CHAPTER

5 5-1

NET PRESENT VALUE

AND OTHER INVESTMENT CRITERIA

Brealey, Myers, and Allen

Principles of Corporate Finance
12th Edition
Slides by Matthew Will
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 Topics Covered
5-2

• A Review of The Basics

• Payback
• Internal (or Discounted-Cash-Flow) Rate of
Return
• Choosing Capital Investments When
Resources Are Limited

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 NPV and Cash Transfers
5-3

• Every possible method for evaluating projects

impacts the flow of cash about the company as
follows.
Cash

Investment Financial Shareholders Investment

(Project X) Manager (financial assets)

Invest Alternative: Pay Shareholders

dividend to invest for
shareholders themselves

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 Three Points to Remember about N
5-4

1. A dollar today is worth more than a dollar

tomorrow
2. Net present value depends solely on the
forecasted cash flows from the project and
the opportunity cost of capital
3. Because present values are all measured in
today’s dollars, you can add them up

NPV(A + B) = NPV(A) + NPV(B)

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 CFO Decision Tools
5-5

Survey Data on CFO Use of Investment Evaluation

Techniques

SOURCE: Graham and Harvey, “The Theory and Practice of Finance: Evidence from the Field,” Journal of Financial Economics 61 (2001), pp. 187-243.

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 Book Rate of Return
5-6

Book Rate of Return - Average income divided by

average book value over project life. Also called
accounting rate of return.

book income
Book rate of return 
book assets

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 Payback
5-7

• The payback period of a project is the number

of years it takes before the cumulative
forecasted cash flow equals the initial outlay.

• The payback rule says only accept projects

that “payback” in the desired time frame.

• This method is flawed, primarily because it

ignores later year cash flows and the present
value of future cash flows.

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 Payback
5-8

Example
Examine the three projects and note the mistake we
would make if we insisted on only taking projects with a
payback period of 2 years or less.

Payback
Project C0 C1 C2 C3 NPV@ 10%
Period
A - 2000 500 500 5000
B - 2000 500 1800 0
C - 2000 1800 500 0

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 Payback
5-9

Example
Examine the three projects and note the mistake we
would make if we insisted on only taking projects with a
payback period of 2 years or less.

Payback
Project C0 C1 C2 C3 NPV@ 10%
Period
A - 2000 500 500 5000 3  2,624
B - 2000 500 1800 0 2 - 58
C - 2000 1800 500 0 2  50

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 Why payback can give misleading answers:
5-10

• The payback rule ignores all cash flows after the cutoff
date. If the cutoff date is two years, the payback rule rejects
project A regardless of the size of the cash inflow in year 3.

• The payback rule gives equal weight to all cash flows

before the cutoff date. The payback rule says that projects
B and C are equally attractive, but because C's cash
inflows occur earlier, C has the higher net present value at
any discount rate.

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 Discounted Payback
5-11

Occasionally companies discount the cash flows before they

compute the payback period. The discounted cash flows for
our three projects are as follows:

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 So why do many companies continue to use it?
5-12

Three possible explanations.

• Payback may be used because it is the simplest way to communicate

an idea of project profitability. Investment decisions require discussion
and negotiation among people from all parts of the firm, and it is
important to have a measure that everyone can understand.

• Managers of larger corporations may opt for projects with short

paybacks because they believe that quicker profits mean quicker
promotion (the need to align the objectives of managers with those of
shareholders).

• Owners of family firms with limited access to capital may worry about
their future ability to raise capital. These worries may lead them to
favor rapid payback projects even though a longer-term venture may
have a higher NPV.

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 Internal Rate of Return
5-13

Internal Rate of Return (IRR) - Discount rate at

which NPV = 0

Internal Rate of Return Rule - Invest in any

project offering a rate of return that is higher
than the opportunity cost of capital

payoff
Rate of return = 1
investment
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 Internal Rate of Return
5-14

Example
You can purchase a turbo powered machine
tool gadget for $4,000. The investment will
generate $2,000 and $4,000 in cash flows for
two years, respectively. What is the IRR on
this investment?

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 Internal Rate of Return
5-15

Example
You can purchase a turbo powered machine tool
gadget for $4,000. The investment will generate $2,000
and $4,000 in cash flows for two years, respectively.
What is the IRR on this investment?

2,000 4,000
NPV  4,000   0
(1  IRR ) (1  IRR )
1 2

IRR  28.08%
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 Internal Rate of Return
5-16

2500

2000

1500
IRR = 28%
1000
NPV (,000s)

500

-500

-1000

-1500

-2000
Discount rate (%)

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 Internal Rate of Return
5-17

Pitfall 1 - Lending or Borrowing?

• With some cash flows (as noted below), the NPV of the
project increases as the discount rate increases
• This is contrary to the normal relationship between NPV
and discount rates

Project C0 C1 IRR NPV @10%

A  1,000  1,500  50%  364
B  1,000  1,500  50%  364

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 Pitfall 2—Multiple Rates of Return

5-18

Assume cash flows from a project are as below:

The project's IRR and its NPV is calculated as follows:

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 5-19

Note that there are two discount rates that make NPV = 0. That is, each
of the following statements holds:

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 Internal Rate of Return
5-20

Pitfall 2 - Multiple Rates of Return

• Certain cash flows can generate NPV = 0 at two different discount rates
• The following cash flow generates NPV = $A 253 million at both IRR% of
+3.50% and +19.54%.

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 Internal Rate of Return
5-21

Pitfall 2 - Multiple Rates of Return

• It is possible to have no IRR and a positive NPV

Project C0 C1 C2 IRR NPV @10%

C 1, 000 3, 000 2,500 None 339

project C has a positive net present value at all discount rates

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 Internal Rate of Return
5-22

Pitfall 3 - Mutually Exclusive Projects

• IRR sometimes ignores the magnitude of the
project
• The following two projects illustrate that
problem

Project C0 C1 IRR NPV @10%

D  10,000  20,000 100%  8,182
E  20,000  35,000  75%  11,818

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 5-23

You can salvage the IRR rule in these cases by looking at the internal
rate of return on the incremental flows.

First, consider the smaller project (D in our example). It has an IRR of

100%, which is well in excess of the 10% opportunity cost of capital.

You know, therefore, that D is acceptable. You now ask yourself whether
it is worth making the additional $10,000 investment in E. The
incremental flows from undertaking E rather than D are as follows:

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 5-24

Unless you look at the incremental expenditure, IRR is unreliable in

ranking projects of different scale.

It is also unreliable in ranking projects that offer different patterns of cash

flow over time.

For example, suppose the firm can take project F or project G but not
both:

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 Internal Rate of Return
5-25

Pitfall 3 - Mutually Exclusive Projects

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 5-26

The reason that IRR is misleading is that the total cash inflow of project G
is larger but tends to occur later. Therefore, when the discount rate is low,
G has the higher NPV; when the discount rate is high, F has the higher
NPV.

The internal rates of return on the two projects tell us that at a discount
rate of 20% G has a zero NPV (IRR = 20%) and F has a positive NPV.
Thus if the opportunity cost of capital were 20%, investors would place a
higher value on the shorter-lived project F.

But in our example the opportunity cost of capital is not 20% but 10%. So
investors will pay a relatively high price for the longer-lived project. At a
10% cost of capital, an investment in G has an NPV of $9,000 and an
investment in F has an NPV of only $3,592.

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 5-27

When business people are asked to choose between F and G, many

choose F.

The reason seems to be the rapid payback generated by project F. In other

words, they believe that if they take F, they will also be able to use the
rapid cash inflows to make other investments in the future, whereas if they
take G, they won't have money enough for these investments.

In other words they implicitly assume that it is a shortage of capital that

forces the choice between F and G. When this implicit assumption is
brought out, they usually admit that G is better if there is no capital
shortage.

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 5-28

When we have to choose between projects F and G, it is easiest to compare

the net present values. But if your heart is set on the IRR rule, you can use it
as long as you look at the internal rate of return on the incremental flows.

The IRR on the incremental cash flows from G is 15.6%. Since this is
greater than the opportunity cost of capital, you should undertake G rather
than F.

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 Internal Rate of Return
5-29

Pitfall 4 – What Happens When There Is More

than One Opportunity Cost of Capital
• Term structure assumption
• We assume that discount rates are stable during the
term of the project
• This assumption implies that all funds are reinvested at
the IRR
• This is a false assumption

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 5-30

So many companies pay such close attention to the internal rate of return,
but it may reflect the fact that management does not trust the forecasts it
receives. Suppose that two plant managers approach you with proposals
for two new investments. Both have a positive NPV of $1,400 at the
company's 8% cost of capital, but you nevertheless decide to accept project
A and reject B. Are you being irrational?

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 Capital Rationing
5-31

Suppose, however, that there are limitations on the investment program that
prevent the company from undertaking all such projects.

Economists call this capital rationing. When capital is rationed, we need a

method of selecting the package of projects that is within the company's
resources yet gives the highest possible net present value.

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 Capital Rationing
5-32

Capital Rationing - Limit set on the amount of

funds available for investment

Soft Rationing - Limits on available funds

imposed by management

Hard Rationing - Limits on available funds

imposed by the unavailability of funds in the
capital market

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 5-33

An Easy Problem in Capital Rationing

Let us start with a simple example. The opportunity cost of capital is 10%,
and our company has the following opportunities:

All three projects are attractive, but suppose that the firm is limited to
spending $10 million. In that case, it can invest either in project A or in
projects B and C, but it cannot invest in all three.
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 5-34

Although individually B and C have lower net present values than project
A, when taken together they have the higher net present value.

Here we cannot choose between projects solely on the basis of net

present values. When funds are limited, we need to concentrate on getting
the biggest bang for our buck.

In other words, we must pick the projects that offer the highest net present
value per dollar of initial outlay.

This ratio is known as the profitability index.

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 Profitability Index
5-35

• When resources are limited, the profitability

index (PI) provides a tool for selecting among
various project combinations and alternatives

• A set of limited resources and projects can

yield various combinations

• The highest weighted average PI can indicate

which projects to select

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 5-36

For our three projects the profitability index is calculated as follows:

Project B has the highest profitability index and C has the next
highest. Therefore, if our budget limit is $10 million, we should
accept these two projects

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 Profitability Index
5-37

For example, suppose that the firm can raise only $10 million for
investment in each of years 0 and 1 and that the menu of possible projects
is expanded to include an investment next year in project D:

Cash Flows ($ millions)

Project C0 C1 C2 NPV@10%
A  10  30  5 21
B  5  5  20 16
C  5  5  15 12
D 0  40  60 13

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 5-38

The reason that ranking on the profitability index fails in this example is
that resources are constrained in each of two periods. In fact, this ranking
method is inadequate whenever there is any other constraint on the choice
of projects.

This means that it cannot cope with cases in which two projects are
mutually exclusive or in which one project is dependent on another.

You need to find the package of projects that satisfies all these constraints
and gives the highest NPV.

One way to tackle such a problem is to work through all possible

combinations of projects. For each combination you first check whether the
projects satisfy the constraints and then calculate the net present value.
But it is smarter to recognize that linear programming (LP) techniques are
specially designed to search through such possible combinations.

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 Profitability Index
5-39

Cash Flows ($ millions)

Project Investment ($) NPV ($) Profitabil ity Index
A 10 21 2.1
B 5 16 3.2
C 5 12 2.4
D 0 13 0.4

NPV
Profitability index 
investment

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 Profitability Index
5-40

NPV
Profitability index 
investment
Example
We only have $300,000 to invest. Which do we
select?

Project NPV Investment PI

A 230,000 200,000 1.15
B 141,250 125,000 1.13
C 194,250 175,000 1.11
D 162,000 150,000 1.08

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 Profitability Index
5-41

Example - continued
Project NPV Investment PI
A 230,000 200,000 1.15
B 141,250 125,000 1.13
C 194,250 175,000 1.11
D 162,000 150,000 1.08

Select projects with highest weighted average PI

125 150 25
WAPI BD = 1.13 × + 1.08 × + 0.0 ×
300 300 300
= 1.01

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 Profitability Index
5-42

Example - continued
Project NPV Investment PI
A 230,000 200,000 1.15
B 141,250 125,000 1.13
C 194,250 175,000 1.11
D 162,000 150,000 1.08

Select projects with highest weighted average PI

WAPI (BD) = 1.01

WAPI (A) = 0.77
WAPI (BC) = 1.12

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 5-43

REVIEW QUESTIONS

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 5-44

Q1) You have the chance to participate in a project that produces the
following cash flows:

The internal rate of return is 13%. If the opportunity cost of capital is

10%, would you accept the offer?

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 5-45

Q2) Consider projects Alpha and Beta:

The opportunity cost of capital is 8%.

Suppose you can undertake Alpha or Beta, but not both. Use the IRR rule
to make the choice.

(Hint: What's the incremental investment in Alpha?)

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 5-46

Q3) Suppose you have the following investment opportunities, but only
$90,000 available for investment. Which projects should you take?

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 Q4) Consider the following projects:

5-47

a. If the opportunity cost of capital is 10%, which projects have a positive

NPV?
b. Calculate the payback period for each project.
c. Which project(s) would a firm using the payback rule accept if the cutoff
period were three years?
d. Calculate the discounted payback period for each project.
e. Which project(s) would a firm using the discounted payback rule accept if
the cutoff period were three years?

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 Q5) Consider the following two mutually exclusive projects:

5-48

a. Calculate the NPV of each project for discount rates of 0%, 10%, and
20%. Plot these on a graph with NPV on the vertical axis and discount
rate on the horizontal axis.

b. What is the approximate IRR for each project?

c. In what circumstances should the company accept project A?

d. Calculate the NPV of the incremental investment (B – A) for discount

rates of 0%, 10%, and 20%. Plot these on your graph. Show that the
circumstances in which you would accept A are also those in which the
IRR on the incremental investment is less than the opportunity cost of
capital.
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 5-49

Discount Rate
0% 10% 20%
NPVA +20.00 +4.13 -8.33
NPVB +40.00 +5.18 -18.98

IRRA = 13.1% and IRRB = 11.9%

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 5-50

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 5-51

b. The cash flows for (B – A) are:

C0 = $ 0
C1 = –$60
C2 = –$60
C3 = +$140
Therefore:
Discount Rate
0% 10% 20%
NPVB − A +20.00 +1.05 -10.65

IRRB − A = 10.7%
The company should accept Project A if the discount rate is greater than 10.7% and
less than 13.1%. As shown in the graph, for these discount rates, the IRR for the
incremental investment is less than the opportunity cost of capital.

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 5-52

50.00

40.00

30.00

20.00
Project A Project B
NPV

10.00
Increment
0.00

-10.00

-20.00

-30.00
0% 10% 20%

Rate of Interest

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