FIN 502

Alternative Investment Criteria

Lecturer: Carmen Stefanescu

Investing Criteria

 Deciding on taking a project

o NPV
o Profitability Index (PI)
o Internal Rate of Return (IRR)
o Payback rule

 A good criterion or evaluation method should

o Consider all cash flows
o Account for timing differences
o Provide unambiguous decision rule
o Measure wealth created for shareholders

Introduction to Financial Valuation 2

Net Present Value

All cash flows

T
CFt
NPV   I 0  
1  RRR 
t
t 1

NPV  0  TAKE

Clear Timing
Decision Differences
Introduction to Financial Valuation 3
XYZ Corp: NPV Example

 XYZ Corp. considering an expansion project requiring an

immediate outlay of $110,000. Project would increase cash
flows by $14,000 per year for 10 years (starting next year.
Residual salvage value: $100,000. Should XYZ take project if
RRR = 10%?
0 1 2 3 10

– $110,000
$14,000 $14,000 $14,000 $14,000
$100,000
é æ öù
1 1 1
NPV = -$110, 000 + $14, 000 ê çç1- ÷ ú + $100, 000
êë 0.1 è (1+ 0.1)10 ÷øúû (1+ 0.1)
10

= $14, 578

Introduction to Financial Valuation 4

Profitability Index = Benefit/Cost Ratio

PV
Profitability Index (PI ) =
I0
Take project if PI > 1. Why?

PV
>1 Þ PV > I 0 Þ
I0

PV - I 0 > 0 Þ

NPV > 0
Introduction to Financial Valuation 5
PI Example

 Project A costs $200 and has a PV of $220

 Project B costs $100 and has a PV of $110
 Calculate PIA and PIB!
 Which should we take?
 What if A and B were mutually exclusive?

220 110
PI A   1.10 PI B   1.10
200 100

 What if A cost $205 instead of $200:

220
PI A   1.07
205
Introduction to Financial Valuation 6
Internal Rate of Return (IRR)

 Internal Rate of Return (IRR) is the discount rate that

makes the NPV of a project equal to zero:

T
CFt
NPV = -I 0 + å =0
(1+ IRR)
t
t=1

IRR > RRR Þ TAKE project, NPV >0

 Take any investment where the IRR exceeds the cost of

capital (RRR). Turn down any investment whose IRR is less
than the cost of capital (RRR).

Introduction to Financial Valuation 7

Payback Rule

 Payback Rule = amount of time it takes to recover or pay back

the initial investment. If the payback period is less than a pre-specified
length of time, accept the project.

 Projects A, B, and C each have an expected life of 5 years.

A B C
Cost $80 $120 $150
Cash Flow $25 $30 $35

 Payback: A: $80 ÷ $25 = 3.2 years

B: $120 ÷ $30 = 4.0 years
C: $150 ÷ $35 = 4.29 years
 Pitfalls: payback rule ignores the cost of capital, time value of money,
cash flows after the payback period; ad hoc decision criterion, but
easy to use.

Introduction to Financial Valuation 8

XYZ Corp: IRR Example
 XYZ Corp. considering an expansion project requiring an immediate outlay of
$110,000. Project would increase cash flows by $14,000 per year for 10
years (starting next year). Residual salvage value: $100,000. Should XYZ
take project if RRR = 10%? Find IRR and compare to RRR!
o NPV falls as RRR Increases
o If IRR = 12.22% < Cost of Capital NPV <0
o IRR = 12.22% > RRR = 10% ⇒ GO (NPV>0)

$150,000 IRR = 12.22%

$120,000

$90,000
NPV

$60,000

$30,000

$0
14,578
0 0.04 0.08 0.12 0.16
-$30,000
RRR

Introduction to Financial Valuation 9

IRR Limitations
 The IRR Investment Rule will give the same answer as the NPV rule in many,
but not all, situations.

 In general, the IRR rule works for a stand-alone project if all of the project’s
negative cash flows precede its positive cash flows.

 The IRR rule may disagree with the NPV rule and thus be incorrect. Situations
where the IRR rule and NPV rule may be in conflict:
o Scale
o Unconventional cash flows
o Multiple IRRs
o Nonexistent IRR

Introduction to Financial Valuation 10

IRR and Unconventional Cash Flows (1)

 Compare the IRRs in order to choose A OR B (assume A and B are mutually

exclusive). Cost of capital is 10% and 20%.

RRR = 10% RRR = 20%

A B A B A-B
NPV $2,384.33 $1,704.39 $319.44 $722.61 $2,500.00
IRR 21.96% 29.36% 21.96% 29.36% 15.66%
Investment (C0) -$6,000.00 -$6,000.00 -$6,000.00 -$6,000.00 $0.00
C1 $500.00 $5,000.00 $500.00 $5,000.00 -$4,500.00
C2 $1,000.00 $2,500.00 $1,000.00 $2,500.00 -$1,500.00
C3 $4,000.00 $1,000.00 $4,000.00 $1,000.00 $3,000.00
C4 $6,000.00 $500.00 $6,000.00 $500.00 $5,500.00

 RRR = 10%  NPV(A) > NPV(B) and when RRR = 20%  NPV(A) < NPV(B)
 IRR(A) < IRR(B)  projects have different scales, cannot compare IRR directly
 Incremental IRR = IRR of the difference in cash flows between A and B, IRR
of switching from B to A
 Incremental IRR = 15.66% > 10% accept A (its larger scale is sufficient to
make up for lower IRR).

Introduction to Financial Valuation 11

IRR and Unconventional Cash Flows (1)

$6,000

$5,000 NPVA NPVB

$4,000
Incremental IRR = 15.66%
$3,000
NPV

$2,000

$1,000

$0
0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0%
($1,000)

($2,000)

($3,000)
RRR
Introduction to Financial Valuation 12
Incremental IRR

 Shortcomings of the Incremental IRR Rule

o You must ensure that the incremental cash flows are initially
negative and then become positive.
o The incremental IRR may not exist.
o Multiple incremental IRRs could exist.
o The fact that the IRR exceeds the cost of capital for both projects
does not imply that both projects have a positive NPV.
o The incremental IRR rule assumes that the riskiness of the two
projects is the same.

Introduction to Financial Valuation

IRR and Unconventional Cash Flows (2)

 Compare the following projects (A, B, C, D and E).

A B C D E
RRR 10% 10% 11% 10% 10%
NPV $842,857 $1,028,571 $781,818 $9,091 $28,531
IRR 29.67% 28.00% 32.50% 15.00% 15.00%
Investment (C0) -300,000 -400,000 -400,000 -200,000 -200,000
C1 80,000 100,000 130,000 230,000 0
C2 perpetuity perpetuity perpetuity 0 0
C3 0 304,175
g 3% 3% 0% 0% 0%

 Problem of scale.
 Problem of cash flow timing.
 Problem of risk.

Introduction to Financial Valuation 14

IRR and Unconventional Cash Flows (3)

 Consider a mining project with the following cash flows. The initial outlay
is C0 = – $60, year 1 CF is C1 = + $155. In year 2, there are additional costs
due to environmentalist lobby groups, C2 = – $100. IRR= ?
0.10

0.05 IRR = 25% IRR = 33.3%

0.00
0% 10% 20% 30% 40% 50%
NPV

-0.05

-0.10

-0.15

-0.20

-0.25
RRR

 Multiple IRRs! For RRR < 25% and RRR >33.3%, the NPV is negative
and the project should be rejected
Introduction to Financial Valuation 15
IRR and Unconventional Cash Flows (4)
0 1 2
 Consider the following cash flows
+ 1,000 – 3,000 2,500

3, 000 2, 500
 NPV at 10%: 338, 84 = 1, 000 - +
1.1 1.12
 This project has no IRR!
450

400

350
NPV

300

250

200

150

100

50 RRR
0
5%

115%
80%

100%
105%
110%

120%
125%
130%
135%
10%
15%
20%
25%
30%
35%
40%
45%
50%
55%
60%
65%
70%
75%

85%
90%
95%

Introduction to Financial Valuation 16

Main Problems with IRR

 IRR Rule. Selecting the project with the highest IRR may lead to mistakes. If
certain instances occur, projects IRRs cannot be meaningfully compared.

 Scale problems (similar to the problem with PI). Would you rather have 20%
on $5 or 10% on $20?
 If a project’s size is doubled, its NPV will double. Not the case with IRR .
IRR rule cannot be used to compare projects of different scales.

 Timing Problems: when projects have the same scale, the IRR may lead you
to rank them incorrectly due to difference in the timing of the cash flows.

 Unconventional cash flows.

 Projects with back-loaded cash flows look worse with using IRR
 If cash flows change sign more than once (for example, - + -) there
could be more than one IRRs (or no IRR at all)

 The IRR that is attractive for a safe project need not be attractive for a much
riskier project.
Introduction to Financial Valuation 17
Projects With Different Lives

 Firm can select one of two machines. Machine is needed for

maintenance. Will not affect cash flow except through its costs
 r =10%

Initial outlay Operating costs per year Life

$10,000 $3,000 3
$9,000 $4,000 5

é 1 æ 1 öù
Machine A; PV = -10, 000 - 3, 000 ´ ê ç1- 3 ÷ú
= -17, 460.55
ë 0.10 è 1.10 øû
é 1 æ 1 öù
Machine B; PV = -9, 000 - 4, 000 ´ ê ç1- 5 ÷ú
= -24,163.47
ë 0.10 è 1.10 øû

Introduction to Financial Valuation 18

Equivalent Annual Cost (EAC)

 Can we compare the two? Machine 2 provides maintenance longer!!!

 Replacement Chain: find common life for the two and calculate PV
over that life - bothersome

 Equivalent Annual Cost (EAC) = What would the annual cost of

maintenance service be (paying same amount each year)?
é 1 æ 1 öù
17, 460.55 = C ´ ê ç1- 3 ÷ú
Þ C = $7, 021.15
ë 0.10 è 1.10 ûø
é 1 æ 1 öù
24,163.47 = C ´ ê ç1- 5 ÷ú
Þ C = 6, 374.17
ë 0.10 è 1.10 ûø

 Choose machine 2. We assume that we will replace the chosen

machine indefinitely (in the foreseeable future…)

Introduction to Financial Valuation 19

Impact of Resource Constraints
 Small business has only $100,000 available for projects, unable to
raise any additional funding

 When there is capital rationing, ranking projects by their profitability

index is useful.

Projects PV I0 NPV = PI =
($ thousands) ($ thousands) PV − I0 PV/I0
A 144 90 54 1.6
B 70 50 20 1.4
C 100 50 50 2

 Maximum combined NPV is achieved if projects B and C are chosen

=> here PI is superior to NPV but is not perfect
Introduction to Financial Valuation 20