CHAPTER 9
NET PRESENT VALUE
AND
OTHER INVESTMENT CRITERIA
Copyright © 2016 by McGraw-Hill Education. All rights reserved.
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?
9-2
1
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.
9-3
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%.
9-4
2
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.
9-5
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?
9-6
3
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?
9-7
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
9-8
4
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
9-9
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?
9-10
5
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?
9-11
ADVANTAGES AND
DISADVANTAGES OF PAYBACK
• Advantages • Disadvantages
Easy to Ignores the time value
understand of money
Adjusts for Requires an arbitrary
uncertainty of cutoff point
later cash flows Ignores cash flows
Biased toward beyond the cutoff date
liquidity Biased against long-
term projects, such as
research and
development, and
new projects
9-12
6
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
9-13
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?
9-14
7
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?
9-15
ADVANTAGES AND DISADVANTAGES OF
DISCOUNTED PAYBACK
• Advantages • Disadvantages
Includes time value May reject positive
of money NPV investments
Easy to understand Requires an arbitrary
Does not accept cutoff point
negative estimated Ignores cash flows
NPV investments beyond the cutoff
when all future cash point
flows are positive Biased against long-
Biased towards term projects, such as
liquidity R&D and new
products
9-16
8
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
9-17
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?
9-18
9
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?
9-19
ADVANTAGES AND
DISADVANTAGES OF AAR
• Advantages • Disadvantages
Easy to calculate Not a true rate of
Needed return; time value of
information will money is ignored
usually be Uses an arbitrary
available benchmark cutoff rate
Based on accounting
net income and book
values, not cash flows
and market values
9-20
10
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
9-21
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.
9-22
11
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?
9-23
NPV PROFILE FOR THE
PROJECT
70,000
60,000 IRR = 16.13%
50,000
40,000
30,000
NPV
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
9-24
12
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?
9-25
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
9-26
13
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
9-27
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
9-28
14
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
9-29
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?
9-30
15
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?
9-31
NPV PROFILE
IRR = 10.11% and 42.66%
$4,000.00
$2,000.00
$0.00
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55
($2,000.00)
NPV
($4,000.00)
($6,000.00)
($8,000.00)
($10,000.00)
Discount Rate
9-32
16
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
9-33
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
9-34
17
EXAMPLE WITH MUTUALLY
EXCLUSIVE PROJECTS
Period Project Project
The required return
A B
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
9-35
NPV PROFILES
IRR for A = 19.43%
$160.00
IRR for B = 22.17%
$140.00
$120.00 Crossover Point = 11.8%
$100.00
$80.00
NPV
A
$60.00
B
$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
9-36
18
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
9-37
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
9-38
19
ADVANTAGES AND DISADVANTAGES OF
PROFITABILITY INDEX
• Advantages • Disadvantages
Closely related to May lead to
NPV, generally incorrect decisions
leading to identical in comparisons of
decisions mutually exclusive
Easy to understand investments
and communicate
May be useful
when available
investment funds
are limited
9-39
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
9-40
20
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
9-41
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
9-42
21
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
9-43
22
