Net present value and Alternative

investment rules
Outline

I. 1. Recap Net present value (NPV)

II. 2. The payback period method
III. 3. The discounted payback period method
IV. 4. The Internal rate of return (IRR)
V. 5. The profitability index
3 xristics of good decision criteria

 Does the rule take the time value of money

into consideration?
 Does the rule adjust for risk?
 Does the rule tell us whether and by how
much the project add value to the firm?
A proposed project

 Your firm is looking at a new project that has

the following cash flows.
 Year 0: initial cost, C0 = 100,000.
 Year 1: CF1 = 30,000.
 Year 2: CF2 = 50,000.
 Year 3: CF3 = 60,000.
 The applicable discount rate is 10%.
1st method: the NPV rule

 NPV = PV – C0: the difference between the

present value of the investment’s future net
cash flows, i.e., benefits, and its initial cost.
 Ideas: (1) an investment is worth undertaking
if it creates value for its owners, and (2) an
investment creates value if it worth more than
it costs within the time value of money
framework.
Decision rule

 If NPV > = 0, accept the project.

 If NPV < 0, reject the project.
 A positive NPV suggests that the project is expected
to add value to the firm, and the project should
improve shareholders’ wealth.
 Because the goal of financial management is to
increase shareholders’ wealth, NPV is a good
measure of how well this project will meet this goal.
 Project NPV
Year CF C(0) PV NPV
0 100000 13674
1 30000 27272.7 >0
2 50000 41322.3 Accept!
3 60000 45078.9
113674
Discount rate 0.1
Judging the NPV rule

 Does the NPV rule take the time value of

money into consideration?
 Does the NPV rule adjust for risk?
 Does the NPV rule tell us whether and by
how much the project add value to the firm?
2nd method: payback period

 Payback period: the amount of time required

for an investment to generate after-tax cash
flows sufficient to recover its initial cost.
Decision rule

 An investment is accepted (rejected), if

payback period < (>) some specified number
of time period.
 The cutoff is arbitrarily chosen by the
manager or the entrepreneur.
Project payback period

Year CF C(0) Accu. CF $ to be recoved Payback period

0 100000
1 30000 30000 70000
2 50000 80000 20000 >2
3 60000 140000 -40000 <3
To be exact,
2+(20000/60000)
2.33 years
The decision

 The payback period is longer than 2 years

and shorter than 3 years.
 If the cutoff is 2 years, we’d reject the project.
 If the cutoff is 3 years, we’d accept the
project.
Judging the payback period rule

 Does the payback period rule take the time

value of money into consideration?
 Does the payback period rule adjust for risk?
 Does the payback period rule tell us whether
and by how much the project add value to
the firm?
The good and the bad

 Advantage:
 Easy to understand and communicate.
 Disadvantages:
 Ignores the time value of money.
 Fail to consider the riskness of the project, no i.
 Requires an arbitrary cutoff point.
 Ignores cash flows beyond the cutoff.
 Biased against long-term projects, such as R&Ds.
3rd method: discounted payback period

 Discounted payback period: the length of

time required for an investment’s discounted
cash flows to equal its initial cost.
Decision rule

 An investment is accepted (rejected), if

discounted payback period < (>) some
specified number of time period.
 Again, the cutoff is arbitrarily chosen.
Project discounted payback period

Year CF C(0) PV Accu. PV To be recovered Dis. Payback

0 100000
1 30000 27272.7 27272.727 72727.27273
2 50000 41322.3 68595.041 31404.95868 >2
3 60000 45078.9 113673.93 -13673.92938 <3

Discount rate 0.1 2+ (31404/45079)

2.70 years
The decision

 The discounted payback period is longer

than 2 years and shorter than 3 years.
 If the cutoff is 2 years, we’d reject the project.
 If the cutoff is 3 years, we’d accept the
project.
Judging discounted payback period

 Does the payback period rule take the time

value of money into consideration?
 Does the payback period rule adjust for risk?
 Does the payback period rule tell us whether
and by how much the project add value to
the firm?
The good and the bad

 Advantage:
o Still fairly easy to understand and communicate.
o Take TVM into consideration.
 Disadvantages:
o Requires an arbitrary cutoff point.
o Ignores cash flows beyond the cutoff.
o Biased against long-term projects, such as R&Ds.
4th method: IRR


Decision rule

 An investment is accepted (rejected), if the

IRR > (<) the required rate.
Project IRR

Year CF C(0) IRR-CF IRR PV

0 100000 -100000 17%
1 30000 30000 25686
2 50000 50000 36654
3 60000 60000 37660
100000
The decision

 The computed IRR is 17%, which is higher

than the 10% required rate. Thus, we accept
the project.
Judging the IRR

 Does the IRR rule take the time value of

money into consideration?
 Does the IRR rule adjust for risk?
 Does the IRR rule tell us whether and by how
much the project add value to the firm?
NPV vs. IRR

 For most projects, NPV and IRR lead to the same

conclusion.
 Practitioners really like to use IRR because this
measure gives practitioners a good idea about at
what rate they are able to earn. Knowing a return is
intuitively appealing.
5th method: the profitability index

 Profitability index (PI) = PV / C0.

 Often used for government or other non-for-
profit investments.
 Measures the benefit per unit cost, based on
the time value of money.
 A profitability index of 1.2 suggests that for
every $1 of initial investment, we create an
additional $0.20 in value.
 Decision rule
 For a project, we accept the project only if PI > 1.
 For mutually exclusive projects, practitioners
sometimes choose the project with the highest
PI.
Project PI

Year CF C(0) PV PI
0 100000 1.1367
1 30000 27272.73 >1
2 50000 41322.31 Accept!
3 60000 45078.89
113673.9
Discount rate 0.1
The good and the bad

 Advantages:
 Related to NPV, generally leading to identical
decisions.
 Easy to understand and communicate.
 Disadvantage:
 Should not be used for making mutually exclusive
decisions.
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