.V. Viswanath
8
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 = 12,627.42
 Do we accept or reject the project?
P.V. Viswanath
9
Estimating Project Cashflows
 Before the NPV decision rule can be applied, we need
project cashflow forecasts for each year.
 These are built up from estimates of incremental revenues
and associated project costs.

Cash Flow = Revenues – Fixed Costs – Variable Costs – Taxes –
Long-term Investment Outlays – Changes in Working Capital
 An equivalent formula is:

Cashflow = Net Income + Noncash expenses (that were included in
the Net Income computation) +(1-tax rate)Interest – Long-term
Investment Outlays – Changes in Working Capital
P.V. Viswanath
10
Cost of Capital
 The cost of capital is the opportunity cost of capital for the
firm’s investors and is used to discount the project cashflows.
 The cost of capital is also called the WACC and is computed as
the firm’s after-tax weighted cost of debt and equity




WACC = (E/V)Re + (D/V)Rd(1-t), where
E, D are market values of the firm’s equity and debt; V = D+E is the
total value of the firm; and t is the firm’s corporate tax rate
The cost of debt Rd is multiplied by (1-t) because interest payments on
debt are deductible for tax purposes.
Since the tax advantage of debt is taken into account in the denominator,
we do not include it in the numerator as well, thus avoiding double
counting.
P.V. Viswanath
11
Sensitivity Analysis
 Since the firm will not know the future level of output, or
the other cost parameters with certainty, it is important to
know how the value of the project changes as these
parameters are varied.
 This is called sensitivity analysis
 If the final decision on the project is very sensitive to a
particular parameter, it would be more valuable to expend
resources on obtaining more precise estimates of that
parameter.
 The break-even point is the point of indifference between
accepting and rejecting the project.
 With respect to sales, this is the number of units that have to
be sold in order for the project to be in the black.
P.V. Viswanath
12
Issues to keep in mind
 Sunk costs should be ignored. These costs have already
been incurred and cannot be undone whatever the decision
that is going to be currently taken.
 Only incremental cashflows should be considered. Hence if
a machine is to be replaced by a new machine, only the
additional flows implied by the new machine should be
considered to make the decision of whether to buy the new
machine.
 Only cashflows must be considered; allocated expenses,
such as depreciation are to be ignored because they reflect
capital expenditures already made and are a kind of sunk
cost.
 Of course, if there are any tax implications related to
depreciation computations, these must be taken into account.
P.V. Viswanath
13
Projects with Unequal Lives
 Suppose we have to choose between the following two
machines, L and S to replace an existing machine.
 Machine L costs $1000 and needs to be replaced once every
four years, while machine S costs $600 a unit and must be
replaced every two years.
 The flows C1-C4 represent cost savings over the current
machine, for the next four years.
 The discount rate is 10 percent.
Project C0
C1
C2
C3 C4
NPV
---------------------------------------------------------------------------L
-1000 500 500
500 500
584.93
S
-600 500 500
267.77
P.V. Viswanath
14
Projects with Unequal Lives
 Treating this problem as a simple present value problem, we
would choose machine L, since the present value of L is
greater than that of S.
 However, choosing S gives us additional flexibility because
we are not locked into a four-year cycle. Perhaps better
alternatives may be available in year 3.
 Furthermore, the present comparison is not appropriate
because even if no better alternatives are available because
we have not considered the tax savings in years 3 and 4 if
we go with machine S – we can always buy a second S-type
machine at the end of year two!
P.V. Viswanath
15
Projects with Unequal Lives
 Consider the modified alternatives:
Project
C0
C1
C2
C3
C4
NPV
------------------------------------------------------------------------------------------L
-1000
500
500
500
500
584.93
S
-600
500
500
267.77
Second S
-600
500
500
220.66
Combination S -600
500
-100
500
500
488.43
 We see that the combination of two S-type machines are not as
disadvantageous compared to one L-type machine, though the L-type
machine still wins out.
P.V. Viswanath
16
Projects with Unequal Lives
 Alternatively, we can convert the flows for the machines
into equivalent equal annual flows.
 Thus, we find X, such that the present value of L and L1 are
equal.
Project C0
C1
C2
C3 C4
NPV
---------------------------------------------------------------------------L
-1000 500 500
500 500
584.93
L1
0
X
X
X
X
584.93
 This is obtained as the solution to the equation PV(Annuity
of $X for 4 years at 10%) = $584.93 and works out to
$184.53
P.V. Viswanath
17
Projects with Unequal Lives
 Similarly, we convert the flows for machine S into
equivalent equal annual flows.
 Thus, we find X, such that the present value of S and S1 are
equal.
Project C0
C1
C2
C3 C4
NPV
---------------------------------------------------------------------------S
-600 500 500
267.77
S1
0
Y
Y
267.77
 This is obtained as the solution to the equation PV(Annuity
of $Y for 2 years at 10%) = $267.77 and works out to
$154.29
P.V. Viswanath
18
Projects with Unequal Lives
 The values X and Y can simply be compared and the project
with the lower equivalent annual flow is chosen.
 We are effectively making the choice between
the following two projects
Project C0
C1
C2
C3 C4
---------------------------------------------------------------------------L1
0
X
X
X
X
S1
0
Y
Y
Y
Y
 The advantage of this approach is that we don’t need to
explicitly construct two projects with the same project lives.
P.V. Viswanath
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
P.V. Viswanath
20
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
P.V. Viswanath
21
Computing IRR For The Project
 If you do not have a financial calculator, then this
becomes a trial and error process


In the case of our problem, we can find that the IRR =
16.13%.
Note that the IRR of 16.13% > the 12% required return
 Do we accept or reject the project?
P.V. Viswanath
22
NPV Profile
 To understand what the IRR is, let us look at the
NPV profile.
 The NPV profile is the function that shows the NPV
of the project for different discount rates.
 Then, the IRR is simply the discount rate where the
NPV profile intersects the X-axis.
 That is, the discount rate for which the NPV is zero.
P.V. Viswanath
23
NPV Profile For The Project
70,000
IRR = 16.13%
60,000
50,000
NPV
40,000
30,000
20,000
10,000
0
-10,000 0
0.02 0.04 0.06 0.08
0.1
0.12 0.14 0.16 0.18
0.2
0.22
-20,000
Discount Rate
P.V. Viswanath
24
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?
P.V. Viswanath
25
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
P.V. Viswanath
26
NPV Vs. IRR
 NPV and IRR will generally give us the same
decision
 Exceptions


Non-conventional cash flows – cash flow signs change
more than once
Mutually exclusive projects


Initial investments are substantially different
Timing of cash flows is substantially different
P.V. Viswanath
27
IRR and Nonconventional Cash Flows
 When the cash flows change sign more than once,
there is more than one IRR
 When you solve for IRR you are solving for the
root of an equation and when you cross the x-axis
more than once, there will be more than one return
that solves the equation
 If you have more than one IRR, which one do you
use to make your decision?
P.V. Viswanath
28
Another Example – Nonconventional
Cash Flows
 Suppose an investment will cost $90,000 initially
and will generate the following cash flows:



Year 1: 132,000
Year 2: 100,000
Year 3: -150,000
 The required return is 15%.
 Should we accept or reject the project?
P.V. Viswanath
29
NPV Profile
IRR = 10.11% and 42.66%
$4,000.00
$2,000.00
NPV
$0.00
($2,000.00)
0
0.05 0.1
0.15
0.2 0.25
0.3 0.35
0.4
0.45 0.5
0.55
($4,000.00)
($6,000.00)
($8,000.00)
($10,000.00)
Discount Rate
P.V. Viswanath
30
Summary of Decision Rules
 The NPV is positive at a required return of 15%, so
you should Accept
 If you compute the IRR, you could get an IRR of
10.11% which would tell you to Reject
 You need to recognize that there are nonconventional cash flows and look at the NPV
profile.
P.V. Viswanath
31
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
P.V. Viswanath
32
Example With Mutually Exclusive
Projects
Period
Project A
Project B
0
-500
-400
1
325
325
2
325
200
IRR
19.43%
22.17%
NPV
64.05
60.74
P.V. Viswanath
The required return
for both projects is
10%.
Which project
should you accept
and why?
33
NPV Profiles
IRR for A = 19.43%
$160.00
$140.00
IRR for B = 22.17%
$120.00
Crossover Point = 11.8%
NPV
$100.00
$80.00
A
B
$60.00
$40.00
$20.00
$0.00
($20.00) 0
0.05
0.1
0.15
0.2
0.25
0.3
($40.00)
Discount Rate
P.V. Viswanath
34
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
P.V. Viswanath
35
Additional Decision Rules
 In addition to the NPV and IRR rules, there are
some other decision rules that are popularly used.
 These are conceptually flawed, but have the
advantage of being easy to compute and use.
 They may, therefore, be used if a quick decision is
necessary and not a lot is riding on the decision.
 Two examples of these alternative decision rules are
the payback rule and the accounting rate of return.
P.V. Viswanath
36
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
P.V. Viswanath
37
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?
P.V. Viswanath
38
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?
P.V. Viswanath
39
Advantages and Disadvantages of
Payback
 Disadvantages
 Advantages



Easy to understand
Adjusts for uncertainty of
later cash flows
Biased towards liquidity




P.V. Viswanath
Ignores the time value of money
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
40
Justifying the Payback Period Rule
 We usually assume that the same discount rate is applied to
all cash flows. Let di be the discount factor for a cash flow
at time i, implied by a constant discount rate, r, where .
Then di+1/di = 1+r, a constant. However, if the riskiness of
successive cash flows is greater, then the ratio of discount
factors would take into account the passage of time as well
as this increased riskiness.
 In such a case, the discount factor may drop off to zero more
quickly than if the discount rate were constant. Given the
simplicity of the payback method, it may be appropriate in
such a situation.
P.V. Viswanath
41
Justifying the Payback Period Rule
Discount factor

Discount factor function implied by
the payback period rule
Discount factor function implied by
a constant discount rate
True discount factor function
0
Timing of cash flow
P.V. Viswanath

42
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.
P.V. Viswanath
43
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?
P.V. Viswanath
44
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 criteria?
P.V. Viswanath
45
Advantages and Disadvantages of
AAR
 Advantages


 Disadvantages
Easy to calculate
Needed information will
usually be available



P.V. Viswanath
Not a true rate of return;
time value of money is
ignored
Uses an arbitrary benchmark
cutoff rate
Based on accounting net
income and book values, not
cash flows and market
values
46
Summary of Decisions For The Project
Summary
Net Present Value
Accept
Payback Period
Reject
Average Accounting Return
Reject
Internal Rate of Return
Accept
P.V. Viswanath
47
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
P.V. Viswanath
48
Advantages and Disadvantages of
Profitability Index
 Advantages



 Disadvantages
Closely related to NPV,
generally leading to identical
decisions
Easy to understand and
communicate
May be useful when
available investment funds
are limited
P.V. Viswanath

May lead to incorrect
decisions in comparisons of
mutually exclusive
investments
49
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
P.V. Viswanath
50
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 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?
P.V. Viswanath
51
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