Chapter 7

Investment
Decision Rules
Ziwei Wang
Wuhan University
Stand-Alone Projects
• There are several rules CFOs use when deciding whether an investment is
worth pursuing: the NPV rule, the IRR rule, and the payback rule, and etc.

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Stand-Alone Projects: the NPV Rule
• The NPV rule: When making an investment decision, take the alternative with
the highest NPV. Choosing this alternative is equivalent to receiving its NPV in
cash today.

• It recognizes that a dollar today is worth more than a dollar tomorrow.

• It solely depends on the forecasted cash ows and the cost of capital.
• All present values are measured in today’s dollars, so you can add them up.
• The NPV pro le: A graph of the project’s NPV over a range of discount rates.
It is much more informative than NPV alone.

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Stand-Alone Projects: the IRR Rule
• The IRR rule: Take any investment opportunity where the IRR exceeds the
opportunity cost of capital. Turn down any opportunity whose IRR is less than
the opportunity cost of capital.

• Some people confuse the internal rate of return and the opportunity cost of
capital.

• The internal rate of return is a pro tability measure that depends solely on the
amount and timing of the project cash ows.

• The opportunity cost of capital is a standard of pro tability that we use to

calculate how much the project is worth.

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Pitfalls of the IRR Rule
• Pitfall #1: Lending or borrowing?

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Pitfalls of the IRR Rule
• Pitfall #2: Multiple rates of return

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Pitfalls of the IRR Rule
• Pitfall #3: Non-existent IRR

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Is the IRR Rule that Evil?
• If you know that all of the project’s negative cash ows precede its positive
cash ows (i.e. it is a “pure investment”), it’d be ne to use it.

• The NPV itself does not tell you the size of the investment for the gain. But the
IRR takes this into account.

• For example, there are two projects that have a NPV of $1400: Project A only
requires an upfront investment of $9,000, while project B needs $9,000,000.

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Stand-Alone Projects: the Payback Rule
• The payback rule: You should only accept a project if its cash ows pay back
its initial investment within a pre-speci ed period.

• This is how I decided to buy a co ee machine: 某品牌咖啡机400⼈⺠币。如果

每天⾃⼰做咖啡，能省下10块钱，那么只需要40天，这个咖啡机就回本了。

• This is inaccurate because

1. It ignores the time value of money and the project’s cost of capital;

2. It ignores cash ows after the payback period;

3. It relies on an ad hoc decision criterion: pre-speci ed period.

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The Discounted Payback
• Occasionally companies discount the cash ows using the cost of capital and
compute the payback period, i.e. 回本需要的时间.

• Rather than automatically rejecting any project with a long discounted

payback period, many managers simply use the measure as a warning signal.

• This is, again, something that NPV alone does not tell you.
• They satisfy themselves that the equipment has a long life and that
competitors will not enter the market and eat into the project’s cash ows.

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Choosing between Projects: NPV
• The NPV rule: Pick the project with the highest NPV.
• Yes, very simple.

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Choosing between Projects: NPV
Problem (Example 7.3 in textbook)

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 ow
estimates (including the cost of purchasing the property). Which investment
should you choose?

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 Choosing between Projects: IRR
• When projects di er in their scale of investment, the timing of their cash
ows, or their riskiness, then their IRRs cannot be meaningfully compared.

• Pitfall #1: Di erences in scale.

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Choosing between Projects: IRR
• Pitfall #2: Di erences in timing.

• The textbook also provides another example

• Notice that despite having the same IRR, the long term project is more than 10
times as valuable as the short-term project. (?)
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Choosing between Projects: IRR
• Pitfall #3: Di erences in risks.
• The attractiveness of a project is given by a comparison between the IRR and
its cost of capital.

• If the risks of two projects are di erent, the comparison between IRRs is
meaningless.

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Midterm Question from Last Year
• Suppose you are the CEO of a company, and you are facing an investment
opportunity today that generates positive cash ows over the next ten years.
Which of the following decision rules is the most likely to reject the
investment: ( )

( A ) the NPV rule

( B ) the discounted payback rule with a target of ve years

( C ) the payback rule with a target of ve years

( D ) the IRR rule

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 Resource Constraints
• Sometimes, a rm can undertake multiple projects subject to resource
constraints –– e.g. the number of buildings/workers/funding the rm has.

• This is a very typical problem in economics: We need to optimally allocate

scarce resources.

• A useful rule is to use the pro tability index to rank the projects and then
select those with higher index values
NPV
Pro tability Index = .
Recource Consumed
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Resource Constraints

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Resource Constraints: An Example
Problem (Example 7.5 in textbook)

NetIt has a total of 190 engineers available. It has the following potential
projects for these engineers. How should NetIt prioritize these projects?

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Resource Constraints: An Example

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Resource Constraints
• The pro tability index rule is only an approximately optimal rule. For it to be
completely reliable, two conditions have to be satis ed:

1. The set of projects taken following the pro tability index ranking
completely exhausts the available resource;

2. There is only a single relevant resource constraint.

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 Optimal Search: An Example (不考)
• Sometimes, a rm faces many potential projects,
and the returns are uncertain.

• The rm has to incur a cost and spend some time

to research the pro tability of a project, before
undertaking it.

• Martin Weitzman (1979) formalizes this problem

and proposes an optimal selection and stopping
rule. He calls it the Pandora’s Rule. (Cited by 1342)

• Here, we shall only consider an example.

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Optimal Search: An Example (不考)

• Suppose the interest rate is 10%.

• The expected value of researching alpha is

( 1.1 )
1
−15 + [0.5 × 100 + 0.5 × 55] = 55.5.

• The expected value of researching omega is

( 1.1 )
2
1
−20 + [0.2 × 240 + 0.8 × 0] = 19.7.
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Optimal Search: An Example (不考)
• The expected value of starting with developing alpha is

( 1.1 ) [ ( 1.1 )
2

]
1 1
−15 + 0.5 × 100 + 0.5 × [−20 + (0.2 × 240 + 0.8 × 55)] = 55.9

• The expected value of beginning with researching omega is

( 1.1 ) [ ( 1.1 ) ]
2
1 1
−20 + 0.2 × 240 + 0.8[−15 + (0.5 × 100 + 0.5 × 55)] = 56.3

• Surprisingly, the project with lower expected return should be researched rst!

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