Chapter No.

Net Present Value And

Other Investment Criteria
Some decisions about capital budgeting

• General Motors had 12 factories in excess. Why?

• Toyota plans to invest $ 1.3 billion in new plant.
• Honda plans to launch new plant of $550 millions.
• BMW expanded its plant to new X6 model.

• All these are examples of capital budgeting

• How these decisions are made?
• Why capital budgeting is needed?
• Who make these decisions?
• Some basics

• What investors want?

– Maximization of stock’s values
• How an investment be evaluated?
– Investment Techniques
• Who create value for investors?
– Managers of a company
• How managers decide to invest in capital?
– Via capital budgeting
• What approach is the best?
– NPV
In chapter 1, we defined 3 major decisions

1. Capital Budgeting Decision

2. Capital Structure Decision
3. Working Capital Management Decision

The overall goal is to

Maximize the value
Stocks
Introduction
What is Capital Budgeting ?
• Capital?
– This words means “ long term.”

• Capital budgeting is the allocation of funds to long-lived

capital projects.
• A Capital project is a long-term investment in tangible
assets.
• But why we need to do Capital budgeting?
– Three Reasons
• The factor of irreversibility
• Huge amount of outlay
• To reduce the factor of risk
 Types of capital projects

1. Replacement projects: Existing assets are replaced

with similar assets
1. Example: A Manufacturing company replacing
equipment on an assembly line
2. Expansion Projects: In this projects, business
operations are expanded
1. Example: Wal-Mart opening a new retail outlet
3. New Products and Services:
3. Apple’s initial introduction of the iphone
4. Introduction of OPPO
4. Regulatory, safety and environmental projects
Mandatory projects
5. Others
1. Research and Development
Basic principles of Capital Budgeting

Decisions are based The timing of cash

on cash flows. flows is crucial.

Cash flows are Cash flows are on an

incremental. after-tax basis.

Financing costs are

ignored.

Copyright © 2013 CFA Institute 9

Basic principles of capital budgeting
Principles
1. Decisions are based on cash flows and not on accounting
income

2. The timing of cash flows are important and by this, we

mean the time value of money

3. Cash flows are incremental

4. Cash flows are on after-tax basis

5. Financing costs are ignored

Cash flow patterns
Today 1 2 3 4 5
| | | | | |
| | | | | |

–CF +CF +CF +CF +CF +CF

–CF –CF +CF +CF +CF +CF

–CF +CF +CF +CF +CF

Negative sign is the cash outflow
Positive sign is the cash inflow
• When evaluating more than one project at a time, it is
important to identify whether the projects are independent
or mutually exclusive
– This makes a difference when selecting the tools to evaluate the
projects.
• Independent projects are projects in which the
acceptance of one project does not preclude the
acceptance of the other(s).

• Mutually exclusive projects are projects in which the

acceptance of one project precludes the acceptance of
another or others.
 Capital Rationing
• Capital rationing is when the amount of expenditure for
capital projects in a given period is limited.

• If the company has so many profitable projects that the

initial expenditures in total would exceed the budget for
capital projects for the period, the company’s management
must determine which of the projects to select.

• The objective is to maximize owners’ wealth, subject to the

constraint on the capital budget.
– Capital rationing may result in the rejection of profitable projects.
 Investment Criteria
6 investment criteria
1. Net Present Value (NPV)
2. Internal Rate of Return (IRR)
3. Pay back period
4. Discounted payback period
5. Average Accounting Rate of Return (AAR)
6. Profitability index (PI)
7. Modified internal rate of return (this is in link
with IRR)
The Net Present Value Approach
Prerequisites
1. Find an investment and analyze
2. Forecast future cash flows from the project
3. Determine the opportunity cost of capital
1. Thus reflects two things: TVM and Risk
4. Use this rate to discount future cash flows
5. The sum is called PV
6. Calculate NPV by subtracting an investment from
PV.
7. Accept if NPV is positive, reject if negative
Why NPV ?
Because, it leads to right decision.

NPV decision rule says that

Payback period
• Payback period is the length of time requires to
recover our initial payment.
• Lets consider an investment
– Initial investment is $50,000
– Cash inflow as given below

– What is the payback period.

Payback period

Payback decision Criteria

Short Coming of Payback Rule.
1. Future cash flows are simply added: no NPV
2. No Risk differences are considered: same for both
risky and safe projects
3. Arbitrary cutoff point
4. Cash flows after the cutoff point are ignored
entirely
Suppose, our payback period is 2 years or less
• We have two projects: short and long projects
• Short project’s payback is = 1.75 years
• Long project’s payback is = 2 years
• With a cutoff point of 2 years, short project is accepted
while long project is rejected
• But NPV comes with different answer.

• Thus long project is accepted which increases the

value while the other decreases the value.
Redeeming Qualities of the Rule
• Used by large companies for minor decisions
– No detail analysis
– Simple and easy to calculate
– Useful for investment with liquid cash inflows
• Short coming of the payback rule is TVM ignored
• But addressed and fixed here

Definition
It is the length of time required until the sum of the
discounted cash flows is equal to the initial
investment.
To see how the mechanics of the discounted payback
rule works, lets consider the example below

Discount each cash flow

And add them.
Draw backs of discounted payback rule
1. Not simpler than NPV to calculate
2. Arbitrary cutoff point
3. Cash flows beyond cutoff are ignored
 Also called benefit-Cost analysis
 Cost of the project: $200
 Present value of future cash flows: $220
 The NPV is $20. so accept the project
 If the NPV is positive, the PV must be bigger than
the cost of the investment.
 So should the PI
 Thus PI is similar to NPV
 Most important after NPV

 Our goal is to find a single rate of return that summarizes the merits
of the project
 “Internal” >>>depends on cash flows, not on the rates offers
elsewhere

 Examples
 Suppose Cost of the project : $100
 Pays $110 in one year
 What is the return on this investment?
 10 percent. How?

 How you would decide to accept the project?

 The decision depends on the comparison of IRR with RRR

 If IRR = RRR (accept)

 If IRR > RRR (Accept)
 If IRR < RRR (Reject)

Thus the decision criterion is:

 If the NPV=0
 Economically, this is a break-even position because value is neither
created nor destroyed.
 Lets solve for R
This R which we call the internal rate of return is the rate of return
(simply) and is the discount rate that makes the NPV equals to Zero.
• So we define IRR as:

• Perfect for single period cash flow

• What about multiple cash flows?
• IRR is found by trial and error method
• Different rates are tried and we get different answers.
• NPV at different rates is below
• Thus NPV and IRR appears similar
• The curve is called the Net Present Value Profile

• Accept the project if the required return is less than IRR, otherwise
reject the project.

• Are they both leads to identical decisions:

– Yes but at two conditions
– All cash flows are conventional
– Projects are independent

• How spread sheet be used to calculate IRR?

• Lets see
Problems with IRR
• An issue when cash flows are nonconventional
• Two or more investments and their comparison

• Nonconventional cash Flows

– Initial investment: $60
– First year cash flow : 155
– 2nd year: mine depletes and spend $100 to restore the terrain
– So the 1st and 3rd year cash flows are negative

– To find IRR, we can calculate the NPV are various stages:

• Peculiar behavior of NPV.
As the discount rates increases from zero to 30,
the NPV starts out negative but then become
positive
This is strange because as the discount rate rises,
NPV rises too (against the discounting)
Again become negative after it become smaller
and smaller

Now the question is what is the IRR?

We draw the NPV profile like the one below
NPV is zero at points
• At 25 % IRR
• At 33.5 IRR

Thus IRR breaks down completely (How?)

• Suppose RRR is 10%, should you accept or not
• Both IRR are greater than 10%
• But the problem is that NPV is negative at any discount
rate less than 25%. So not a good investment
But when should we accept the project?

• When NPV is positive

• In this case, NPC is positive only when our RRR is
between 24% to 33.5%
• Moral of the story
– Strange things starts to happen to IRR when the cash
flows are nonconventional
– But don’t worry because we have the solution
• Use NPV rule
• But what is the rate of return ? Does not give a good answer.
2nd Problem : Mutually Exclusive Investment
• Mutually exclusive is a situation in which you take only
one of the many alternative
• Thus mutually exclusive investment decision is a situation
in which taking one investment prevents taking the other.

• If you have two or more investments, which one to select?

• The answer is simple ( The one with largest NPV)
• Can we say that the best one has the largest return as well.
Lets see the next slide for NPV profiles
• Crossover Point

• The IRR is 20% is the discount rate

• Indifferent between the two investment because NPV=20
And is the cross over rate
Financing or investing?
Consider the following two independent investments:

• Suppose the RRR for both projects is 12%.

• According to IRR rule, which project should we accept?
• For both the IRR is 30% and thus should accept both.
• However, under NPV rule, the NPV of Project B at 12% is

The NPV and IRR disagree here.

Lets see below, the NPV profile for each one.
S
The Modified Internal Rate of Return (MIRR)

• Problems in IRR are addressed by using MIRR

• Several ways to calculate MIRR but the basic idea is to
– Modify the cash flows first
– Then calculate the IRR using the modified cash flows

• Suppose the cash flows are as:

: -$60, +$155, and -$100.
We saw there are two IRR: 25% and 33.5%
• Lets consider three different MIRR, but each one
has the property that only answer will result ad
thus thereby eliminating the IRR problem.
Method # 1: The Discounting Approach
The idea is
• Discount all negative cash flows back to the present at
RRR.
• Then, Add them to the initial cost
• Then Calculate the IRR using the method discussed before.
MIRR or IRR: which one is better to use?

MIRR is controversial
 At the one end, MIRR is superior to IRR because it does
not suffer from multiple rate of return.

 at the other end, MIRR should stand for meaningless rate

of return.
 Three different methods and by reason, no one is better than
other.
 The differences are small for small project but…

Conclusion: No need to reinvest the interim cash flows

End of the Chapter!