Chapter 9: Net Present Value and Other Investment Criteria

Capital budgeting is a critical aspect of financial decision-making for businesses and

organizations. In Chapter 9, the first in a series of three chapters on capital budgeting,
we dive into various investment appraisal techniques that play a pivotal role in
evaluating potential projects and investments. This chapter focuses on methods such as
Net Present Value (NPV), Internal Rate of Return (IRR), payback period, discounted
payback, and accounting rate of return. The aim is to provide students with an intuitive
understanding of these methods, their advantages and limitations, and the factors to
consider when selecting the most appropriate approach for a given investment. To bring
these concepts to life, we present a mini-case study centered around Bullock Gold
Mining, offering a practical application of these capital budgeting techniques in a real-
world context with nonstandard cash flows.

Capital budgeting involves the process of assessing and selecting long-term investment
projects that can generate value for a company or organization. It's a critical function
because the decisions made in capital budgeting can significantly impact a company's
profitability, growth, and overall financial health.

One of the fundamental tools in capital budgeting is Net Present Value (NPV). NPV is a
financial metric that calculates the difference between the present value of cash inflows
and outflows associated with an investment project. In other words, it measures the net
benefit or value that an investment project is expected to generate in today's dollars. A
positive NPV indicates that the project is expected to increase the value of the firm,
while a negative NPV suggests that the project may erode value.

The formula for calculating NPV is as follows:

NPV = Σ (Cash Inflows / (1 + r)^t) - Initial Investment

Where:

 Σ denotes the summation of cash flows over each period.

 Cash Inflows represent the expected cash received from the project.
 r is the discount rate, reflecting the cost of capital or the required rate of return.
 t represents the time period.

The chapter delves into NPV in detail, explaining the significance of discounting future
cash flows to their present value. It illustrates how NPV allows organizations to
determine whether an investment is financially viable and whether it is expected to
generate a positive return that exceeds the cost of capital.
In addition to NPV, the chapter explores other investment criteria, including the Internal
Rate of Return (IRR). IRR represents the discount rate that makes the net present value
of an investment equal to zero. It can be thought of as the rate of return the investment
is expected to yield over its life. IRR is a crucial metric because it provides insights into
the project's internal profitability, allowing decision-makers to compare it with the cost
of capital. If the IRR exceeds the cost of capital, the project is generally considered
attractive.

The chapter also covers metrics like the payback period, which measures the time it
takes to recover the initial investment through project cash flows. While the payback
period offers a straightforward assessment of how quickly an investment pays for itself,
it does not consider the time value of money and may overlook the project's long-term
profitability. Therefore, the chapter emphasizes the importance of complementing the
payback period with other metrics like NPV and IRR.

Discounted payback is another technique introduced in this chapter, addressing the

shortcomings of the traditional payback period by accounting for the time value of
money. It considers the time it takes to recover the initial investment when cash flows
are discounted to their present value.

Furthermore, the chapter explores the accounting rate of return, which assesses the
project's profitability by comparing accounting profits to the initial investment. While
this metric is easy to calculate, it may not provide an accurate reflection of a project's
financial viability, as it ignores cash flows and the time value of money.

To provide students with a practical application of these investment appraisal

techniques, the chapter includes a mini-case study focused on Bullock Gold Mining. In
this scenario, students are tasked with evaluating the investment opportunity presented
by a gold mining project, where cash flows occur at various points in time and may not
follow a standard pattern. This mini-case allows students to apply their understanding of
NPV, IRR, payback period, and other criteria to assess the project's financial feasibility
and recommend a course of action.

The Bullock Gold Mining mini-case presents a realistic challenge that requires students
to consider the project's nonstandard cash flows, which may include initial investments,
operating cash flows, and terminal cash flows at the end of the project's life. It also
prompts students to think critically about the discount rate, considering factors such as
the project's risk profile and market conditions.
In summary, Chapter 9: Net Present Value and Other Investment Criteria is a
foundational component of any finance curriculum. It equips students and finance
professionals with a comprehensive understanding of investment appraisal techniques
used in capital budgeting. By exploring NPV, IRR, payback period, discounted payback,
and accounting rate of return, this chapter provides a robust toolkit for evaluating
investment opportunities and making informed financial decisions. The inclusion of the
Bullock Gold Mining mini-case offers students practical experience in applying these
techniques to real-world scenarios, where cash flows may not follow a conventional
pattern. Armed with this knowledge, students are better prepared to assess the financial
viability of projects and investments, contributing to sound decision-making in both
their professional and personal financial endeavors.