Chapter 9

NPV and other investment criteria

 PhD, Phan Hong Mai

 School of Banking and Finance
 National Economics University
 hongmai@neu.edu.vn

9-1
 Key Concepts and Skills

 Be able to compute payback and discounted

payback and understand their shortcomings
 Understand accounting rates of return and their
shortcomings
 Be able to compute internal rates of return
(standard and modified) and understand their
strengths and weaknesses
 Be able to compute the net present value and
understand why it is the best decision criterion
 Be able to compute the profitability index and
understand its relation to net present value
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Chapter Outline

9.1 Net Present Value

9.2 The Payback Rule
9.3 The Discounted Payback
9.4 The Average Accounting Return
9.5 The Internal Rate of Return
9.6 The Profitability Index
9.7 The Practice of Capital Budgeting
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The basic idea

What is a good decision criterion?

 Does the decision rule adjust for the time value

of money?
 Does the decision rule adjust for risk?
 Does the decision rule provide information on
whether we are creating value for the firm?

9-4 9-4
9.1 Net Present Value

Definition:

 The difference between the market value of a

project and its cost
 Used in capital budgeting to analyze the
profitability of a projected investment or
project.
 How much value is created from undertaking
an investment?

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 9.1 Net Present Value
Estimation:
 The first step is to estimate the expected future
cash flows.
 The second step is to estimate the required return
for projects of this risk level.
 The third step is to find the present value of the
cash flows and subtract the initial investment.
n
NCFt
NPV    CFo

t 1 ( 1  r )
t

9-6
9.1 Net Present Value

 You are reviewing a new project A and have

estimated the following cash flows:
 Year 0: CF = - $100
 Year 1: NCF = $10
 Year 2: NCF = $60
 Year 3: NCF = $80
 Your required return for assets of this risk level
is 10%. What is the NPV of the project A?

9-7
9.1 Net Present Value

Decision Rule:

 If the NPV is positive -> Accept the project.

 A positive NPV means that the project is
expected to add value to the firm and will
therefore increase the wealth of the owners.
 Since our goal is to increase owner wealth, NPV
is a direct measure of how well this project will
meet our goal.

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9.1 Net Present Value

 You are reviewing another project B and have

estimated the following cash flows:
 Year 0: CF = - $100
 Year 1: NCF = $70
 Year 2: NCF = $50
 Year 3: NCF = $20
 Your required return for assets of this risk level
is also 10%. What is the NPV of the project B?

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9.1 Net Present Value

 If projects are independent, accept if the

project NPV > 0.
 If projects are mutually exclusive, accept
projects with the highest positive NPV, those
that add the most value.

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9.1 Net Present Value

Is the NPV a good investment criterion?

 Does the NPV rule account for the time value of

money?
 Does the NPV rule account for the risk of the
cash flows?
 Does the NPV rule provide an indication about
the increase in value?

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9.1 Net Present Value

Disadvatages:

 The task of coming up with the cash flows and

the discounted rate is much more challenging.
 The value of NPV is an estimate. The only way
to find out the true NPV would be to place the
investment up for sale and see what we could
get for it. So our estimate can be reliable.

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 CONCEPT QUESTION 9.1

 What is the net present value?

 If we say an investment has an NPV of $1,000,
what exactly do we mean?

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9.2 Payback Period

Definition:

 The amount of time required for an investment

to generate cash flows sufficient to recover its
initial cost.
 How long does it take to get the initial cost
back in a nominal sense?

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 9.2 Payback Period

Computation:

 Estimate the cash flows.

 Subtract the future cash flows from the initial cost
until the initial investment has been recovered.

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9.2 Payback Period

 Here are expected cash flows of the project A

and the project B:
A B
 Year 0: CF = - $100 Year 0:CF = - $100
 Year 1: NCF = $10 Year 1:NCF = $70
 Year 2: NCF = $60 Year 2:NCF = $50
 Year 3: NCF = $80 Year 3:NCF = $20
 What is the PP of this investment?
 Which project should you accept?
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9.2 Payback Period

Decision Rule:

 An investment is acceptable if its calculated

payback period is less than some pre-specified
number of years.

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9.2 Payback Period

Is the Payback a good decision criterion?

 Does the payback rule account for the time

value of money?
 Does the payback rule account for the risk of
the cash flows?
 Does the payback rule provide an indication
about the increase in value?

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 9.2 Payback Period
19

Advantages:

 Easy to understand
 Adjusts for uncertainty of later cash flows
 Biased toward liquidity
 9.2 Payback Period
20

Disadvantages:

 Ignores the time value of money

 Requires an arbitrary cutoff point
 Ignores cash flows beyond the cutoff date
 Biased against long-term projects, such as
research and development, and new projects
 CONCEPT QUESTION 9.2

 In words, what is the payback period? The

payback period rule?
 Why do we say that the payback period is, in a
sense, an accounting break-even measure?

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9.3 Discounted Payback Period

Definition:

 The length of time required for an investment’s

discounted cash flows to equal its initial cost.
 Fixes the particular problem of payback period
that ignored the time value of money.

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9.3 Discounted Payback Period

Computation:

 Compute the present value of each cash flow.

 Then determine how long it takes to pay back
on a discounted basis.

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9.3 Discounted Payback Period

 Here are expected cash flows of the project A:

 Year 0: CF = - $100
 Year 1: NCF = $10
 Year 2: NCF = $60
 Year 3: NCF = $80
 What is the Discounted PP of this investment?
 Should you accept or reject the project A?

9-24
9.3 Discounted Payback Period

Decision Rule:

 Accept the project if it pays back on a

discounted basis within the specified time.

9-25
 9.3 Discounted Payback Period

Is the Discounted payback period a good

decision criterion?

 Does the discounted payback rule account for the

time value of money?
 Does the discounted payback rule account for the
risk of the cash flows?
 Does the discounted payback rule provide an
indication about the increase in value?

9-26
 9.3 Discounted Payback Period
27

Advantages:

 Includes time value of money

 Easy to understand
 Does not accept negative estimated NPV
investments when all future cash flows are
positive
 Biased towards liquidity
 9.3 Discounted Payback Period
28

Disadvantages:

 May reject positive NPV investments

 Requires an arbitrary cutoff point
 Ignores cash flows beyond the cutoff point
 Biased against long-term projects, such as
R&D and new products
 CONCEPT QUESTION 9.3

 In words, what is the discounted payback

period? Why do we say it is, in a sense, a
financial or economic break-even measure?
 What advantage(s) does the discounted payback
have over the ordinary payback?

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9.4 Average Accounting Return

Definition:

 There are many definitions of the AAR but, in

one form or another, AAR is always defied as:

Some measure of average accounting profit

Some measure of average accounting value

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9.4 Average Accounting Return

Computation:

 There are many ways to compute the average

accounting return. The one we will use is:

Average net income

Average book value
 Note that the average book value depends on
how the asset is depreciated.

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 9.4 Average Accounting Return
 Suppose you are deciding to open a small book
store in a new shopping mall. The required
investment is $500. The store would have a five-
year life because everything reverts to the mall
owners after that time. The required investment
would be 100% depreciated over five years. The
tax rate is 10%. This following table contains the
projected revenues and expenses.
 What is the AAR of this investment?
Year 1 Year 2 Year 3 Year 4 Year 5
Revenue $430 $450 $260 $200 $130
Expenses 200 150 100 100 100
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 9.4 Average Accounting Return

Decision rule:

 A project is acceptable if its average accounting

return exceeds a target average accounting return.

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9.4 Average Accounting Return

Is the AAR a good decision criterion?

 Does the AAR rule account for the time value of

money?
 Does the AAR rule account for the risk of the
cash flows?
 Does the AAR rule provide an indication about
the increase in value?

9-34
 9.4 Average Accounting Return
35

Advantages:

 Easy to calculate
 Needed information will usually be available
 9.4 Average Accounting Return
36

Disadvantages:

 Not a true rate of return; time value of money

is ignored
 Uses an arbitrary benchmark cutoff rate
 Based on accounting net income and book
values, not cash flows and market values
 CONCEPT QUESTION 9.4

 What is an average accounting rate of return?

 What are the weakness of the AAR rule?

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9.5 Internal Rate of Return

Definition:

 The discount rate that makes the NPV of an

investment zero.
 It is based entirely on the estimated cash
flows and is independent of interest rates
found elsewhere.
n
NCFt
NPV    CFo  0
t 1 ( 1  IRR )
t

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9.5 Internal Rate of Return

Estimation:

Three ways to determine IRR are:

 By trial and error
 By calculator/ financial calculator
 By function IRR(values,[guess]) in Excel

9-39
 9.5 Internal Rate of Return

 Here are expected cash flows of the project A:

 Year 0: CF = - $100
 Year 1: NCF = $10
 Year 2: NCF = $60
 Year 3: NCF = $80
 What is the IRR of the project A?
 If your required return for this investment is 10%.
Should you accept or reject the project A?

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 9.5 Internal Rate of Return

Decision Rule:

 Accept the project if the IRR is greater than

the required return.

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9.5 Internal Rate of Return

 NPV and IRR will generally give us the same

decision as long as two very important
condition are met.
 The cash flows must be conventional (the initial
investment is negative and all the rest are
positive)
 The project must be independent (the decision
accept or reject this project does not affect the
decision or reject any other).

9-42
 9.5 Internal Rate of Return

IRR and Nonconventional Cash Flows:

 When the cash flows change sign more than

once, there is more than one IRR
 When you solve for IRR you are solving for the
root of an equation, and when you cross the x-
axis more than once, there will be more than one
return that solves the equation
 If you have more than one IRR, which one do
you use to make your decision?
9-43
9.5 Internal Rate of Return

 Suppose an investment C will cost $90,000

initially and will generate the following cash
flows:
 Year 1: $132,000
 Year 2: $100,000
 Year 3: -$150,000
 The required return is 15%.
 Should you accept or reject the project C?

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 9.5 Internal Rate of Return

IRR and Mutually Exclusive Projects:

 If projects are mutually exclusive, you would use

the following decision rules:
 NPV – choose the project with the higher NPV
 IRR – choose the project with the higher IRR

9-45
 9.5 Internal Rate of Return

 Here is a graphical representation of project NPVs

at various different costs of capital.

WACC NPVL NPVS

0 $50 $40
5 33 29
10 19 20
15 7 12
20 (4) 5
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9.5 Internal Rate of Return
NPV
($)

.
60

. .
50

40

30 . . IRRL = 18.1%

.. .
20
IRRS = 23.6%
S
.
10
L
0
5 10 15
. . 20 23.6 Discount Rate (%)
-10
9-47
 9.5 Internal Rate of Return

 If the required return for both projects is 15%.

 Which project should you accept based on the
NPV rule?
 Which project should you accept based on the
IRR rule?
 If the required return for both projects is 5%.
 Which project should you accept based on the
NPV rule?
 Which project should you accept based on the
IRR rule?
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9.5 Internal Rate of Return

Is the IRR a good decision criterion?

 Does the IRR rule account for the time value of

money?
 Does the IRR rule account for the risk of the
cash flows?
 Does the IRR rule provide an indication about
the increase in value?

9-49
9.5 Internal Rate of Return

Advantages:

 Closely related to NPV, often leading to

identical decisions.
 Easy to understand and communicate.

9-50
9.5 Internal Rate of Return

Disdvantages:

 May result in multiple answers or not deal with

nonconventional cash flows.
 May lead to incorrect decisions in comparisons
of mutually exclusive investment.

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9.5 Internal Rate of Return

Modified Interal Rate of Return:

 MIRR is a modification of IRR and as such

aims to resolve the problem with the IRR
when the cash flows are nonconventional.
 The basic idea is to modify the cash flows
first, then calculate an IRR using modified
cash flows.

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 9.5 Internal Rate of Return
 Method 1 - The discounting approach: Discount all
negative cash flows back to the present at the
required return and add them to the initial cost.
Then calculate IRR.
 Method 2 – The reinvestment approach: Compound
all cash flows (except the first one) to the end of
the project’s life. Then calculate IRR.
 Method 3 – The combination approach: Negative
cash flows are discounted back to the present and
positive cash flows are compounded to the end of
the project. Then calculate IRR.
-> No clear reason to say which method is the best. 9-53
 CONCEPT QUESTION 9.5

 Under What circumstances will the IRR and NPV

rules lead to the same accept – reject decisions?
When might they conflict?
 Is it generally true that an advantage of the IRR
rule over the NPV rule is that we don’t need to
know the required return to use the IRR rule?

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9.6 Profitability Index

Definition:

 The present value of an investment’s future

cash flows dividend by its initial cost.
 Measures the benefit per unit cost, based on
the time value of money.

9-55
 9.6 Profitability Index

Computation:
 Find the present value of the cash flows.
 Then dividends by the initial investment.
n
NCFt

t 1 (1  r)
t
PI 
CFo
 PI of 1.1 implies that for every $1 of investment,
we create an additional $0.10 in value.
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9.6 Profitability Index

 You are reviewing a new project A and have

estimated the following cash flows:
 Year 0: CF = - $100
 Year 1: NCF = $10
 Year 2: NCF = $60
 Year 3: NCF = $80
 Your required return for assets of this risk level
is 10%. What is the PI of the project A?

9-57
9.6 Profitability Index

Decision rule:

 If projects are independent, accept if the PI is

higher than 1.
 If projects are mutually exclusive, accept
projects with the highest PI.

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9.6 Profitability Index

Is the PI a good decision criterion?

 Does the PI rule account for the time value of

money?
 Does the PI rule account for the risk of the
cash flows?
 Does the PI rule provide an indication about
the increase in value?

9-59
 9.6 Profitability Index
60

Advantages:

 Closely related to NPV, generally leading to

identical decisions
 Easy to understand and communicate
 May be useful when available investment funds
are limited
 9.6 Profitability Index
61

Disadvantages:

 May lead to incorrect decisions in comparisons

of mutually exclusive investments
 CONCEPT QUESTION 9.6

 What does the profitable index measure?

 How would you state the profitable index rule?

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 9.7 Capital Budgeting In Practice

 Capital budgeting is the process by which a

company determines whether projects are worth
pursuing. A project is worth pursuing if it increases
the value of the company.
 Steps to Capital Budgeting in practice:
 Estimate CFs (inflows & outflows).
 Assess riskiness of CFs.
 Determine the appropriate cost of capital.
 Find NPV and/or IRR.
 Accept if NPV > 0 and/or IRR > the required return.
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 SUMMARY and CONCLUSIONS

 A good capital budgeting criterion must tell us

two things: Is a particular project a good
investment? And if we have more than one good
project, but we can take only one of them,
which one should we take?
 NPV criterion can always provide the correct
answer to both above questions. However, NPV
can’t be observed in the market so financial
managers use other criteria to give additional
information about whether a project truly has a
positive NPV.
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 HOMEWORKS

Concepts review:
1, 2, 3, 4, 5, 6, 7, 8, 9.

Question and Problems:

1, 2, 3, 4, 6, 7, 9, 12, 14.

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