Chap 7 - Investment Desicion Rules 3ed

Chapter 7
Investment
Decision Rules
Chapter Outline
7.1 NPV and Stand-Alone Projects

7.2 The Internal Rate of Return Rule
7.3 The Payback Rule
7.4 Choosing Between Projects
7.5 Project Selection with Resource
Constraints
Copyright ©2014 Pearson Education, Inc. All rights reserved. 7-2

7.1 NPV and Stand-Alone
Projects
• Consider a take-it-or-leave-it investment

decision involving a single, stand-alone
project for Fredrick’s Feed and Farm (FFF).
– The project costs $250 million and is expected to
generate cash flows of $35 million per year,
starting at the end of the first year and lasting
forever.
NPV Rule
• The NPV of the project is calculated as:
• The NPV is dependent on the discount rate.

Figure 7.1 NPV of Fredrick’s
Fertilizer Project
• If FFF’s cost of capital is 10%, the NPV is $100 million and they
should undertake the investment.
7.2 The Internal Rate of Return

Rule
• Internal Rate of Return (IRR)

Investment Rule
– Take any investment where the IRR exceeds the
cost of capital. Turn down any investment whose
IRR is less than the cost of capital.

Alternative Rules Versus the NPV
Rule
• Sometimes alternative investment rules

may give the same answer as the NPV rule,
but at other times they may disagree.
– When the rules conflict, the NPV decision rule
should be followed.
The Internal Rate of Return Rule

(cont'd)
• The IRR Investment Rule will give the same

answer as the NPV rule in many, but not all,
situations.
• In general, the IRR rule works for a
stand-alone project if all of the project’s
negative cash flows precede its positive
cash flows.
– In Figure 7.1, whenever the cost of capital is
below the IRR of 14%, the project has a positive
NPV and you should undertake the investment.

Applying The IRR Rule
• In other cases, the IRR rule may disagree

with the NPV rule and thus be incorrect.
– Situations where the IRR rule and NPV rule may
be in conflict:
• Delayed Investments
• Nonexistent IRR
• Multiple IRRs
Applying The IRR Rule (cont'd)
– Assume you have just retired as the CEO of a
successful company. A major publisher has
offered you a book deal. The publisher will pay
you $1 million upfront if you agree to write a
book about your experiences. You estimate that
it will take three years to write the book. The
time you spend writing will cause you to give up
speaking engagements amounting to $500,000
per year. You estimate your opportunity cost to
be 10%.

– Should you accept the deal?
• Calculate the IRR.
– The IRR is greater than the cost of capital. Thus,

the IRR rule indicates you should accept the
deal.
– Should you accept the deal?
– Since the NPV is negative, the NPV rule indicates

you should reject the deal.

Figure 7.2 NPV of Star’s $1 Million
Book Deal
• When the benefits of an investment occur before the costs, the NPV
is an increasing function of the discount rate.
• Multiple IRRs
– Suppose Star informs the publisher that it needs
to sweeten the deal before he will accept it. The
publisher offers $550,000 advance and
$1,000,000 in four years when the book is
published.
– Should he accept or reject the new offer?

• Multiple IRRs
– The cash flows would now look like:
– The NPV is calculated as:
If r = 10%, NPV = -$10,000

• Multiple IRRs
– By setting the NPV equal to zero and solving for
r, we find the IRR. In this case, there are two
IRRs: 7.164% and 33.673%. Because there is
more than one IRR, the IRR rule cannot be
applied.

Figure 7.3 NPV of Star’s Book Deal
with Royalties
• Multiple IRRs
– Between 7.164% and 33.673%, the book deal
has a negative NPV. Since your opportunity cost
of capital is 10%, you should reject the deal.

• Nonexistent IRR
– Finally, Star is able to get the publisher to
increase his advance to $750,000, in addition to
the $1 million when the book is published in four
years. With these cash flows, no IRR exists;
there is no discount rate that makes NPV equal
to zero.
Figure 7.4 NPV of Star’s Final Offer
• No IRR exists because the NPV is positive for all values of the
discount rate. Thus the IRR rule cannot be used.

• IRR Versus the IRR Rule

– While the IRR rule has shortcomings for making
investment decisions, the IRR itself remains
useful. IRR measures the average return of the
investment and the sensitivity of the NPV to any
estimation error in the cost of capital.
Textbook Example 7.1

Textbook Example 7.1 (cont’d)
Figure 7.5 NPV Profiles for Example

7.1
While the IRR Rule works for project A, it fails for
each of the other projects.

7.3 The Payback Rule
• The payback period is amount of time it

takes to recover or pay back the initial
investment. If the payback period is less
than a pre-specified length of time, you
accept the project. Otherwise, you reject
the project.
– The payback rule is used by many companies
because of its simplicity.

Textbook Example 7.2 (cont'd)
Alternative Example 7.2
• Problem
– Projects A, B, and C each have an expected life
of 5 years.
– Given the initial cost and annual cash flow
information below, what is the payback
period for each project?
A B C
Cost $80 $120 $150
Cash Flow $25 $30 $35

• Solution
– Payback A
• $80 ÷ $25 = 3.2 years
– Project B
• $120 ÷ $30 = 4.0 years
– Project C
• $150 ÷ $35 = 4.29 years
The Payback Rule (cont’d)
• Pitfalls:
– Ignores the project’s cost of capital and time
value of money.
– Ignores cash flows after the payback period.
– Relies on an ad hoc decision criterion.

7.4 Choosing Between Projects
• Mutually Exclusive Projects

– When you must choose only one project among
several possible projects, the choice is mutually
exclusive.
– NPV Rule
• Select the project with the highest NPV.
– IRR Rule
• Selecting the project with the highest IRR may lead
to mistakes.

• Problem
– A small commercial property is for sale near your university.
Given its location, you believe a student-oriented business
would be very successful there. You have researched several
possibilities and come up with the following cash flow
estimates (including the cost of purchasing the property).
Which investment should you choose?
Initial First-Year Growth Cost of

Project
Investment Cash Flow Rate Capital
Used Book Store $250,000 $55,000 4% 7%
Sandwich Shop $350,000 $75,000 4% 8%
Hair Salon $400,000 $120,000 5% 8%
Clothing Store $500,000 $125,000 8% 12%

Alternative Example 7.3 (cont’d)
• Solution
– Assuming each business lasts indefinitely, we can compute
the present value of the cash flows from each as a constant
growth perpetuity. The NPV of each project is
– Thus, all of the alternatives have a positive NPV. But

because we can only choose one, the clothing store is the
best alternative.
IRR Rule and Mutually Exclusive

Investments: Differences in Scale
• If a project’s size is doubled, its NPV will

double. This is not the case with IRR. Thus,
the IRR rule cannot be used to compare
projects of different scales.

Investments: Differences in Scale (cont’d)
– Consider two of the projects from Example 7.3
Bookstore Coffee Shop

Initial Investment $300,000 $400,000
Cash FlowYear 1 $63,000 $80,000
Annual Growth Rate 3% 3%
Cost of Capital 8% 8%
IRR 24% 23%
NPV $960,000 $1,200,000

Investments: Timing of Cash Flows
• Another problem with the IRR is that it can be

affected by changing the timing of the cash flows,
even when the scale is the same.
– IRR is a return, but the dollar value of earning a given
return depends on how long the return is earned.
• Consider again the coffee shop and the music store
investment in Example 7.3. Both have the same
initial scale and the same horizon. The coffee shop
has a lower IRR, but a higher NPV because of its
higher growth rate.

Investments: Differences in Risk
• An IRR that is attractive for a safe project

need not be attractive for a riskier project.
• Consider the investment in the electronics
store from Example 7.3. The IRR is higher
than those of the other investment
opportunities, yet the NPV is the lowest.
• The higher cost of capital means a higher
IRR is necessary to make the project
attractive.
7.5 Project Selection

with Resource Constraints
• Evaluation of Projects with Different Resource

Constraints
– Consider three possible projects with a $100
million budget constraint
Table 7.1 Possible Projects for a $100 Million Budget

Profitability Index
• The profitability index can be used to

identify the optimal combination of projects
to undertake.
– From Table 7.1, we can see it is better to take

projects II & III together and forego project I.

• Problem
– Suppose your firm has the following five positive NPV
projects to choose from. However, there is not enough
manufacturing space in your plant to select all of the
projects. Use profitability index to choose among the
projects, given that you only have 100,000 square feet of
unused space.
Project NPV Square feet needed
Project 1 100,000 40,000
Project 2 88,000 30,000
Project 3 80,000 38,000
Project 4 50,000 24,000
Project 5 12,000 1,000
Total 330,000 133,000
• Solution
– Compute the PI for each project.
Project NPV Square feet Profitability Index

needed (NPV/Sq. Ft)
Project 1 100,000 40,000 2.5
Project 2 88,000 30,000 2.93
Project 3 80,000 38,000 2.10
Project 4 50,000 24,000 2.08
Project 5 12,000 1,000
12.0
Total 330,000 133,000
• Solution
– Rank order them by PI and see how many
projects you can have before you run out of
space.
Project NPV Square Profitability Cumulative total
feet Index space used
needed (NPV/Sq. Ft)
Project 5 12,000 1,000 2.5 1,000
Project 2 88,000 30,000 2.93 31,000
Project 1 100,000 40,000 2.5 71,000
Project 3 80,000 38,000 2.11
Project 4 50,000 24,000 2.08

Homework
1. Your brother wants to borrow $10,000 from you. He has offered to pay you back $12,000 in a year.
If the cost of capital of this investment opportunity is 10%, what is its NPV? Should you undertake
the investment opportunity? Calculate the IRR and use it to determine the maximum deviation
allowable in the cost of capital estimate to leave the decision unchanged.
2. You are considering investing in a start-up company. The founder asked you for $200,000 today
and you expect to get $1,000,000 in nine years. Given the riskiness of the investment opportunity,
your cost of capital is 20%. What is the NPV of the investment opportunity? Should you undertake
the investment opportunity? Calculate the IRR and use it to determine the maximum deviation
3. You are considering opening a new plant. The plant will cost $100 million upfront. After that, it is
expected to produce profits of $30 million at the end of every year. The cash flows are expected to
last forever. Calculate the NPV of this investment opportunity if your cost of capital is 8%. Should
you make the investment? Calculate the IRR and use it to determine the maximum deviation
Copyright © 2011 Pearson Prentice Hall. All rights reserved. 6-47
Homework
7. You are a real estate agent thinking of placing a sign advertising your services at a local bus stop. The
sign will cost $5000 and will be posted for one year. You expect that it will generate additional
revenue of $500 per month. What is the payback period?
8. You are considering making a movie. The movie is expected to cost $10 million upfront and take a
year to make. After that, it is expected to make $5 million when it is released in one year and $2
million per year for the following four years. What is the payback period of this investment? If you
require a payback period of two years, will you make the movie? Does the movie have positive NPV if
the cost of capital is 10%?
9. Consider two investment projects, which both require an upfront investment of $10 million, and both
of which pay a constant positive amount each year for the next 10 years. Under what conditions can
you rank these projects by comparing their IRRs?

Homework
10. AOL is considering two proposals to overhaul its network infrastructure. They have received two
bids. The first bid, from Huawei, will require a $20 million upfront investment and will generate $20
million in savings for AOL each year for the next three years. The second bid, from Cisco, requires a
$100 million upfront investment and will generate $60 million in savings each year for the next three
years.
a. What is the IRR for AOL associated with each bid?
b. If the cost of capital for this investment is 12%, what is the NPV for AOL of each bid? Suppose
Cisco modifies its bid by offering a lease contract instead. Under the terms of the lease, AOL will
pay $20 million upfront, and $35 million per year for the next three years. AOL’s savings will be
the same as with Cisco’s original bid.
c. Including its savings, what are AOL’s net cash flows under the lease contract? What is the IRR
of the Cisco bid now?
d. Is this new bid a better deal for AOL than Cisco’s original bid? Explain.
Homework
11. Natasha’s Flowers, a local florist, purchases fresh flowers each day at the local flower market.
The buyer has a budget of $1000 per day to spend. Different flowers have different profit
margins, and also a maximum amount the shop can sell. Based on past experience, the shop has
estimated the following NPV of purchasing each type:
What combination of flowers should the shop purchase each day?

Homework
12. Kaimalino Properties (KP) is evaluating six real estate investments. Management plans
to buy the properties today and sell them five years from today. The following table
summarizes the initial cost and the expected sale price for each property, as well as the
appropriate discount rate based on the risk of each venture.
KP has a total capital budget of $18,000,000 to invest in properties.

a. What is the IRR of each investment?
b. What is the NPV of each investment?
c. Given its budget of $18,000,000, which properties should KP choose?
d. Explain why the profitably index method could not be used if KP’s budget were
$12,000,000 instead. Which properties should KP choose in this case?
Homework
13. Orchid Biotech Company is evaluating several development projects for experimental
drugs. Although the cash flows are difficult to forecast, the company has come up with
the following estimates of the initial capital requirements and NPVs for the projects.
Given a wide variety of staffing needs, the company has also estimated the number of
research scientists required for each development project (all cost values are given in
millions of dollars).
a. Suppose that Orchid has a total capital budget of $60 million. How should it prioritize
these projects?
b. Suppose in addition that Orchid currently has only 12 research scientists and does not
anticipate being able to hire any more in the near future. How should Orchid prioritize these
projects?
c. If instead, Orchid had 15 research scientists available, explain why the profitability index
ranking cannot be used to prioritize projects. Which projects should it choose now?

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Chapter 7

7.1 NPV and Stand-Alone Projects

Copyright ©2014 Pearson Education, Inc. All rights reserved. 7-2

• Consider a take-it-or-leave-it investment

Copyright ©2014 Pearson Education, Inc. All rights reserved. 7-3

• The NPV of the project is calculated as:

• The NPV is dependent on the discount rate.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 7-4

7.2 The Internal Rate of Return

• Internal Rate of Return (IRR)

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• Sometimes alternative investment rules

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The Internal Rate of Return Rule

• The IRR Investment Rule will give the same

Copyright ©2014 Pearson Education, Inc. All rights reserved. 7-8

• In other cases, the IRR rule may disagree

Copyright ©2014 Pearson Education, Inc. All rights reserved. 7-9

Applying The IRR Rule (cont'd)

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– The IRR is greater than the cost of capital. Thus,

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Applying The IRR Rule (cont'd)

– Since the NPV is negative, the NPV rule indicates

Copyright ©2014 Pearson Education, Inc. All rights reserved. 7-12

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Applying The IRR Rule (cont'd)

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– The NPV is calculated as:

If r = 10%, NPV = -$10,000

Applying The IRR Rule (cont'd)

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Applying The IRR Rule (cont'd)

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Figure 7.4 NPV of Star’s Final Offer

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• IRR Versus the IRR Rule

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Textbook Example 7.1

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Figure 7.5 NPV Profiles for Example

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• The payback period is amount of time it

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Textbook Example 7.2

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Alternative Example 7.2

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The Payback Rule (cont’d)

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• Mutually Exclusive Projects

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Textbook Example 7.3

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Alternative Example 7.3

Initial First-Year Growth Cost of

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