Chapter 05 - Net Present Value and Other Investment Rules

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Chapter 5
NET PRESENT VALUE AND OTHER INVESTMENT
RULES
SLIDES

5-1
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Chapter 05 - Net Present Value and Other Investment Rules

5.1 Key Concepts and Skills

5.2 Chapter Outline
5.3 Why Use Net Present Value?
5.4 The Net Present Value (NPV) Rule
5.5 Calculating NPV with Spreadsheets
5.6 The Payback Period Method
5.7 The Payback Period Method
5.8 The Discounted Payback Period
5.9 The Internal Rate of Return
5.10 Internal Rate of Return (IRR)
5.11 IRR: Example
5.12 NPV Payoff Profile
5.13 Calculating IRR with Spreadsheets
5.14 Problems with IRR
5.15 Mutually Exclusive vs. Independent
5.16 Multiple IRRs
5.17 Modified IRR
5.18 The Scale Problem
5.19 The Timing Problem
5.20 The Timing Problem
5.21 Calculating the Crossover Rate
5.22 NPV versus IRR
5.23 The Profitability Index (PI)
5.24 The Profitability Index
5.25 The Practice of Capital Budgeting
5.26 Example of Investment Rules
5.27 Example of Investment Rules
5.28 Example of Investment Rules
5.29 NPV and IRR Relationship
5.30 NPV Profiles
5.31 Summary – Discounted Cash Flow
5.32 Summary – Payback Criteria
5.33 Quick Quiz

CHAPTER WEB SITES

Section Web Address

5.1 www.missouribusiness.net
CHAPTER ORGANIZATION

5.1 Why Use Net Present Value?

5.2 The Payback Period Method

Defining the Rule
5-2
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Chapter 05 - Net Present Value and Other Investment Rules

Problems with the Payback Method

Managerial Perspective
Summary of Payback

5.3 The Discounted Payback Period Method

5.4 The Internal Rate of Return

5.5 Problems with the IRR Approach

Definition of Independent and Mutually Exclusive Projects
Two General Problems Affecting Both Independent and Mutually
Exclusive Projects
Problems Specific to Mutually Exclusive Projects
Redeeming Qualities of IRR
A Test

5.6 The Profitability Index

Calculation of Profitability Index

5.7 The Practice of Capital Budgeting

ANNOTATED CHAPTER OUTLINE

Slide 5.0 Chapter 5 Title Slide

Slide 5.1 Key Concepts and Skills
Slide 5.2 Chapter Outline
Lecture Tip: A logical prerequisite to the analysis of investment
opportunities is the creation of investment opportunities. Unlike
the field of investments, where the analyst more or less takes the
investment opportunity set as a given, the field of capital budgeting
relies on the work of people in the areas of engineering, research
and development, information technology, and others for the
creation of investment opportunities. As such, it is important to
remind students of the importance of creativity in this area, as well
as the importance of analytical techniques.

5-3
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Chapter 05 - Net Present Value and Other Investment Rules

5.1. Why Use Net Present Value?

Net present value – the difference between the present value of a

project’s future cash flows and its cost. Estimating cost is usually
straightforward; however, estimating future cash flows can be
tricky.

Slide 5.3 Why Use Net Present Value?

Lecture Tip: You may wish to take the opportunity to use this
example to illustrate the interpretation of NPV and its relationship
to organizational form. Specifically, assume that, in order to raise
the $50,000 needed to buy and rehab a house, you had sold 50,000
shares of stock in the venture for $1 apiece. Your father purchased
15,000 shares, your brother purchased 15,000 shares, and you
purchased the remaining 20,000 shares. How much are the shares
worth upon the sale of the house for $60,000? Your father’s share
of the selling price is $18,000 =(15,000/50,000)(60,000), as is
your brother’s. Your share is $24,000 =(20,000/50,000)(60,000).
In other words, the value created accrued to the owners of the
investment. This is the essence of the NPV approach: The NPV
measures the increase in firm value, which is also the increase in
the value of what the shareholders own. Thus, making decisions
with the NPV rule facilitates the achievement of our goal in
Chapter 1 – making decisions that will maximize shareholder
wealth.

Lecture Tip: Although this point may seem obvious, it is often

helpful to stress the word “net” in net present value. It is not
uncommon for some students to carelessly calculate the PV of a
project’s future cash flows and fail to subtract out its cost (after
all, this is what the programmers of Lotus and Excel did when they
programmed the NPV function). The PV of future cash flows is not
NPV; rather, NPV is the amount remaining after offsetting the PV
of future cash flows with the initial cost. Thus, the NPV amount
determines the incremental value created by undertaking the
investment.

Slide 5.4 The Net Present Value (NPV) Rule

Discounted cash flow (DCF) valuation – finding the market value
of assets or their benefits by taking the present value of future cash
flows, i.e., by estimating what the future cash flows would trade
for in today’s dollars.

5-4
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Chapter 05 - Net Present Value and Other Investment Rules

Lecture Tip: Here is another perspective on the meaning of NPV.

If we accept a project with a negative NPV of -$2,422, this is
financially equivalent to investing $2,422 today and receiving
nothing in return. Therefore, the total value of the firm would
decrease by $2,422. This assumes that the various components
(cash flow estimates, discount rate, etc.) used in the computation
are correct.

The benefit of NPV is that it measures the magnitude, timing, and

risk of cash flows, which further illustrates its link to the firm’s
stock price.

If NPV > 0, then accepting the project creates value. So, to

maximize value, choose projects with the highest NPV.

Lecture Tip: In practice, financial managers are rarely presented

with zero NPV projects for at least two reasons. First, in an
abstract sense, zero is just another of the infinite number of values
the NPV can take; as such, the likelihood of obtaining any
particular number is small. Second, and more pragmatically, in
most large firms capital investment proposals are submitted to the
finance group from other areas for analysis. Those submitting
proposals recognize the ambivalence associated with zero NPVs
and are less likely to send them to the finance group in the first
place.
Conceptually, a zero-NPV project earns exactly its required
return. Assuming that risk has been adequately accounted for,
investing in a zero-NPV project is equivalent to purchasing a
financial asset in an efficient market. In this sense, one would be
indifferent between the capital expenditure project and the
financial asset investment. Further, since firm value is completely
unaffected by the investment, there is no reason for shareholders to
prefer either one.
However, several real-world considerations make such
comparisons difficult. For example, adjusting for risk in capital
budgeting projects can be problematic. And, some investment
projects may have benefits that are difficult to quantify, but exist,
nonetheless. Consider an investment with a low or zero NPV that
enhances a firm’s image as a good corporate citizen. Additionally,
the secondary market for most physical assets is less efficient than
the secondary market for financial assets. While, in theory, you
can adjust for differences in liquidity, it is problematic. Finally, all
else equal, some investors prefer larger firms to smaller; if true,
investing in any project with a nonnegative NPV may be desirable.

5-5
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Chapter 05 - Net Present Value and Other Investment Rules

Slide 5.5 Calculating NPV with Spreadsheets – Click on the Excel icon
to go to an embedded spreadsheet to see the correct and incorrect ways to
compute NPV in a spreadsheet.
5.2. The Payback Period Method

A. Defining the Rule

Slide 5.6 The Payback Period Method

Ethics Note: Because a project is financially sound, it must be
ethically sound, right? Well … the question of ethical
appropriateness is less frequently discussed in the context of
capital budgeting than that of financial appropriateness.
Consider the following simple example. An ABC poll in the
spring of 2004 found that one-third of students ages 12 – 17
admitted to cheating, and the percentage increased as the students
got older and felt more grade pressure. You might pose the ethical
question of whether it would be proper for a publishing company
to offer a new book “How to Cheat: A User’s Guide.” The
company has a cost of capital of 8% and estimates it could sell
10,000 volumes by the end of year one and 5,000 volumes in each
of the following two years. The immediate printing costs for the
20,000 volumes would be $20,000. The book would sell for $7.50
per copy and net the company a profit of $6 per copy after
royalties, marketing costs, and taxes. Year one net would be
$60,000.
From a capital budgeting standpoint, is it financially wise to
buy the publication rights? What is the NPV of this investment?
The year 0 cash flow is -20,000, year 1 is 60,000 and years 2 and 3
are 30,000 each. Given a cost of capital of 8%, the NPV is just
over $85,000. It looks good, right? Now ask the class if the
publishing of this book would encourage cheating and if the
publishing company would want to be associated with this text and
its message. Some students may feel that one should accept these
profitable investment opportunities, while others might prefer that
the publication of this profitable text be rejected due to the
behavior it could encourage. Although the example is simplistic,
this type of issue is not uncommon and serves as a starting point
for a discussion of the value of “reputational capital.”

Payback period – length of time until the accumulated cash flows

equal or exceed the original investment.

5-6
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Chapter 05 - Net Present Value and Other Investment Rules

Payback period rule – investment is acceptable if the calculated

payback is less than some prespecified number of years.

B. Problems with the Payback Method

Slide 5.7 The Payback Period Method

-No “real” discounting is involved (although, cash flows prior to
the cutoff are essentially discounted at a rate of zero, while cash
flows after the cutoff are discounted at an infinite rate)
-Does not consider risk differences
-How do we determine the cutoff point
-Bias toward short-term (liquid) investments

Redeeming Qualities of the Rule

-Simple to use
-Bias for short-term promotes liquidity

Lecture Tip: Interestingly, the payback period technique is used

quite heavily in determining the viability of certain investment
projects in the health care industry. Why?
Consider the nature of the health care industry: the technology
is rapidly changing, some of the equipment tends to be extremely
expensive, and the industry itself is increasingly competitive. What
this means is that, in many cases, an equipment purchase is
complicated by the fact that, while the machine may be able to
perform its function for, say, 6 years or more, new and improved
equipment is likely to be developed that will supersede the “old”
equipment long before its useful life is over. Demand from patients
and physicians for “cutting-edge technology” can drive a push for
new investment. In the face of such a situation, many hospital
administrators then focus on how long it will take to recoup the
initial outlay, in addition to the NPV and IRR of the equipment.

C. Managerial Perspective

Lecture Tip: Teaching the payback rule seems to put one in a

delicate situation – as the text indicates, the rule is flawed as an
indicator of project desirability. Yet, past surveys suggest that
practitioners often use it as a secondary decision measure. How
can we explain this apparent discrepancy between theory and
practice?

5-7
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Chapter 05 - Net Present Value and Other Investment Rules

While the payback period is widely used in practice, it is rarely

the primary decision criterion. As William Baumol pointed out in
the early 1960s, the payback rule serves as a crude “risk
screening” device – the longer cash is tied up, the greater the
likelihood that it will not be returned. The payback period may be
helpful when mutually exclusive projects are compared. Given two
similar projects with different paybacks, the project with the
shorter payback is often, but not always, the better project.

D. Summary of Payback

Advantages:
Easy to understand
Adjusts for the uncertainty of later cash flows
Biased towards liquidity

Disadvantages:
Ignores the time value of money
Requires an arbitrary cutoff point
Ignores cash flows beyond the cutoff date
Biased against long-term projects

Lecture Tip: The payback period can be interpreted as a naïve

form of discounting if we consider the class of investments with
level cash flows over arbitrarily long lives. Since the present value
of a perpetuity is the payment divided by the discount rate, a
payback period cutoff can be seen to imply a certain discount rate.

That is:
cost/annual cash flow = payback period cutoff
cost = annual cash flow times payback period cutoff

The PV of a perpetuity is: PV = annual cash flow / R. This

illustrates the inverse relationship between the payback period
cutoff and the discount rate.

Lecture Tip: Firms that have operations in countries with volatile

governments may also be concerned with quick paybacks. When
there is always a possibility that the government may seize your
assets, you want to make sure that you have recovered your
investment as quickly as possible.

5-8
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Chapter 05 - Net Present Value and Other Investment Rules

5.3. The Discounted Payback Period Method

Discounted payback rule – An investment is acceptable if its

discounted payback is less than some prespecified number of
years.

Slide 5.8 The Discounted Payback Period

Lecture Tip: The discounted payback period is the length of time
until accumulated discounted cash flows equal or exceed the initial
investment. Use of this technique entails all the work of NPV, but
its decision rule is arbitrary. Redeeming features of this approach
are that (1) the time value of money is accounted for and (2) if the
project pays back on a discounted basis, it has a positive NPV
(assuming no large negative cash flows after the cut-off period).

Advantages
-All those of the simple payback rule, plus, the time value of
money is taken into account (at least for cash flows prior to the
cutoff)
-If a project pays back on a discounted basis, and has all positive
cash flows after the initial investment, then it must have a positive
NPV

Disadvantages
-The arbitrary cut-off period may eliminate projects that would
increase firm value
-If there are negative cash flows after the cut-off period, the rule
may indicate acceptance of a project that has a negative NPV

5.4. The Internal Rate of Return

Slide 5.9 –
Slide 5.10 The Internal Rate of Return
Internal Rate of Return (IRR) – the rate that makes the present
value of the future cash flows equal to the initial cost or
investment. In other words, the discount rate that gives a project a
$0 NPV.

IRR decision rule – the investment is acceptable if its IRR exceeds

the required return.

5-9
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Chapter 05 - Net Present Value and Other Investment Rules

Ethics Note: Assume that to comply with the Air Quality Control
Act of 1989, a company must install three smoke stack scrubber
units to its ventilation stacks at an installed cost of $350,000 per
unit. An estimated $100,000 per unit in fines (after tax) could be
saved each year over the five-year life of the ventilation stacks. The
cost of capital is 14% for the firm. The analysis of the investment
results in a NPV of -$6,691.
Despite the financial assessment dictating rejection of the
investment, public policy might suggest acceptance of the project.
Should the firm exceed the minimum legal limits and be
responsible for the environment, even if this responsibility leads to
a wealth reduction for the firm? Is environmental damage merely a
cost of doing business? Could investment in a healthier working
environment result in lower long-term costs in the form of lower
future health costs? If so, might this decision result in an increase
in shareholder wealth? Notice that if the answer to this second
question is yes, it suggests that our original analysis omitted some
side benefits to the project.

Slide 5.11 IRR Example

Slide 5.12 NPV Payoff Profile

Net present value profile – plot of an investment’s NPV at various
discount rates.

Slide 5.13 Calculating IRR With Spreadsheets – Click on the Excel icon
to go to an embedded spreadsheet that illustrates how to compute IRR.
5.5. Problems with the IRR Approach

Slide 5.14 Problems with IRR

A. Definition of Independent and Mutually Exclusive Projects

Slide 5.15 Mutually Exclusive vs. Independent

Mutually exclusive investment decisions – taking one project
means another cannot be taken

Independent – a given project can be taken in conjunction with

other projects. Accept all that meet the minimum criteria.

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Chapter 05 - Net Present Value and Other Investment Rules

Lecture Tip: A good introduction to mutually exclusive projects

and non-conventional cash flows is to provide examples that
students can relate to. An excellent example of mutually exclusive
projects is the choice of which college or university to attend. Most
students apply and are accepted to more than one college, yet they
cannot realistically attend more than one at a time. Consequently,
they have to decide between mutually exclusive projects.

B. Two General Problems Affecting Both Independent and Mutually

Exclusive Projects

Problem 1: Investing or Financing?

If the cash flows are of loan type, meaning money is
received at the beginning and paid out over the life of the
project, then the IRR is really a borrowing rate, and lower
is better.

Problem 2: Multiple IRRs

Slide 5.16 Multiple IRRs

Non-conventional cash flows – the sign of the cash flows changes
more than once (or, as above, the cash inflow comes first and
outflows come later).

Lecture Tip: Non-conventional cash flows and multiple IRRs occur

when there is a net cost to shutting down a project. The most
common examples deal with collecting natural resources. After the
resource has been harvested, there is generally a cost associated
with restoring the environment.

If cash flows change sign more than once, then you will have
multiple internal rates of return. This is problematic for the IRR
rule; however, the NPV rule still works fine.

Slide 5.17 Modified IRR

One method for eliminating multiple IRRs is to use the Modified
Internal Rate of Return (MIRR). Discount all cash outflows to the
present, and compound all cash inflows to the last period of the
project. Then, find the rate that equates the values. The discounting
and compounding can be done at different borrowing and
investment rates, respectively.

5-11
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Chapter 05 - Net Present Value and Other Investment Rules

The alternative approach discussed in the text is to discount cash

flows over a single period (or subset of time), then combine them
as necessary to eliminate any sign differences.

C. Problems Specific to Mutually Exclusive Projects

Problem 1: Scale
IRR does not account for the amount of total value created, only a
percentage return.

Slide 5.18 The Scale Problem

Problem 2: Timing

Slide 5.19 –
Slide 5.20 The Timing Problem

Slide 5.21 Calculating the Crossover Rate

The crossover rate is where two projects have the same IRR (and
NPV). With timing issues, the NPV ranking may be different
above and below this rate.

D. Redeeming Qualities of IRR

-People seem to prefer talking about rates of return rather than

dollars of value
-NPV requires a market discount rate; IRR relies only on the
project cash flows, although you do need an estimate of a required
return to make the final decision

Slide 5.22 NPV versus IRR

NPV and IRR comparison: If a project’s cash flows are
conventional (costs are paid early and benefits are received over
the life), and if the project is independent, then NPV and IRR will
give the same accept or reject signal.

E. A Test

5.6. The Profitability Index

A. Calculation of Profitability Index

5-12
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Chapter 05 - Net Present Value and Other Investment Rules

Slide 5.23 –
Slide 5.24 The Profitability Index (PI)
Profitability index – present value of future cash flows divided by
the initial investment

Technically, this is true only if the initial investment is the only

outflow. If there are additional outflows after year 0, then the
profitability index = PV of inflows / PV of outflows.

If a project has a positive NPV, then the PI will be greater than 1.

5.7. The Practice of Capital Budgeting

Slide 5.25 The Practice of Capital Budgeting

It is common among large firms to employ a discounted cash flow
technique such as IRR or NPV along with a technique such as the
payback period. It is suggested that this is one way to resolve the
considerable uncertainty over future events that surrounds the
estimation of NPV.

Lecture Tip: While uncertainty about inputs and interpretation of

the outputs helps explain why multiple criteria are used to judge
capital investment projects in practice, another reason is
managerial performance assessment. When managers are judged
and rewarded primarily on the basis of periodic accounting
figures, there is an incentive to evaluate projects with methods
such as payback or average accounting return. On the other hand,
when compensation is tied to firm value, it makes more sense to
use NPV as the primary decision tool.

Ethics Note: The use of various financial incentives to induce

firms to locate in a given municipality raises some interesting
issues in the capital budgeting area. From the viewpoint of the
firm’s analysts, how do you estimate the impact of such incentives?
A reduction in the initial outlay? Increases in future cash inflows?
And, what discount rate should be assigned to these tax
reductions? Are these promises riskless?
And, what about the municipal officials who offer such
incentives? Stated reasons are typically related to “employment
growth” or “increased economic activity.” But, from a capital
budgeting standpoint, have you ever seen a fully developed cash
flow analysis of the stated benefits relative to the costs?
Consider this example from a Federal Reserve publication:
5-13
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Chapter 05 - Net Present Value and Other Investment Rules

“Alabama offered Mercedes-Benz a package valued

at more than the cost of the plant itself. To lure the
$300 million plant, with about 1,500 jobs, the state
promised to buy the site for $30 million, and lease it
to Mercedes for $100. Surrounding communities
will contribute an additional $5 million each, and
the University of Alabama will offer German
language and culture classes to the children of
plant employees. On top of this, the state will
provide a package of tax breaks valued at more
than $300 million, which will, among other things,
allow the plant to be paid for with money that would
have been paid to the state.”
Several incentives described above directly affect the costs and
benefits of the proposed project and would be accounted for in the
capital budgeting analysis performed by Mercedes. However, the
state officials should perform their own capital budgeting analysis
– they, too, are incurring economic costs in the hope of future
benefits. But at least one aspect is different: when a corporation
makes a poor investment, shareholders suffer. When states make
poor decisions, all of the residents of the state suffer. Thus, the
ethics of the capital budgeting decision come into play more
clearly in the latter case.

Slide 5.26 –
Slide 5.28 Example of Investment Rules

Slide 5.29 NPV and IRR Relationship

Slide 5.30 NPV Profiles

Slide 5.31 Summary – Discounted Cash Flow

Slide 5.32 Summary – Payback Criteria

Slide 5.33 Quick Quiz

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 CHAPTER VI

Arrival in London. Conditions I found there. Preparations and Start.

reached London very early next morning, and drove

directly to the lodgings of my friend, Mr. Wellington
Lee, the only American resident in London whom I
knew. These were on a short street extending from the
Strand down to the river, a short distance west of
Temple Bar, the ancient city gate, which was then
standing. Who was Mr. Lee and what was he doing in London?
These were questions in which I had an interest of which I was as
yet entirely ignorant. The firm of Lee & Larned were the first
successful designers of steam fire-engines in this country. More than
seventy of these steamers had been built from their plans and under
their direction by the Novelty Iron Works in New York, and the fire
department of that city was completely equipped with them. One of
their engines had been sold to the city of Havre, and Mr. Lee had
gone over with it to test it publicly on its guaranteed performance. Mr.
Amos, one of the senior members of the great London engineering
firm of Easton, Amos & Sons, went over to Havre to witness this trial,
with a view to the manufacture of these steam fire-engines in
London. He was so much pleased that he determined to make the
fire-engines, and engaged Mr. Lee to take the direction of their
manufacture. So it came to pass that at this particular time Mr. Lee
was in London superintending the first manufacture of his steam fire-
engines by this firm.
After our salutations Mr. Lee said: “First of all I have something to
tell you.” Before relating this, I must mention something that I knew
before I sailed. About the time when the cargo of United States
exhibits started, the well-known Mason and Slidell incident occurred.
These gentlemen, commissioners sent by the Confederacy to
represent their cause before European governments, had sailed on a
British vessel flying the British flag. This vessel was overhauled on
the high seas by one of our cruisers, and the commissioners were
taken off and brought prisoners to New York. Mr. Lincoln made haste
to disavow this illegal proceeding, so singularly inconsistent with our
own principles of international law, and to make all the reparation in
his power. But a bitter feeling towards England was then growing in
the Northern States, and in a moment of resentment Congress
hastily passed a resolution repealing the law creating the Exhibition
Commission and making an appropriation for its expenses, and
Secretary Seward issued a proclamation dissolving the commission.
The vessel carrying the exhibits had been gone scarcely more than a
day when this action of Congress and Mr. Seward surprised the
country.
I now take up Mr. Lee’s narrative. The news of this action, carried
by a mail steamer, had reached London several days before the
arrival of the exhibits. Under the pressure of an urgent demand the
Royal Commission confiscated the space allotted to the United
States and parceled it out to British exhibitors. Mr. Holmes on his
arrival found not a spot in the Exhibition buildings on which to set his
foot. But he was a man of resources. He went before the
commission with an eminent Queen’s counsel, who made the point
that they had received no official notification of any such action by
the United States Government, but had proceeded on a mere
newspaper rumor, which they had no right to do; and there was the
United States assistant commissioner with his credentials and a
shipload of exhibits, and they must admit him.
The commissioners yielded most gracefully. They said: “Now, Mr.
Holmes, the American space is gone; we cannot restore that to you,
but there are unoccupied spots all over the Exhibition, and you may
take up any of these, and we will undertake that your whole exhibit
shall be well placed.” Upon this Mr. Holmes had gone to work and
had been able to find locations for every exhibit, except my engine.
 Wellington Lee

“But only yesterday,” said Mr. Lee, “Mr. Holmes learned that an
engine ordered by the commission to drive the British exhibit of
looms, of which there were thirty-three exhibitors, had been
condemned by the superintendent of machinery, Mr. Daniel Kinnear
Clark, and ordered out of the building.” He added that Mr. Holmes
went directly to Mr. Clark and applied for the place for my engine, the
bedplate of which, thanks to my precipitate action, had arrived and
was then on a truck, in England called a lurry, waiting to be
unloaded. In answer to Mr. Clark’s questions, Mr. Holmes had given
him his personal assurance that I would be there, and the rest of the
engine would be there in ample time, and it would be all that he
could possibly desire; and on that assurance he had got the place for
me.
I informed Mr. Lee that I also had something to tell him. I then
gave him the situation as already related. He looked very grave.
When I had finished he said: “Well, you are in a hole, sure enough;
but come, let us get some breakfast, and then we will see what
Easton & Amos can do for you.” After eating my first English mutton-
chop in a chop-house on the Strand, I accompanied Mr. Lee to their
works in the Borough, a long distance away, on the south or Surrey
side of the Thames, to reach which we crossed the Southwark
bridge.
None of the partners had yet reached the office. Very soon Mr.
James Easton arrived. He was a young man about my own age. Mr.
Lee introduced me and told my story. The instant he finished Mr.
Easton came across the room and grasped my hand most cordially.
“That’s the kind of pluck I like,” said he; “we will see you through, Mr.
Porter; we will build this engine for you, whatever else may have to
wait.” Directly he added: “We have a good deal of ‘red tape’ here, but
it won’t do in this case. There will be no time to lose. Come with me.”
He then took me through the shops and introduced me to every
foreman, telling them what he had undertaken to do, and gave each
of them the same instruction, as follows: “Mr. Porter will come
directly to you with his orders. Whatever he wants done, you are to
leave everything else so far as may be necessary, and do his work
as rapidly as possible.”
As I listened to these orders, I could hardly believe my senses or
keep back the tears. Coming on top of the devotion of Mr. Holmes
they nearly overcame me. The sudden relief from the pressure of
anxiety was almost too much. It seemed to me to beat all the fairy
stories I had ever heard. This whole-hearted cordiality of the first
Englishman I had met gave me a high idea of the people as a whole,
which, I am happy to say, a residence of over six years in England
served only to increase.
Returning to the office, we found Mr. Lee, who said, “Now, Mr.
Porter, I think Mr. Holmes would like to see you.” Getting the
necessary directions, in due time I found myself in the Exhibition
building on Cromwell Road and in the presence of Mr. Holmes, who
received me joyfully and led me at once to Mr. Clark’s office. As he
opened the door, Mr. Clark looked up from his desk and exclaimed,
“Good morning, Mr. Holmes; where is that engine?” “Well,” replied
Mr. Holmes, “here is Mr. Porter, and the engine is here or on the
way.” Mr. Clark asked me a number of questions about the engine,
and finally how many revolutions per minute it was intended to make.
I replied, “One hundred and fifty.” I thought it would take his breath
away. With an expression of the greatest amazement he exclaimed:
“What! a hundred and fifty! B—b—b—but, Mr. Porter, have you had
any experience with such a speed as that?” I told him my experience
with the little engine, which did not seem to satisfy him at all. Finally
he closed the matter, or supposed he had done so, by saying: “I
cannot allow such a speed here; I consider it dangerous.” I decided
instantly in my own mind not to throw away all that I had come for;
but I made no sign, but humbly asked what speed I might employ.
After a little consideration Mr. Clark replied: “One hundred and
twenty revolutions; that must not be exceeded.” This he considered a
great concession, the usual speed of stationary engines being from
fifty to sixty revolutions. I meekly acquiesced, then made my plans
for one hundred and fifty revolutions, and said nothing to anybody. I
had no idea of the gravity of my offence. It was the first time since I
was a child that I had been ordered to do or not to do anything, and I
had no conception of orders except as given by myself. If there was
any risk, I assumed it gaily, quite unconscious how such a daredevil
defiance of authority would appear to an Englishman. Mr. Clark
showed me my location, and gave me an order for my engine-bed to
be brought in immediately, and also other parts of the engine as
soon as they arrived. Trucks generally, I was told, had to wait in the
crowd about ten days for their turn to be unloaded.
 Charles T. Porter
A.D. 1862

I hurry over the time of erection. Everything arrived promptly and

the whole came together without a hitch, as I knew it would. The fly-
wheel and pulley and cylinder lagging I had left to be made in
England. I was at the works of Easton, Amos & Sons every morning
at 6 o’clock, and laid out the work for the day. I made the gauges for
boring the fly-wheel and pulley, which I had now learned how to do,
and adjusted everything about the engine myself, and knew it was
right.
I had a talk with the foreman of the pattern-shop about the best
thickness of felt on the cylinder to be covered by the mahogany
lagging, in the course of which I remarked, “It is the air that is the
real non-conductor.” “Yes,” he replied, “and felt, you know, is ‘air’.”
I learned several things I did not know before, among others how
the English made a steam-pipe joint, using parallel threads and a
backing-up nut, packed with long hemp which was filled with a putty
made of red and white lead rubbed together dry.
I had great luck in the way of a driving-belt. An American exhibitor
of india-rubber belting asked the privilege of exhibiting a belt in use
on my engine, which I was glad enough to have him do. Otherwise I
hardly know what I should have done. The widest English belts were
12 inches wide, double, and sewn together from end to end with five
rows of sheepskin lacing. The belt ran on the knobs of this lacing.
English machinists then knew nothing of the hold of belts by
excluding the air. The ends of all belts were united by lapping them
about two feet and sewing them through and through with this same
lacing. Fine pounding these joints would have made on the pulleys. I
got a governor belt from him also. Both belts were united by butt-
joints laced in the American fashion. I did this job myself, and,
indeed, I put the whole engine together mostly with my own hands,
although Easton, Amos & Sons sent two of their best fitters to help
me. I learned afterwards that I should have had a sorry time driving
my governor by a belt laced in the English way.
In spite of all efforts and all our good luck, we were not ready to
start until a week after the opening day, May 1, and the exhibitors
were in despair, for none of them believed that this new-fangled
American trap would work when it did start at the frightful speed of a
hundred and twenty revolutions per minute, which they had learned
from Mr. Clark it was to make. Finally one day after our noon dinner I
turned on the steam, and the governor rose at the speed of one
hundred and fifty revolutions precisely. It was immediately
surrounded by a dense crowd, every man of whom looked as if he
expected the engine to fly in pieces any instant.
It was not more than two minutes after it started when I saw Mr.
Clark coming with his watch in his hand. Some one had rushed to his
office and told him the Yankee engine was running away. The crowd
opened for him, and he came up to the engine and watched it for
some time, walking leisurely around it and observing everything
carefully from all points of view. He then counted it through a full
minute. At its close he turned to me and exclaimed, “Ah, Porter—
but,” slapping me cordially on the shoulder, “it’s all right. If you will
run as smoothly as this you may run at any speed you like.”
And so the high-speed engine was born, but neither Mr. Clark, nor
I, nor any human being then knew what it was that made it run so
smoothly.
I have since realized more and more what a grand man Mr. Clark
then showed himself to be. A small souled man might have regarded
the matter entirely from a personal point of view, and been furious at
my defiance of his authority. There are such men. I will show one to
the reader by and by. Officialism is liable to produce them. I was
quite unconscious of the risk in this respect that I was running. I have
always felt that I could not be too thankful that at this critical point I
fell into the hands of so noble a man as Daniel Kinnear Clark.
Mr. Porter’s Exhibit at the London International Exhibition, 1862
 CHAPTER VII

My London Exhibit, its Success, but what was the matter? Remarkable Sale of the
Engine.

hus, as the result of a remarkable combination of

circumstances, upon which I look back with feelings
more of awe than of wonder, the high-speed system
made its appearance in the London International
Exhibition of 1862, installed in the midst of the British
machinery exhibit, under conditions more
advantageous than any which I could have imagined.
But the engine had a weak feature: it was wanting in an essential
respect, of which I was, and remained to the end, quite unconscious,
as will presently appear. Before entering on this subject I will give the
reader an idea of what the exhibit was like. The accompanying half-
tone from a photograph will, with the help of a little explanation,
make this quite real.
The location was in a narrow space between a side aisle and the
wall of the temporary wooden structure, 300 feet wide by nearly
1000 feet long, which formed the machinery hall. The engine was
crowded closely by looms on both sides. Here were shown together
the first high-speed engine, the first high-speed governor, and the
first high-speed indicator. My marine governor could not be
accommodated there, and had to be shown elsewhere. I was so
much afraid of deflection or vibration of the shaft that I shortened up
the length between the bearings and placed the driving-pulley on the
overhanging end of the shaft, which for the light work to be done
there answered sufficiently well. I showed also the largest and the
smallest sizes of my stationary-engine governors. These were belted
from the shaft to revolve so as to stand always in positions
coincident with those of the governor which regulated the engine.
 On a table between the railing and the head of the engine I
showed mahogany sectional models of the valves at one end of the
cylinder in the engine exhibited, and of the now well-known Allen
slide valve, with double opening for admission made by a passage
over the exhaust-cup.
The Richards indicator is seen placed on the cylinder midway of its
length, and connected by pipes with the ends over the clearances,
so that in the familiar manner by means of a three-way cock the
opposite diagrams could be taken on the same sheet. After a few
days’ use I mistrusted that the lead lines were not correctly drawn,
and I took away these pipes, placing the indicator on the cylinder
itself, at the opposite ends alternately. The diagrams then taken
showed that the error from transmission through these pipes had
been even greater than I had feared. I have, of course, employed the
close connection ever since.
This identifies the time when the photograph was taken. It must
have been within a few days after starting.
The center of the eccentric coinciding with the crank, as already
stated, and the center line of the link being in the same horizontal
plane with that of the engine, I was able to take the motion of the
paper drum from the sustaining arms of the link instead of from the
cross-head. This was very convenient.
During the first two or three weeks the steam pressure was kept
up to 75 pounds, as intended, and I was able to get diagrams cutting
off quite early, which were then erroneously supposed to show
superior economy. But when all the steam-eaters had got in their
work the pressure could not be maintained much above 40 pounds,
and for that exhibition the day of fancy diagrams was over. Gwynne
& Co. showed a large centrifugal pump driven by a pair of engines
which always brought the pressure down at the rate of a pound a
minute. They were not allowed to run longer than fifteen minutes at a
time, but it took a long time after they stopped before the pressure
could be got up again even to 40 pounds. Whenever I took a
diagram somebody was always standing ready to take it away, and
so among my mementoes I have been able to find none cutting off
earlier than the one here represented. On the wall at the back I hung
the largest United States flag I could find, with a portrait of President
Lincoln. This seems all that needs to be said about the photograph
and the diagram.

INTERNATIONAL EXHIBITION, UNITED STATES DEPARTMENT

1862 DIAGRAM TAKEN FROM 1862
THE ALLEN ENGINE BY THE RICHARDS INDICATOR.
ENGINE, 8 INCHES BY 24 INCHES, REVOLUTIONS PER MINUTE, 150.
SCALE, 40 LBS. TO THE INCH.

But what was the matter? I will clear the way to answering this
question by relating the following incident: Six months later, with a
feeling of bitter disappointment, I contemplated my engine standing
alone where the place had been thronged with surging life. All the
other exhibits had been removed. This was left in stillness and
desolation, and I was making up my mind to the necessity of
shipping it home again, its exhibition to all appearance absolutely
fruitless—a failure, which I was utterly at a loss to comprehend,
when I had a call from Mr. James Easton, the same man who had
first welcomed me in England. His firm had perhaps the largest
exhibit in the Machinery Hall, of a waterfall supplied by a centrifugal
pump, and they had been frequent observers of the running of my
engine, which was quite near them. Mr. Easton bluntly asked me if I
thought my engine could be run 50 per cent. faster or at 225
revolutions per minute, because they had concluded that it could be,
and if I agreed with them they had a use for it themselves. Under the
circumstances I did not hesitate long about agreeing with them in
respect to both ability and price, and the sale was quickly concluded.
I noted an entire absence of any disposition to take an undue
advantage. Mr. Easton then told me that they were troubled with lack
of power every afternoon when the foundry blower was on, and had
long wanted to drive this blower independently. It needed to make
2025 revolutions per minute to give the blast they required, and they
had planned to drive it by a frictional gearing, nine to one, if my
engine could run at the necessary speed. So this most peculiar and
exceptional opportunity for its application, absolutely the only chance
for its sale that had appeared, and that at the very last moment,
prevented my returning home in disappointment. It is hardly
necessary to add that the engine proved completely successful. I
shall refer to it again.
The point of the incident is this: It established the fact, the
statement of which otherwise no one from the result would credit for
an instant, that, from the afternoon when the black and averted looks
of my loom exhibitors were changed to smiling congratulations down
to the close of the exhibition, the engine never once had a warm
bearing or was interrupted for a single moment. It was visited by
every engineer in England, and by a multitude of engine users, was
admired by every one, and won the entire confidence of all
observers in its speed, its regulation, and the perfection of its
diagrams; and yet in all that six months not a builder ever said a
word about building it, nor a user said a word about using it; and, as
week after week and month after month passed without a sign, I
became almost stupefied with astonishment and distress.
The explanation of this phenomenon was entirely simple, but I did
not know it, and there was no one to even hint it to me. I was among
a people whose fundamental ideas respecting steam-engines were
entirely different from those to which I had been accustomed, and I
knew nothing about them, and so could not address myself to them.
In the view of every Englishman a non-condensing engine was
rubbish. Those which were made were small, cheap affairs, mostly
for export. Neither a builder nor a user could regard a non-
condensing engine with the slightest interest.
Now I do not think that in my limited sphere of observation at
home I had ever seen a condensing stationary engine, except the
engine which pumped out the dry-dock at the Brooklyn Navy Yard. In
my mind condensing engines were associated with ships and
steamboats. At this exhibition also there were shown only non-
condensing engines. I did not think of the reason for this, that in this
part of London, far away from the Thames, no water could be had for
condensing purposes. I took it all as a matter of course, though I was
astonished at the queer lot of engines in the company of which I
found myself.
I was, of course, familiar with the development of the stationary
engine in England from the original type, in which the pressure of
steam below that of the atmosphere, and sometimes the pressure of
the atmosphere itself furnished the larger proportion of the power
exerted; but after all I carried with me my American ideas, which
were limited to non-condensing engines, and had no conception of
the gulf that separated my thoughts from those of the men about me.
My visitors always wound up with the same question, “How do you
drive your air-pump?” And in my innocence I uniformly replied, “The
engine is a non-condensing engine; it has no air-pump”; all
unconscious that every time I said that I was consigning the engine
to the rubbish heap. This reply was taken necessarily as a frank
admission that the high-speed engine was not adapted for
condensing. Of course, then, it had no interest for them. No doubt
many wondered why I should have troubled myself to show it there
at all. If I had thought more deeply I must have been struck by the
unvarying form of this question, always assuming the air-pump to be
a part of the engine, but which, of course, could not be used there,
and only inquiring how I worked it; and also by the fact that after
getting my answer the questioner soon departed, and I scarcely ever
saw the same visitor again. But I did not think deeply. Perhaps the
conditions of excitement were not favorable to reflection. All I thought
was that this same everlasting question, which at home I would
never have heard, was getting awfully monotonous. After a while this
annoying question came to be asked less and less frequently, and
also the engine attracted less and less attention. The engine had
failed in a vital respect, and I did not know it. That the fact of the
engine being non-condensing should have been an objection to it
never once entered my mind.
But I doubt if I could have bettered the matter, however alive to
this difficulty I might have been. I showed all I had yet accomplished.
In the minds of my visitors it no doubt appeared impossible to run an
air-pump successfully at such a speed; the water and air would be
churned into foam, and the valves would not close in time. This
objection I was not prepared to meet, for I had not thought on the
subject at all. Moreover, it could not have been met in any way
except by a practical demonstration. For that demonstration I had yet
to wait five years.
There were many things connected with this season which were
well worth remembering. One of these was the visit of the jury. It was
the only time I ever met Professor Rankine. There were two or three
Frenchmen on the jury, and they engaged in an animated discussion
of the question whether the steam could follow the piston at so great
a speed. I well remember the sharp exclamation with which
Professor Rankine put an end to this nonsense, when he had got
tired of it. “There is no limit to the speed at which steam will follow a
piston.”
One day I had a call from Mr. John Penn, Mr. William Fairbairn,
and Mr. Robert Napier, who came together on a visit of ceremony,
and presented me their cards. In return I presented to them the
cards of the engine. But their visit, like most others, closed with the
same inevitable question.
It was a delightful hour that Mr. F. W. Webb spent with me. He was
then assistant engineer of the London & Northwestern Railway under
Mr. Ramsbottom, afterwards Mr. Ramsbottom’s successor, and the
pioneer builder of compound-cylinder locomotives. He told me about
the new form of traveling-crane invented by Mr. Ramsbottom for the
shops at Crewe, which was driven by a flying-rope, a ³⁄₄-inch cotton
cord, and also of other inventions of Mr. Ramsbottom—among these
the automatic cylinder lubricator, in which the condensation of the
steam was so rapid, from the locomotive rushing through the
atmosphere, that only the water formed on the conical end of a bolt
was permitted to drop into the oil, other condensation running into a
circular trough and back through an external gooseneck pipe to the
steam-chest; and of their experiments to observe the rate of this
condensation. For this purpose they used soda-water bottles, which
they found capable of resisting a pressure of 200 pounds on the
square inch, and in which they could see the rapidity with which the
condensed water displaced the oil, thus leading to the above device
for limiting this action; also about the Ramsbottom piston rings,
which came to be, and still are, so largely used. These consist, as is
well known, of square wrought-iron rods, say ¹⁄₂ inch square, two for
each piston, sprung into grooves. What is not so generally known is
the way in which these rings were originated, which Mr. Webb then
described to me. As sold, these are not circular rings, but when
compressed in the cylinder they become truly circular and exert the
same pressure at every point. The original form was found for each
size in this way: A circular iron table was prepared, provided with a
large number of pulleys located radially and equidistant around its
edge. A ring having the section of the proposed rings, turned to the
size of the cylinder, and cut on one side, was laid on this table, and
cords were attached to it at equal distances passing over these
pulleys. Equal weights were hung on these cords, sufficient to
expand this ring to the extent desired. The form of the expanded ring
was then marked on the table, and to the lines thus obtained the
rings were then rolled. He told me also of the trough and scoop
invented by Mr. Ramsbottom, and now used the world over, for
refilling locomotive tanks while running at full speed. Being a
locomotive man, Mr. Webb did not ask about the way I drove my air-
pump.
Mr. Clark formed a scheme to indicate all the engines in the
exhibition, twenty-four in number, all English except mine, so far as I
remember, and employed my indicator for the purpose, the diagrams
being taken by myself. Only two exhibitors declined to have their
engines indicated. As I afterwards learned, most of the engines were
bought for use there, as exhibitors would not exhibit non-condensing
engines.
One of those who refused permission were Gwynne & Co., the
principal partner a nephew of my centrifugal-force friend of earlier
days. They exhibited a centrifugal pump supplying a waterfall. They
employed Mr. Zerah Colburn, then editor of The Engineer, to
investigate their pair of non-condensing engines and find out why
they used so much steam. He borrowed my indicator to make a
private test. Of course, I never saw the diagrams, but Mr. Colburn
informed me that by making some changes he had reduced the back
pressure to 7 pounds above the atmosphere, which he claimed to be
as good as could be expected. No material improvement in the
engines was to be observed, however.
Some of the diagrams taken on these tests exhibited almost
incredible faults. The only really good ones were from a pair of
engines made by Easton, Amos & Sons, also to drive a large
centrifugal pump, built for drainage purposes in Demerara, and
sustaining another waterfall. These showed the steam cut off sharply
at one third of the stroke by separately driven valves on the back of
the main slides. A mortifying feature of this work for myself was that
on testing the indicator Mr. Clark found that the area of the piston,
which was represented to be one quarter of a square inch, was really
considerably less than this, showing lamentable inaccuracy on the
part of the makers, as well as my own neglect to discover it. This
rendered the instrument valueless for measuring power, but it
showed the character of the diagrams all right.
The finest mechanical drawing I ever saw—or any one else, I think
—was shown in this exhibition. It was a drawing of the steamship
“Persia,” then the pride of the Cunard fleet, and was the only
mechanical drawing ever admitted to the walls of the National
Gallery, where it had appeared the year before. It represented side
and end elevations and plan, as well as longitudinal and cross-
sections, was painted and shaded in water-colors, and involved an
almost incredible amount of work. It was made by Mr. Kirkaldy, then
a draftsman in the employ of the Napiers, of Glasgow, the builders of
the vessel. I am tempted to refer to this, as it forms a prominent
datum point from which to measure the development of steam
navigation in the brief space of forty years. The vessel did not
possess a single feature, large or small, that now exists. It was of
only about 3000 tons burden. It was an iron ship built in the days of
the rapid transition from wood to steel. It was propelled by paddle-
wheels. These were driven by a pair of side-lever engines. The
engines had each a single cylinder. The steam pressure carried was
nominally 25 pounds above the atmosphere, but practically only from
15 to 20 pounds. Full pressure was not pretended to be maintained.
They had jet condensers. All forged work was of iron. The vessel
was steered by hand. The rigging, standing as well as running, was
of hemp. It was full bark-rigged.
Frederick E. Sickels