CHAPTER 9

N E T P R E S E N T VA L U E A N D
OTHER INVESTMENT CRITERIA

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 KEY CONCEPTS AND SKILLS
• Show the reasons why the net present value criterion is the best way to
evaluate proposed investments

• Discuss the payback rule and some of its shortcomings

• Discuss the discounted payback rule and some of its shortcomings

• Explain accounting rates of return and some of the problems with them

• Present the internal rate of return criterion and its strengths and
weaknesses

• Calculate the modified internal rate of return

• Illustrate the profitability index and its relation to net present value

9-2
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 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

9-3
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 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?

9-4
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 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. 9-5
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 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%.
9-6
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 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.

9-7
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 COMPUTING NPV FOR THE
PROJECT
• Using the formulas:
 NPV = -165,000 + 63,120/(1.12) + 70,800/(1.12)2 +
91,080/(1.12)3 = 12,627.41

• Using the calculator:

 CF0 = -165,000; C01 = 63,120; F01 = 1; C02 = 70,800; F02
= 1; C03 = 91,080; F03 = 1; NPV; I = 12; CPT NPV =
12,627.41

• Do we accept or reject the project?

9-8
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 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?
9-9
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 CALCULATING NPVS WITH A
SPREADSHEET
• Spreadsheets are an excellent way to compute NPVs,
especially when you have to compute the cash flows
as well.

• Using the NPV function

 The first component is the required return entered as a
decimal.
 The second component is the range of cash flows beginning
with year 1.
 Subtract the initial investment after computing the NPV.

9-10
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 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.
9-11
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 COMPUTING PAYBACK

• 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?

9-12
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 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?
9-13
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 ADVANTAGES AND
DISADVANTAGES OF PAYBACK
• Advantages • Disadvantages
 Easy to understand  Ignores the time value of
 Adjusts for uncertainty of money
later cash flows  Requires an arbitrary cutoff
 Biased toward liquidity point
 Ignores cash flows beyond
the cutoff date
 Biased against long-term
projects, such as research
and development, and new
projects

9-14
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 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.

9-15
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 COMPUTING DISCOUNTED PAYBACK

• 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?

9-16
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 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?
9-17
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 ADVANTAGES AND DISADVANTAGES
OF DISCOUNTED PAYBACK
• Advantages • Disadvantages
 Includes time value of  May reject positive NPV
money investments
 Easy to understand  Requires an arbitrary
 Does not accept negative cutoff point
estimated NPV  Ignores cash flows
investments when all beyond the cutoff point
future cash flows are  Biased against long-term
positive projects, such as R&D
 Biased towards liquidity and new products

9-18
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 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. 9-19
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 COMPUTING AAR

• 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?

9-20
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 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? 9-21
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 ADVANTAGES AND
DISADVANTAGES OF AAR
• Advantages • Disadvantages
 Easy to calculate  Not a true rate of return;
 Needed information will time value of money is
usually be available ignored
 Uses an arbitrary
benchmark cutoff rate
 Based on accounting net
income and book values,
not cash flows and market
values

9-22
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 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.

9-23
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 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.

9-24
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 COMPUTING IRR

• If you do not have a financial calculator, then this

becomes a trial and error process.

• Calculator
 Enter the cash flows as you did with NPV.
 Press IRR and then CPT.
 IRR = 16.13% > 12% required return

• Do we accept or reject the project?

9-25
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 NPV PROFILE FOR THE PROJECT

IRR = 16.13%
70,000
60,000
50,000
NPV

40,000
30,000
20,000
10,000
0
0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22
-10,000
-20,000
Discount Rate

9-26
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 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? 9-27
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 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.
9-28
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 CALCULATING IRRS WITH A
SPREADSHEET
• You start with the cash flows the same as you did for
the NPV.

• You use the IRR function.

 You first enter your range of cash flows, beginning with the
initial cash flow.
 You can enter a guess, but it is not necessary.
 The default format is a whole percent – you will normally
want to increase the decimal places to at least two.

9-29
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 SUMMARY OF DECISIONS FOR THE
PROJECT
Summary
Net Present Value Accept

Payback Period Reject

Discounted Payback Period Reject

Average Accounting Return Reject

Internal Rate of Return Accept

9-30
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 NPV VS. IRR

• NPV and IRR will generally give us the same

decision.

• Exceptions:
 Nonconventional cash flows – cash flow signs change more
than once

 Mutually exclusive projects

• Initial investments are substantially different (issue of scale).
• Timing of cash flows is substantially different.

9-31
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 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?
9-32
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 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?

9-33
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 NPV PROFILE

IRR = 10.11% and 42.66%

$12.00

$10.00
NPV

$8.00

$6.00

$4.00

$2.00

$0.00
0.25 0.3 0.35 0.4 0.45 0.5 0.55
Discount Rate

9-34
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 SUMMARY OF DECISION RULES

• The NPV is positive at a required return of 15%, so you

should Accept.

• If you use the financial calculator, you would get an IRR of

10.11% which would tell you to Reject.

• You need to recognize that there are non-conventional cash

flows and look at the NPV profile.

9-35
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 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 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

9-36
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 EXAMPLE WITH MUTUALLY
EXCLUSIVE PROJECTS

Period Project Project

A B The required return
for both projects is
0 -500 -400
10%.
1 325 325
2 325 200 Which project
should you accept
IRR 19.43% 22.17% and why?
NPV 64.05 60.74
9-37
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 NPV PROFILES

IRR for A = 19.43%

$160.00
IRR for B = 22.17%
$140.00
$120.00 Crossover Point = 11.8%
$100.00
NPV

$80.00
A
$60.00
B
$40.00
$20.00
$0.00
0 0.05 0.1 0.15 0.2 0.25 0.3
($20.00)
($40.00)
Discount Rate

9-38
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 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:

 Nonconventional cash flows
 Mutually exclusive projects

9-39
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 MODIFIED IRR

• Calculate the net present value of all cash outflows

using the borrowing rate.

• Calculate the net future value of all cash inflows

using the investing rate.

• Find the rate of return that equates these values.

• Benefits: single answer and specific rates for

borrowing and reinvestment

9-40
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 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 in which we

have limited capital.

9-41
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 ADVANTAGES AND DISADVANTAGES
OF PROFITABILITY INDEX
• Advantages • Disadvantages
 Closely related to NPV,  May lead to incorrect
generally leading to decisions in comparisons
identical decisions of mutually exclusive
 Easy to understand and investments
communicate
 May be useful when
available investment
funds are limited

9-42
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 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.

9-43
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 SUMMARY – DCF CRITERIA
• Net present value
 Difference between market value and cost
 Take the project if the NPV is positive.
 Has no serious problems
 Preferred decision criterion

• Internal rate of return

 Discount rate that makes NPV = 0
 Take the project if the IRR is greater than the required return.
 Same decision as NPV with conventional cash flows
 IRR is unreliable with nonconventional cash flows or mutually exclusive projects.

• Profitability Index
 Benefit-cost ratio
 Take investment if PI > 1
 Cannot be used to rank mutually exclusive projects
 May be used to rank projects in the presence of capital rationing 9-44
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 SUMMARY – PAYBACK CRITERIA

• Payback period
 Length of time until initial investment is recovered
 Take the project if it pays back within some specified period.
 Doesn’t account for time value of money, and there is an arbitrary
cutoff period

• Discounted payback period

 Length of time until initial investment is recovered on a discounted
basis
 Take the project if it pays back in some specified period.
 There is an arbitrary cutoff period.

9-45
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 SUMMARY – ACCOUNTING
CRITERION
• Average Accounting Return
 Measure of accounting profit relative to book value

 Similar to return on assets measure

 Take the investment if the AAR exceeds some specified

return level.

 Serious problems and should not be used

9-46
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 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?

9-47
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 ETHICS ISSUES
• An ABC poll in the spring of 2004 found that one-third of students
age 12 – 17 admitted to cheating and the percentage increased as
the students got older and felt more grade pressure. If a book
entitled “How to Cheat: A User’s Guide” would generate a positive
NPV, would it be proper for a publishing company to offer the new
book?
• Should a firm exceed the minimum legal limits of government
imposed environmental regulations and be responsible for the
environment, even if this responsibility leads to a wealth reduction
for the firm? Is environmental damage merely a cost of doing
business?
• Should municipalities offer monetary incentives to induce firms to
relocate to their areas?

9-48
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 COMPREHENSIVE PROBLEM

• An investment project has the following cash flows: CF0 =

-1,000,000; C01 – C08 = 200,000 each

• If the required rate of return is 12%, what decision should be

made using NPV?

• How would the IRR decision rule be used for this project, and
what decision would be reached?

• How are the above two decisions related?

9-49
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 END OF CHAPTER
CHAPTER 9

9-50
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