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FINANCIAL MANAGEMENT: CHAPTER 11
PRINCIPLES & APPLICATIONS
• Thirteenth Edition Investment Decision Criteria
To identify the sources and types of profitable
investment opportunities.
Evaluate investment opportunities using net present
value and describe why net present value is the best
measure to use.
Use the profitability index, internal rate of return,
and payback criteria to evaluate investment
opportunities.
current business practice with respect to the use of
capital-budgeting criteria.
2 Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
INVESTMENT DECISION
CRITERIA

The net present value (NPV)

PRINCIPLES APPLIED IN THIS CHAPTER

• Principle 1: Money Has a Time Value.

• Principle 2: There is a Risk-Return Tradeoff.
• Principle 3: Cash Flows Are the Source of Value.
• Principle 5: Individuals Respond to Incentives.

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TYPES OF CAPITAL INVESTMENT PROJECTS
1. Revenue enhancing Investments (such as introducing a new product line),
2. Cost-reducing investments (such as replacing old equipment with a more
efficient equipment), and
3. Mandatory investments that are a result of government mandates (such as
investments to meet safety and environmental regulations)

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TYPES OF CAPITAL INVESTMENT PROJECTS
• The net present value (NPV) is the difference between the present value of cash
inflows and the cash outflows. NPV estimates the amount of wealth that the
project creates.
• Decision Criteria: Investment projects should be accepted if the NPV of the
project is positive and should be rejected if the NPV is negative.

Cash Flow Cash Flow Cash Flow

Net Present Cash Flow for Year 1 (CF1 ) for Year 2 (CF2 ) for Year n (CFn )
   
Value (NPV ) for Year 0 (CF0 )  Discount 1  Discount 
2
 Discount 
n

1  1   1  
 Rate (k )   Rate (k )   Rate (k ) 
 

Cost of making the investment = Initial cash

Present value of the investment’s cash inflows = Present
flow (this is typically a cash outflow, taking
value of the project’s future cash inflows
on a negative value)
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CALCULATING AN INVESTMENT’S NPV
NPV reflects the first three principles:
• The project’s cash flows are used to measure the benefits the project provides
(Principle 3, cash flows are the source of value),
• cash flows are discounted back to the present (Principle 1, money has time value),
and
• the discount rate used to discount the cash flows back to the present reflects the
risk in the future cash flows (Principle 2, There is a risk-return tradeoff)

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THE PROBLEM
Saber Electronics provides specialty manufacturing services to defense contractors
located in the Seattle, Washington area. The initial outlay is $3 million and,
management estimates that the firm might generate cash flows for years one
through five equal to $500,000; $750,000; $1,500,000; $2,000,000; and
$2,000,000. Saber uses a 20% discount rate for projects of this type. Is this a
good investment opportunity?

Cash flows
(in $ millions)

Net Present Value = ?

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DECIDE ON A SOLUTION STRATEGY
• We need to analyze if this is a good investment opportunity. We can do that by
computing the Net Present Value (NPV), which requires computing the present
value of all cash flows.
• We can compute the NPV by using a mathematical formula, a financial calculator
or a spreadsheet.

Using a Mathematical Formula

Cash Flow Cash Flow Cash Flow
Net Present Cash Flow for Year 1 (CF1 ) for Year 2 (CF2 ) for Year n (CFn )
   
Value (NPV ) for Year 0 (CF0 )  Discount 1  Discount 
2
 Discount 
n

1  1   1  
 Rate (k )   Rate (k )   Rate (k ) 
 

Cost of making the investment = Initial Present value of the investment’s cash inflows = Present
cash flow (this is typically a cash value of the project’s future cash inflows
outflow, taking on a negative value)
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SOLVE
• NPV = −$3m + $.5m/(1.2) + $.75m/(1.2)2 + $1.5m/(1.2)3 + $2m/(1.2)4 +
$2m/(1.2)4
• NPV = −$3,000,000 + $416,666.67 + $520,833.30 + $868,055.60 +
$964,506 + $803,755.10
• NPV = $573,817
Using an Excel Spreadsheet
NPV = NPV (discount rate, CF1-5 ) - CF0 • The project requires an initial investment of
= NPV(.20, 500000, 750000, 1500000, $3,000,000 and generates futures cash flows
that have a present value of $3,573,817.
2000000,2000000) − 3000000
Consequently, the project cash flows are
= $573,817 $573,817 more than the required investment.
• Since the NPV is positive, the project is an
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acceptable project.
INDEPENDENT VERSUS MUTUALLY EXCLUSIVE INVESTMENT PROJECTS
• An independent investment project is one that stands alone and can be
undertaken without influencing the acceptance or rejection of any other project.
1. Calculate NPV;
2. Accept the project if NPV is positive and reject if it is negative.
• Accepting a mutually exclusive project prevents another project from being
accepted.
1. Substitutes – When a firm is analyzing two or more alternative investments, and each performs
the same function.
2. Firm Constraints – Firm faces constraints such as limited managerial time or limited financial
capital that limit its ability to invest in every positive NPV project.

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INVESTMENT DECISION
CRITERIA

Equivalent Annual Cost (EAC) or

Equivalent Annual Annuity (EAA)
CHOOSING BETWEEN MUTUALLY EXCLUSIVE INVESTMENTS
• If mutually exclusive investments have equal lives, we will calculate the NPVs and
choose the one with the higher NPV.
• If mutually exclusive investments do not have equal lives, we must calculate the
Equivalent Annual Cost (EAC). The EAC technique provides an estimate of the
annual cost of owning and operating the investment over its lifetime. We will then
select the one that has a lower EAC.
CF1 CF2 CFn
CF0   
Equivalent PV of Costs (1  k ) (1  k )
1 2
(1  k )n NPV
  
Annual Cost (EAC ) Annuity Present Value 1 1  1 1 
Interest Factor  k  k (1  k )n   k  k (1  k )n 
   

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THE PROBLEM
• What is the EAC for machine A that costs $50,000, requires payment of $6,000
per year for maintenance and operation expense, and lasts for 6 years? You
may assume that the discount rate is 9% and there will be no salvage value
associated with the machine. In addition, you intend to replace this machine at the
end of its life with an identical machine with identical costs.
k = 9%

Cash flows
(in $, thousands)
EAC = ?

Using a Mathematical Formula

It requires 2 steps:
1. Computation of NPV
2. Computation of EAC

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SOLVE NPV
Cash Flow Cash Flow Cash Flow
Net Present Cash Flow for Year 1 (CF1 ) for Year 2 (CF2 ) for Year n (CFn )
   
Value (NPV ) for Year 0 (CF0 )  Discount 1  Discount 
2
 Discount 
n

1  1   1  
 Rate (k )   Rate (k )   Rate (k ) 
 

Cost of making the investment = Initial Present value of the investment’s cash inflows = Present
cash flow (this is typically a cash outflow, value of the project’s future cash inflows
taking on a negative value)

NPV A = −$50,000 + PV of $6,000 each year

= −$50,000 + −$6,000 (PV of Annuity Factor)
= −$50,000 + −$6,000 {[1−(1/(1.09)6] ÷ (.09)}
= −$50,000 + −$6,000 {4.4859) = −$76,915

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SOLVE EAC
EAC A = NPV ÷ Annuity Factor
= −$76,915 ÷ 4.4859
= −$17,145.95 (Proyek 6 tahun)

Misalnya ada mesin lain yang kinerja sama tetapi masanya

berbeda yaitu EAC B = −$20,000 untuk proyek 3 tahun maka
dipilih yang EAC paling kecil yaitu EAC A.

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INVESTMENT DECISION
CRITERIA

The profitability index (PI)

PROFITABILITY INDEX
The profitability index (PI) is a cost-benefit ratio equal to the present
value of an investment’s future cash flows divided by its initial cost.
Decision Criteria:
– If PI is greater than one, the NPV will be positive and the investment should be
accepted
– When PI is less than one, which indicates a bad investment, NPV will be negative
and the project should be rejected.

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PROBLEM

PNG Pharmaceuticals is considering an investment in a

new automated materials handling system that is
expected to reduce its drug manufacturing costs by
eliminating much of the waste currently involved in its
specialty drug division. The new system will require an
initial investment of $50,000 and is expected to
provide cash savings over the next six-year period as
shown on next slide.

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 SOLVE THE PROBLEM
k = 10%

(in $, thousands)
The PI for a project is equal to the present value of the project’s
PI = ? expected cash flows for years 1-6 divided by the initial outlay.
PI = PV of expected cash flows ÷ −Initial outlay
We can proceed in two steps:
1. Compute PV of expected cash flows by discounting the cash
flows from Year 1 to Year 6 at 10%.
PVt = CFt ÷ (1.09)t
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2. Compute PI
COMPUTING PV OF CASH INFLOWS

Compute the PI • PNG Pharmaceuticals requires an initial investment of

PI = PV of expected CF1-6 ÷ Initial Outlay $50,000 and provides future cash flows that have a
= $53,681.72 ÷ $50,000 present value of $53,681.72. Thus, PI is equal to 1.0733.
= 1.0733
• It is an acceptable project since PI is greater than one.
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INVESTMENT DECISION
CRITERIA

The internal rate of return

(IRR)
INTERNAL RATE OF RETURN
The internal rate of return (IRR) of an investment is analogous to the yield to maturity
(YTM) on a bond as defined in Chapter 9. Specifically, the IRR is the discount rate that
results in a zero NPV for the project.

Cash Flow Cash Flow

Net Present Cash Flow for Year 1 (CF1 ) for Year 2 (CF2 )
  1
 2
Value for Year 0 (CF0 )  Internal Rate   Internal Rate 
1  1 
 of Return (IRR )   of Return (IRR ) 
Cash Flow
for Year n (CFn )
 n
0
 Internal Rate 
1  
 of Return (IRR ) 

Decision Criteria: Accept the project if the IRR is greater than the required rate of
return or discount rate used to calculate the net present value of the project, and
23 reject it otherwise.
THE PROBLEM
Knowledge Associates is a small consulting firm in Portland, Oregon, and
they are considering the purchase of a new copying center for the office
that can copy, fax, and scan documents. The new machine costs $10,010 to
purchase and is expected to provide cash flow savings over the next four
years of $1,000; $3,000; $6,000; and $7,000.
The employee in charge of performing financial analysis of the proposed
investment has decided to use the IRR as her primary criterion for making
a recommendation to the managing partner of the firm. If the discount
rate the firm uses to value the cash flows from office equipment purchases
is 15%, is this a good investment for the firm?

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 SOLVE THE PROBLEM

IRR = ?

• Here we have to calculate the project’s IRR. IRR is equal to the discount rate that makes the
present value of the future cash flows (in years 1-4) equal to the initial cash outflow of
$10,010.
• We can compute the IRR using trial & error, financial calculator or an excel spreadsheet.
Using a Mathematical Formula
– This will require finding the rate at which NPV is equal to zero.
– We compute the NPV at different rates to determine the range of IRR.
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SOLVE THE PROBLEM
Using an Excel Spread sheet
• When the first cash flow is
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• The new copying center requires
an initial investment of $10,010
and provides future cash flows
that offer a return of 19%. Since
the firm has decided 15% as the
minimum acceptable return, this is
a good investment for the firm.
negative and the subsequent cash
flows are positive, there is one
unique IRR. However, there can
be multiple values for the IRR
when at least one of the later cash
flow is negative. Checkpoint 10.5
demonstrates a project that has
two IRRs.
THE PROBLEM
Suppose that the firm is considering the above investment is able to pay
an additional $65,000 in year 0, which pays for cleanup expenses at the
end of the project’s life in year 3. In its previous analysis, the firm
estimated these costs to be $100,000, so the year 3 cash outflow is
reduced to $210,000. What is your estimate of the firm’s NPV and IRR for
the project based on the renegotiated cash flows?

IRR, NPV = ?

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SOLVE THE PROBLEM

• There are three IRRs for this project 0%,

100% and 200%. At all of these rates, NPV
is equal to zero.
• However, NPV will be a better decision tool
to use under this situation as it is not subject to
multiple answers like IRR.

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USING THE IRR WITH MUTUALLY EXCLUSIVE INVESTMENTS
Figure 11.1 shows that if we use NPV, project AA+ is better while if we
use IRR, project BBR is better. How to select under such circumstances?
– Use NPV as it will give the correct ranking for the projects.
• Both alternatives have positive NPVs and IRRs that
exceed Apex’s 15% required rate of return.
• However, the projects are ranked differently using NPV
or IRR: AA+ has the higher NPV, while BBR has a higher
IRR.
• The ranking difference is due to the effect of discounting
and the difference in the patterns of the cash flows for
the two projects.
• AA+’s cash flows increase over time, while BBR’s
decrease.
• Higher discount rates have a disproportionate effect on
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present values, as we see in Panel B.
INVESTMENT DECISION
CRITERIA

The Modified internal rate of

return (MIRR)
MODIFIED INTERNAL RATE OF RETURN
Modified Internal Rate of Return (MIRR) eliminates the problem of multiple IRRs. MIRR
rearranges the project cash flows such that there is only one change in the sign of the
cash flows over the life of the project. There are two steps to computing MIRR.
Step 1: Modify the project’s cash flow stream by discounting the negative future cash
flows back to the present using the discount rate. The present value of these future
negative cash flows is then added to the initial outlay to form a modified project cash
flow stream
Step 2: MIRR = IRR (modified cash flow stream).

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THE PROBLEM
Analyze the MIRR for the preceding problem where the required rate of return used to
discount the cash flows is 8%. What is the MIRR?
• If we use IRR, we will get multiple IRRs
as there are two sign changes in cash
flow stream.
• We can use MIRR by doing the
following:
First Second – First, discount the year 2
Sign Sign negative cash flows back to year
change change 0 using the 8% discount rate.
– Second, calculate the MIRR of
the resulting cash flows for years
0 and 1.

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SOLVE THE PROBLEM
First, discount the year 2 negative cash flows back to year 0 using the 8% discount rate

We were able to
−$265,947 compute IRR by
−$500,947 eliminating the second
sign change and thus
The modified cash flow stream is as follows: modifying the cash
flows. MIRR is not the
same as IRR as
modified cash flows are
• Calculating the IRR for the above modified cash flows produces discounted based on the
MIRR equal to 7.9% discount rate used to
calculate NPV (which is
not the same as IRR).
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INVESTMENT DECISION
CRITERIA

The Payback period

PAYBACK PERIOD
• The Payback period for an investment opportunity is the number of years needed to
recover the initial cash outlay required to make the investment.
• Decision Criteria: Accept the project if the payback period is less than a prespecified
maximum number of years.
Limitations
1. It ignores the time value of money
2. It ignores cash flows that are generated by the project beyond the end of the
payback period.
3. It utilizes an arbitrary cutoff criterion.

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TABLE 11.1 LIMITATIONS OF THE PAYBACK PERIOD CRITERION

The payback period

equals two years for both
projects because it takes
two years to recover the
cost of the initial outlay
from the cash inflows.
However, Project Long
looks a lot better because
it continues to provide
cash inflows after the
payback year.

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INVESTMENT DECISION
CRITERIA

The Discounted Payback

period
DISCOUNTED PAYBACK PERIOD
• Discounted payback period approach is similar except that it uses discounted cash
flows to calculate the payback period.
• Decision Criteria: Accept the project if its discounted payback period is less than the
pre-specified number of years. (Example Discount Rate = 17 percent)
The discounted payback
period equals 2.97 years for
Project Long. Three years of
discounted cash flows sum to
a positive $476. However,
since we need to sum to 0,
we do not need a full three
years of discounted cash
flows (we need
$18,256/$18,731 = .97 of
Year 3’s cash inflow).
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INVESTMENT DECISION
CRITERIA

The Survey
A GLANCE AT ACTUAL CAPITAL BUDGETING PRACTICES

• Figure 11.2 provides the results of a survey of the

CFOs of large US firms, showing the popularity of
various tools.
• The results show that NPV and IRR methods are by
far the most widely used methods, although more
than half the firms surveyed did use the Payback
method.

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TABLE 11.3 BASIC CAPITAL—BUDGETING TECHNIQUES

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TABLE 11.3 BASIC CAPITAL—BUDGETING TECHNIQUES

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TABLE 11.3 BASIC CAPITAL—BUDGETING TECHNIQUES

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TABLE 11.3 BASIC CAPITAL—BUDGETING TECHNIQUES

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