7-1

NPV and Other Investment Criteria

Chapter Outline

Net Present Value (NPV) Other Investment Criteria

IRR (Internal Rate of Return) Payback and Discounted Payback Book Rate of Return

Investment Criteria When Projects Interact Pitfalls with IRR Capital Rationing
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Net Present Value

Capital

Budgeting Decision

Central to the success of any company is the investment decision, also known as the capital budgeting decision. Assets acquired as a result of the capital budgeting decision can determine the success of the business for many years. It is extremely important that we ensure that the correct capital budgeting decision is made!
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Net Present Value

Capital

Budgeting Decision

Suppose you had the opportunity to buy a Tbill (Treasury Bill) which would be worth $400,000 one year from today.
Interest

rates on Tbills are a risk free 7%.

What would you be willing to pay for this investment?

-$400,000

PV today:
$400,000 / (1.07) = $373,832

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Net Present Value

Capital

Budgeting Decision

You would be willing to pay $373,382 for a risk free $400,000 a year from today. Suppose this were, instead, an opportunity to construct a building, which you could sell in a year for $400,000 with certainty (That means the project is risk free.) Since this investment has the same risk and promises the same cash flows as the Tbill, it is also worth the same amount to you:

$373,282
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Net Present Value

Capital

Budgeting Decision

Now, assume you could buy the land for $50,000 and construct the building for $300,000. Is this a good deal? Sure! If you would be willing to pay $373,382 for this investment and can acquire it for only $350,000, you have found a very good deal! You are better off by: $373,382 - $350,000 = $23,832

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Net Present Value

Capital

Budgeting Decision

We have just developed a way of evaluating an investment decision which is known as Net Present Value (NPV). NPV is defined as the PV of the cash flows from an investment minus the initial investment.
NPV = PV Required Investment (C0) = [$400,000/(1+.07)] - $350,000 = $23,832
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Net Present Value

Capital

Budgeting Decision This discount rate is known as the opportunity cost of capital.
is called this because it is the return you give up by investing in the project. In this case, you give up the money you could have used to buy a 7% tbill so that you can construct a building. But, a Tbill is risk free! A construction project is not! We should use a higher opportunity cost of capital.
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It

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Net Present Value

Risk

and Net Present Value

Suppose instead you believe the building project is as risky as a stock which is yielding 12%. Now your opportunity cost of capital would be 12% and the NPV of the project would be: NPV = PV IC0 = [$400,000/(1+.12)] - $350,000 = $357,143 - $350,000 = $7,142.86 The project is significantly less attractive once you take account of risk. This leads to a basic financial principal: A risky dollar is worth less than a safe one.
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Net Present Value

Valuing long lived projects

The NPV rule works for projects of any duration: Simply discount the cash flows at the appropriate opportunity cost of capital and then subtract the cost of the initial investment.

The critical problems in any NPV problem are to determine:

The amount and timing of the cash flows. The appropriate discount rate.

NPV Rule: Accept Projects with Positive NPVs

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Net Present Value

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Other Investment Criteria

Net

Present Value vs Other Criteria

Use of the NPV criterion for accepting or rejecting investment projects will maximize the value of a firms shares. Other criteria are sometimes used by firms when evaluating investment opportunities.
Some

of these criteria can give wrong answers! Some of these criteria simply need to be used with care if you are to get the right answer!

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Other Investment Criteria

Internal Rate of Return (IRR)

IRR is simply the discount rate at which the NPV of the project equals zero.

You can calculate the rate of return on a project by:

1. Setting the NPV of the project to zero. 2. Solving for r.

Unless you have a financial calculator, this calculation must be done by using trial and error!

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Other Investment Criteria

Internal

Rate of Return (IRR)

To go back to our office example, we discovered the following:

Discount Rate NPV of Project

7%
12%

$23,382
$7,143

At what rate of return will the NPV of this project be equal to zero?
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Other Investment Criteria

Internal

Rate of Return (IRR)

If we solve for r in the equation below, we find the IRR for this project is 14.29%:

IRR

Decision Rule: Accept Projects withr IRR which exceeds the opportunity cost of capital
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Other Investment Criteria

Internal

Rate of Return (IRR)

Another way of solving for IRR is to graph the NPV at various discount rates. The point where this NPV profile crosses the x axis will be the IRR for the project.

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IRR BY GRAPH
NPV Profile for this Project
$60,000 $50,000 $40,000 $30,000 $20,000 $10,000 $0 ($10,000) ($20,000)

IRR = 14.3%
(occurs where NPV = 0)

NPV ($)

5%

10%
Discount Rate

15%

20%

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Other Investment Criteria

Internal

Rate of Return (IRR) vs NPV:

The NPV Rule states that you invest in any project which has a positive NPV when its cash flows are discounted at the opportunity cost of capital. The Rate of Return Rule states that you invest in any project offering a rate of return which exceeds the opportunity cost of capital.

i.e., if you can earn more on a project than it costs to undertake, then you should accept it!

The NPV and IRR rules will give the same accept/reject answer about a project as long as the NPV of a project declines smoothly as the discount rate increases. Do not confuse IRR and the opportunity cost of capital
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Other Investment Criteria

Payback

Payback is the time period it takes for the cash flows generated by the project to recover the initial investment in the project. Example: You are paying $150 a month to park a car in your apartments garage. You can purchase a parking spot for $5,400. What is the payback for this project? 3 years $5,400 / (12 * $150) The Payback Rule states that a project should be accepted if its payback is less than a specified cutoff period.

For example, if your cutoff were 4 years to payback, then you would buy the parking spot. If it were 2 years, you wouldnt buy the parking spot: 3 years is longer than you consider desirable to get your money out of a project.

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Other Investment Criteria

Payback

Payback is a very poor way of determining a projects acceptability:

It ignores all cashflows after your cutoff date. It ignores TVM principle: it does not discount CFs

Calculate the payback and NPV for the following projects if the discount rate is 10%:
Cash Flows in Dollars C0 -2,000 -2,000 -2,000 C1 +1,000 +1,000 C2 +$1,000 +$1,000 +$2,000
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Project: A B C

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Other Investment Criteria

Project: A B C Payback (years) 2 2 2 NPV @ 10% $7,248.69 - 264.46 - 347.11

Payback
Under

vs NPV what to do?

NPV, only project A is acceptable. B and C have negative NPVs and are thus both unacceptable. But if your payback period is 2 years, then all the projects are acceptable.
NPV and payback disagree what is the correct answer?
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Other Investment Criteria

Payback

vs NPV what to do?

Payback gives the same weight to all CFs which occur before the cutoff period, while it completely ignores the CFs after the cutoff

The firm decision will be biased towards too many short term lived projects And against some long-lived projects. Only project A will increase shareholder value. Therefore, it should be the only project accepted.

NPV gives the correct answer:

Lesson: Use NPV if you want to make the correct investment decision!
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Other Investment Criteria

Discounted

Payback

Discounted payback is the time period it takes for the discounted cash flows generated by the project to cover the initial investment in the project.
a

It offers an important advantage over Payback: if a project is acceptable with the Discounted Payback, it must have a positive NPV (if the ignored Cashflows are all positive!)

Although better than payback, it still ignores all cash flows after an arbitrary cutoff date.

Therefore it will reject some positive NPV projects.

NPV is thus always preferable to discounted payback in evaluating projects!

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Discounted Payback Example (OCC=10%, cut-off = 4 years)

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Other Investment Criteria

Book

Rate of Return
a

Book rate of return equals the companys accounting income divided by its assets.
Book Rate of Return = Book Income / Book Assets

Managers rarely use this measurement to make decisions: The components reflect historic costs and accounting income, not market values and cash flows.
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a

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Project Interactions
Investment

Criteria When Projects Interact

NPV has proven to be the only reliable measure of a projects acceptability. But, what happens when we must choose among projects which interact? The NPV rule can be adapted to deal with the following situations:

Mutually Exclusive Projects The Investment Timing Decision Long- vs Short-Lived Equipment (Unequal Lives) Replacing an Old Machine
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Project Interactions
Mutually

Exclusive Projects

Most projects you deal with will be either-or propositions.

For example, you own a vacant piece of land. You have many either-or choices: You could construct a townhouse or a condo. You could heat it with oil or with natural gas.

If you choose one of the options, you cannot pursue the other. They cannot be realized simultaneously.

Calculate the NPV of each project From those, chose the project with the highest (positive) NPV.

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Project Interactions

Mutually Exclusive Projects

In Example 7.4, you are going to replace your office network.

You can choose between a cheaper, slower package or a more expensive, faster option.
a

Calculate the NPV for the two projects if the discount rate is 7%:

Cash Flows in Dollars

Project: Faster Slower

C0 $ (800)

C1 $ 350

C2 $ 350

C3 $ 350

NPV @7% $ 118.50

$ (700)

$ 300

$ 300

$ 300

87.30

Both projects have a positive NPV, thus both are acceptable. However, you cannot do both of the these projects! Since the faster system would make a greater contribution to the value of the firm, it should be your preferred choice.
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Project Interactions
The

Investment Timing Decision

Sometimes your choice is start a project now or wait and do it at a later date. In Example 7.1, you looked at purchasing a new computer system.
Its

cost today was $50,000 and its NPV was $19,740. However, you know that these systems are dropping in price every year. From the numbers on the next slide, when should you purchase the computer?
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Project Interactions
Year of Purchase t=0 t=1 t=2 t=3 t=4 t=5 Cost $50 $45 $40 $36 $33 $31 PV of Savings $70 $70 $70 $70 $70 $70 NPV at Year of Purchase $20 $25 $30 $34 $37 $39 NPV Today $20.0 $22.7 $24.8 $25.5 $25.3 $24.2

The decision rule for investment timing is to choose the investment date which results in the highest net present value today.
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Project Interactions
Long

vs Short-Lived Equipment

Suppose you must choose between buying Machine D and E.

The

two machines are designed differently, but have identical capacity and do the same job. The difference?
Machine D costs $15,000 and lasts 3 years. It costs $4,000 per year to operate. Machine E costs $10,000 and lasts 2 years. It costs $6,000 per year to operate.

Which machine should the firm acquire?

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Project Interactions
Long

vs Short-Lived Equipment
a

So far, this looks like a mutually exclusive choice like problem 7.4 Calculate PV of the costs for the projects if the discount rate is 6%:
Cash OutFlows in Dollars C0 15000 10000 C1 4000 6000 C2 4000 6000 C3 4000 PV @ 6% $25,692.5 $21,000

Project: Machine D Machine E

Should you accept Machine E because the PV of its costs are lower?
.

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Project Interactions

Long- vs Short-Lived Equipment

Choosing Machine E may not be the best decision. Why not?

All we know is that Machine E costs less to run over 2 years than Machine D does over 3 years. D is being penalized by having one extra year of costs charged against it! What we should be asking is: How much would it cost per year to use
a

Machine E as versus Machine D?

We solve this problem by calculating the Equivalent Annual Cost (EAC) of the two machines. The EAC is the cost per period with the same PV as the cost of the machine.

Think of it as calculating the annual rental charge for the machine. There will be equal annual payments (an annuity). The PV of these payments must equal the PV of the cost of the machine.
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Annuity factor
An

Annuity is any continuing payment with a fixed total annual amount. Annuity may refer to: Annuity (finance theory):any terminating stream of fixed payments over a specified period of time Life annuity: a financial contract providing payments for a person's lifetime An annuity that has no definite end is called a perpetuity.

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Annuity factor

The present value annuity factor is used to calculate the present value of future one dollar cash flows. This formula relies on the concept of time value of money. Time value of money is the concept that a dollar received at a future date is worth less than if the same amount is received today. An example of this equation in practice is determining the original amount of a loan.

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Annuity factor
An

amount received today can be invested towards future earnings or receive sooner utility. For this particular formula, the present value of one dollar periodic cash flows is to be used for simplifying the calculation of payments larger than one dollar.
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Annuity factor
An

amount received today can be invested towards future earnings or receive sooner utility. For this particular formula, the present value of one dollar periodic cash flows is to be used for simplifying the calculation of payments larger than one dollar.
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Annuity factor

The present value annuity factor is used for simplifying the process of calculating the present value of an annuity. A table is used to find the present value per dollar of cash flows based on the number of periods and rate per period. Once the value per dollar of cash flows is found, the actual periodic cash flows can be multiplied by the per dollar amount to find the present value of the annuity.

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Annuity factor

For example, an individual is wanting to calculate the present value of a series of $500 annual payments for 5 years based on a 5% rate. By looking at a present value annuity factor table, the annuity factor for 5 years and 5% rate is 4.3295. This is the present value per dollar received per year for 5 years at 5%. Therefore, $500 can then be multiplied by 4.3295 to get a present value of $2164.75.

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Annuity factor

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Project Interactions
Calculating
Project: Machine D Equivalent Annual cost:

Equivalent Annual Cost:

Cash Flows in Dollars
C0 15000 C1 4000 C2 4000 C3 4000 PV @ 6% $25,692.5

9,611.5 9,611.5 9,611.5 ? ? ?

$25,692.5

The equivalent annual cost is calculated as follows:

Equivalent Annual Cost = PV of Costs / Annuity Factor = $25,692.5 / 3 Year Annuity Factor = $25,692.5 / 2.673 = $9,611.5 per year

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Project Interactions
Cash Flows in Dollars Project: D E PV @ 6% $25,692.5 $21,000 Equivalent Annual Cost $9,611.50 $11,454.37

Long We

vs Short-Lived Equipment

see from the equivalent annual costs that D is actually the better choice because its annual cost is lower than for Machine E. If mutually exclusive projects have unequal lives, then you should calculate the equivalent annual cost of the projects. This will allow you to select the project which will maximize the value of the firm.
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Project Interactions
Replacing

an old machine

When should existing equipment be replaced? For example:

You

are operating an old machine which will last 2 more years. It costs $12,000 per year to operate. A new machine costs $25,000 to buy, but is more efficient and can be operated for $8,000 per year. It will last for 5 years.

Should you replace the old machine?

.

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Project Interactions
Replacing an old machine Solve these problems by calculating for the new machine the PV of the cash flows and its equivalent annual cost:
Cash Flows in Dollars Project: New Machine Equivalent Annual cost: C0 25 C1 8 ? 13.93 C2 8 C3 8 C4 8 C5 PV @ 6% 8 $58.70 $58.70

? 13.93 ? ? ? 13.93 13.93 13.93

Your choice: pay $12,000 per year to run the old machine or $13,930 per year for the new machine.

Obviously, its cheaper to keep your old machine!

.

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Project Interactions
Pitfalls

with IRR: 1-Mutually Exclusive Projects

IRR can mislead you when choosing among mutually exclusive projects. Calculate the IRR and NPV for the following projects:
Cash Flows in Dollars C0 -350 -350 C1 400 16 C2 16 C3 466 IRR 14.29% 12.96% NPV @ 7% $24,000 $59,000

Project: H I

Project H has a higher IRR but Project I contributes more to the value of the firm.

Obviously, you should prefer Project I!

.

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Project Interactions
Pitfalls

with IRR

Remember: a high IRR is not an end in itself! Higher IRR for a project does not necessarily mean a higher NPV. You goal should be to maximize the value of the firm. Remember:
NPV

is the most reliable criterion for project evaluation. Only NPV measures the amount by which a project would increase the value of the firm.
.

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Project Interactions
Pitfalls

with IRR: 2 Lending vs Borrowing

Calculate the IRR and NPV for the projects below:

Cash Flows in Dollars

Project: J K

C0 -100 +100

C1 +150 -150

IRR 50% 50%

NPV @ 10% + $36.4 - $36.4

Both projects have the same IRR but Project J contributes more to the value of the firm.

Obviously, you should prefer Project J!

.

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Project Interactions
Pitfalls

with IRR Lending vs Borrowing

Project J involves lending $100 at 50% interest. Project K involves borrowing $100 at 50% interest.

Which option should you choose?

Remember:

When you lend money, you want a high rate of return. When you borrow money, you want a low rate of return.

The IRR calculation shows that both projects have a 50% rate of return and are equally desirable.

You should see that this is a trap!

The NPV rule correctly warns you away from a project which involves borrowing money at 50%.
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Project Interactions
Other

Pitfalls with IRR

3. Some projects will generate multiple internal rates of return.

Look

at Figure 7.4 on page 218 for an example. at Footnote #6 on page 219 for an example.

4. Some projects have no internal rate of return.

Look

How should you evaluate a project in cases like this?

You should calculate NPV!
.

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Capital Rationing
Capital

Rationing

Occurs when a limit is set on the amount of funds available to a firm for investment.

Soft

Rationing

Occurs when these limits are imposed by senior management.

Hard

Rationing

Occurs when these limits are imposed by the capital markets.

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Capital Rationing
Rules

for Project Selection

A firm maximizes its value by accepting all positive NPV projects.

With

capital rationing, you need to select a group of projects which is within the companys resources and gives the highest NPV. the projects that give the highest NPV per dollar of investment.

This is done with the Profitability Index (PI)

pick

PI = NPV / Initial Investment (C0)

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Capital Rationing
Profitability

Index (PI)

For example: Suppose your firm had the following projects and only $20 million to spend:
C0 -3.00 -5.00 -7.00 -6.00 -4.00 -25.00 C1 2.20 2.20 6.60 3.30 1.10 C2 2.42 4.84 4.84 6.05 4.84 NPV @ 10% 1.00 1.00 3.00 2.00 1.00

Project L M N O P Budget

Which Projects should your firm select?

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Capital Rationing
Profitability

Index

Project L M N O P

C0 3.00 5.00 7.00 6.00 4.00

NPV @ 10% 1.00 1.00 3.00 2.00 1.00

PI 1/3 = 0.33 1/5 = 0.20 3/7 = 0.43 2/6 = 0.33 1/4 = 0.25
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ACCEPT

ACCEPT ACCEPT ACCEPT

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Summary of Chapter 6

NPV is the only measure which always gives the correct decision when evaluating projects. The other measures can mislead you into making poor decisions if used alone. The other measures are:
IRR Payback Discounted

Payback Book Rate of Return Profitability Index (PI)

See the next slide for a summary.

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Summary of Chapter 6
Type of Decision: Independent Projects NPV IRR Payback Discounted Payback Book Rate of Return Profitability Index Mutually Exclusive Projects * Capital Rationing

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* Includes: Investment T iming Decision, Unequal Lives and Replacement Decision

7-55

Summary of Chapter 6

It should be noted that when capital rationing is in place, NPV by itself, cannot lead you to the correct decision.
You

must combine NPV with the Profitability Index. Ranking the projects this way will allow you to choose the package of projects which will offer the highest NPV per dollar of investment.

In summary:

NPV should always be used when evaluating project acceptability!

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