Ch.

5 Why Net Present Value Leads to Better Investment Decisions than Other
Criteria

 A review of the basics

 Net Present Value

 The Payback Rule
 The Internal Rate of Return
 Profitability index

 Net Present Value

The difference between the present value of all future cash inflows minus the cost
of investment.
Accept a project if its NPV is positive.
Reject a project if its NPV is negative.

 Ex) Find NPV of the following project using a discount rate of 12%
Initial outlay: $40,000
CF year1 = 15,000
CF year2 = 14,000
CF year3 = 13,000
NPV = 15,000(PVIF 12%,1) + 14,000(PVIF 12%,2) + 13,000(PVIF 12%,3) - 40,000
= -6,191
Do not take this project.

 Ex) Find NPV of the following project using a discount rate of 12%
Initial outlay: $40,000
CF year1 = 15,000 CF year2 = 14,000 CF year3 = 13,000 CF year4 = 12,000 CF
year5 = 11,000

NPV = 15,000(PVIF 12%,1) + 14,000(PVIF 12%,2) +

13,000(PVIF 12%,3) + 12,000(PVIF 12%,4)
+ 11,000(PVIF 12%,5) - 40,000
= $7,678
Accept this project.

 Key features of NPV:

 Recognizes the time value of money
 Solely depends on the forecasted cash flows and the opportunity cost of capital
 Since present values are all measured in today’s dollars, you can add them up
So, NPV (A+B) = NPV (A) + NPV (B)

Q) You are given a job to make a decision on project X, which is composed of three
projects A, B, and C which have NPVs of +$50, -$20 and +$100, respectively. How
would you go about making the decision about whether to accept or reject the
project?
 Why does the NPV rule work?
The market value of the firm is based on the present value of the cash flows it is
expected to generate.
Additional investments are “good” if the present value of the increased expected
cash flows exceeds their cost.
Thus, “good” projects are those which increase firm value - or, put another way,
good projects are those projects that have positive NPVs!
Moral of the story: Invest only in projects with positive NPVs.

 The Payback Rule

The payback is defined to be the amount of time until cash flows recover the cost
of investment (counted in years).
It measures how quickly the project will return its original investment
Accept the project if calculated payback period is less than some prespecified
number of years

EX) Initial outlay $10,000

Year Cash flow
1 $2,000
2 4,000
3 3,000
4 3,000
5 1,000
after three years the firm will have recaptured $9,000 on an initial investment of
$10,000, leaving $1,000 of the initial investment to be recovered.
during the fourth year, a total of $3,000 will be returned from this investment.

Assuming it will flow into the firm at a constant rate over the year, it will take one-
third of the year (1000/3000) to recover the remaining $1,000.
Thus, the payback period on this project is 3.33 years.
Suppose a firm’s maximum desired payback period is three years.
Then, calculated payback is more than the desired payback period. Reject this
project.

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.
 Disadvantages of payback period:
1. Requires an arbitrary cutoff point.
2. Ignores cash flows beyond the cutoff date.

3. Gives equal weight to all cash flows before the cutoff date. From the
previous example, the payback rule says that projects B and C are
acceptable, but because C’s cash inflows occur earlier, C has the higher NPV
at any discount rate.

4. Does not use use the time value of the money. Some companies discount
the cash flows before they compute the payback. However, the discounted-
payback rule still takes no account of any cash flows after the cutoff date.

 Internal Rate of Return (IRR)

The discount rate that equates the present value of the project’s future cash flows
with the project’s initial cash outlay.
Alternatively, the discount rate that makes NPV=0.
Accept the project if IRR > the required rate of return
Reject the project if IRR < the required rate of return.

The required rate of return(also called the discount rate) is the opportunity cost of
investing in the project rather than in the capital market. In other words, instead
of accepting a project, the firm can always give the cash to the shareholders an
let them invest it in financial assets.

Therefore, the IRR rule says that accept investment opportunities offering rates of
return in excess of their opportunity costs of capital.

The IRR must be calculated by trial and error, because there is no explicit solution except
for even cash flows cases.

Initial outlay = $200

Year Cash flow
1 50
2 100
3 150
 Find the IRR such that NPV = 0
50 100 150
0 = -200 + + +
(1+IRR)1 (1+IRR)2 (1+IRR)3

50 100 150
200 = + +
(1+IRR)1 (1+IRR)2 (1+IRR)3
 Trial and Error
Discount rates NPV
0% $100
5% 68
10% 41
15% 18
19% 1.65
20% -2
IRR is between 19% and 20%. (using a financial calculator, it is 19.44%)
 An easy case for finding IRR
Assume that a firm with a required rate of return of 10% is considering a project that
involves an initial outlay of $45,555. If the investment is taken, the cash flows are
expected to be $15,000 per year over the project’s four year life.
Find IRR for this example. This is an annuity problem, because we have an equal amount
of money and a limited period.
Note that IRR is the discount rate that equates the present value of the project’s future
cash flows with the project’s initial cash outlay.

 Therefore, 45,555 = 15,000 (PVIFA r%, 4)

3.037 = (PVIFA r%, 4)
r = 12% = IRR
Since IRR > 10%, Accept the project

 Ex) Initial investment: $275

1 100
2 100
3 100
4 100
 275 = 100 (PVIFA r%, 4)
2.75 = (PVIFA r%, 4)
IRR = between 16% and 18%

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. IRR
method cannot distinguish between a borrowing project and a lending project.
 In this case, IRR > Opportunity cost ;Accept or reject?
The only way to find the answer is to look at the NPV. Reject.
Pitfall 2 - Multiple Rates of Return
 Certain cash flows can generate NPV=0 at two different discount rates.
 The following cash flow generates NPV=0 at both (-50%) and 15.2%.
 There can be as many different internal rates of return for a project as there are
changes in the sign of the cash flows

Pitfall 3 - Mutually Exclusive Projects

 Mutually exclusive investment decisions: a situation where taking one investment prevents
the taking of another.
 As noted below, both projects are good investments, but F has the higher NPV and is better.
 Why? Remember, we are ultimately interested in creating value for the shareholders, so the
option with the higher NPV is preferred, regardless of the relative values.
 Therefore, projects cannot be ranked using their IRRs