You are on page 1of 48

7-1

Chapter 7
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
Semih Yildirim ADMS 3530
7-2

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!
Semih Yildirim ADMS 3530
7-3

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:
0 1 2

$400,000 / (1.07) = $373,832

Semih Yildirim ADMS 3530


7-4

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
Semih Yildirim ADMS 3530
7-5

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

Semih Yildirim ADMS 3530


7-6

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

Semih Yildirim ADMS 3530


7-7

Net Present Value


Capital Budgeting Decision
This discount rate is known as the
opportunity cost of capital.
Itis 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.

Semih Yildirim ADMS 3530


7-8

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.
Semih Yildirim ADMS 3530
7-9

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

Semih Yildirim ADMS 3530


7-10

Net Present Value

Semih Yildirim ADMS 3530


7-11

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!

Semih Yildirim ADMS 3530


7-12

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!

Semih Yildirim ADMS 3530


7-13

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% $23,382
12% $7,143

At what rate of return will the NPV


of this project be equal to zero?
Semih Yildirim ADMS 3530
7-14

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%:

IRRDecision Rule: Accept Projects withr IRR


which exceeds the opportunity cost of capital
Semih Yildirim ADMS 3530
7-15

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.

Semih Yildirim ADMS 3530


7-16

IRR BY GRAPH
NPV Profile for this Project
$60,000
$50,000
$40,000 IRR = 14.3%
(occurs where NPV = 0)
NPV ($)

$30,000
$20,000
$10,000
$0
($10,000) 5% 10% 15% 20%
($20,000)
Discount Rate
Semih Yildirim ADMS 3530
7-17

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
Semih Yildirim ADMS 3530
7-18

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.

Semih Yildirim ADMS 3530


7-19

Other Investment Criteria


Payback
Payback is a very poor way of determining a projects
acceptability:
It ignores all cashflows after your cutoff date. a

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
Project: C0 C1 C2 C3
A -2,000 +1,000 +$1,000 +10,000
B -2,000 +1,000 +$1,000 -
C -2,000 - +$2,000 -
Semih Yildirim ADMS 3530
7-20

Other Investment Criteria


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

Payback vs NPV what to do?


Under 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?

Semih Yildirim ADMS 3530


7-21

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.
NPV gives the correct answer:
Only project A will increase shareholder value.
Therefore, it should be the only project accepted.
Lesson:
Use NPV if you want to make the correct
investment decision!

Semih Yildirim ADMS 3530


7-22

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!
Semih Yildirim ADMS 3530
7-23
Discounted Payback Example
(OCC=10%, cut-off = 4 years)

Semih Yildirim ADMS 3530


7-24

Other Investment Criteria


Book Rate of Return
Book rate of return equals the companys
accounting income divided by its assets. a

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.
a
Semih Yildirim ADMS 3530
7-25

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

Semih Yildirim ADMS 3530


7-26

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.

Semih Yildirim ADMS 3530


7-27

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

Cash Flows in Dollars


Project: C0 C1 C2 C3 NPV @7%
Faster $ (800) $ 350 $ 350 $ 350 $ 118.50
Slower $ (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.
Semih Yildirim ADMS 3530
7-28

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.
Itscost 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?

Semih Yildirim ADMS 3530


7-29

Project Interactions
NPV at
Year of PV of Year of NPV
Purchase Cost Savings Purchase Today
t=0 $50 $70 $20 $20.0
t=1 $45 $70 $25 $22.7
t=2 $40 $70 $30 $24.8
t=3 $36 $70 $34 $25.5
t=4 $33 $70 $37 $25.3
t=5 $31 $70 $39 $24.2

The decision rule for investment timing is to


choose the investment date which results
in the highest net present value today.
Semih Yildirim ADMS 3530
7-30

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?
Semih Yildirim ADMS 3530
7-31

Project Interactions
Long- vs Short-Lived Equipment
So far, this looks like a mutually exclusive
choice like problem 7.4
Calculate PV of the costs for the projects if the
a

discount rate is 6%:


Cash OutFlows in Dollars
Project: C0 C1 C2 C3 PV @ 6%
Machine D 15000 4000 4000 4000 $25,692.5
Machine E 10000 6000 6000 - $21,000
Should you accept Machine E
because the PV of its costs are lower?
. Semih Yildirim ADMS 3530
7-32

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
a

it!
What we should be asking is: How much would it cost per year to use
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.

. Semih Yildirim ADMS 3530


7-33

Project Interactions
Calculating Equivalent Annual Cost:
Cash Flows in Dollars
Project: C0 C1 C2 C3 PV @ 6%
Machine D 15000 4000 4000 4000 $25,692.5
Equivalent
Annual cost: 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
. Semih Yildirim ADMS 3530
7-34

Project Interactions
Cash Flows in Dollars
Project: PV @ 6% Equivalent Annual Cost
D $25,692.5 $9,611.50
E $21,000 $11,454.37
Long- vs Short-Lived Equipment
We 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.
Semih Yildirim ADMS 3530
7-35

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?


. Semih Yildirim ADMS 3530
7-36

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: C0 C1 C2 C3 C4 C5 PV @ 6%
New Machine 25 8 8 8 8 8 $58.70
Equivalent 13.93 13.93
Annual cost: ? ? 13.93
? 13.93
? 13.93
? $58.70

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!


. Semih Yildirim ADMS 3530
7-37

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
Project: C0 C1 C2 C3 IRR NPV @ 7%
H -350 400 - - 14.29% $24,000
12.96% $59,000
I -350 16 16 466

Project H has a higher IRR


but Project I contributes more to the value of the firm.

Obviously, you should prefer Project I!


. Semih Yildirim ADMS 3530
7-38

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.
. Semih Yildirim ADMS 3530
7-39

Project Interactions
Pitfalls with IRR: 2 Lending vs Borrowing
Calculate the IRR and NPV for the projects below:

Cash Flows in Dollars


Project: C0 C1 IRR NPV @ 10%
J -100 +150 50% + $36.4
50% - $36.4
K +100 -150

Both projects have the same IRR


but Project J contributes more to the value of the firm.

Obviously, you should prefer Project J!


. Semih Yildirim ADMS 3530
7-40

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%.

. Semih Yildirim ADMS 3530


7-41

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.
4. Some projects have no internal rate of return.
Look at Footnote #6 on page 219 for an example.

How should you evaluate a project in cases like this?

You should calculate NPV!


. Semih Yildirim ADMS 3530
7-42

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.
Semih Yildirim ADMS 3530
7-43

Capital Rationing
Rules for Project Selection
A firm maximizes its value by accepting all
positive NPV projects.
Withcapital rationing, you need to select a group
of projects which is within the companys
resources and gives the highest NPV.
This is done with the Profitability Index (PI)
pickthe projects that give the highest NPV per
dollar of investment.

PI = NPV / Initial Investment (C0)

Semih Yildirim ADMS 3530


7-44

Capital Rationing
Profitability Index (PI)
For example: Suppose your firm had the following
projects and only $20 million to spend:
NPV @
Project C0 C1 C2 10%
L -3.00 2.20 2.42 1.00
M -5.00 2.20 4.84 1.00
N -7.00 6.60 4.84 3.00
O -6.00 3.30 6.05 2.00
P -4.00 1.10 4.84 1.00
Budget -25.00

Which Projects should your firm select?


Semih Yildirim ADMS 3530
7-45

Capital Rationing
Profitability Index
NPV @
Project C0 10% PI
L 3.00 1.00 1/3 = 0.33 ACCEPT

M 5.00 1.00 1/5 = 0.20


N 7.00 3.00 3/7 = 0.43 ACCEPT

O 6.00 2.00 2/6 = 0.33 ACCEPT

P 4.00 1.00 1/4 = 0.25 ACCEPT

Semih Yildirim ADMS 3530


7-46

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.


Semih Yildirim ADMS 3530
7-47

Summary of Chapter 6

Semih Yildirim ADMS 3530


7-48

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!
Semih Yildirim ADMS 3530