Net Present Value and Other

Investment Rules
Lecture # 01
Dr. Raazia Gul
 Content
• Investment, types of investment,
• Capital budgeting techniques:
• NPV
• Single Cash inflow
• Many Cash inflow
• Independent and mutually exclusive projects.
• Payback periods
• Cumulative net cash flows based approach
• Discounted net cash flows based approach
• Profitability index
• NPV Versus IRR
• Modified IRR ( MIRR)
 Definition

• Capital budgeting is the decision process that

managers use to identify those projects that are
profitable and add value to the company.
• In simple words, a capital budgeting consist of
some techniques that screen out the projects for
those that add value to the company.
 Importance of capital
budgeting technique
• Capital budgeting decisions define company's strategic
decision
• Eg: Entering into new market required capital expenditure
• Poor capital budgeting leads to financial loss
• Therefore good capital budgeting technique will help the
company to become more competitive and profitable.
• Capital budgeting decisions increase shareholder wealth.
How?
 Steps in Capital decision
Process
• Step 1: Idea Generation.
• Idea can come from number of sources
• Eg: Senior management or employees
• Step2 : Analyzing project proposals.
• A Cash flow forecast should be made to determine expect profitability.
• Step 3: Create the Firm-Wide capital budget.
• Firm should select the most profitable projects.
• Step 4: Monitoring decisions and conducting a post Audit:
• Actual results should be compared with projected..
 Capital budgeting methods

• Net Present value (NPV)

• Payback
• Cumulative net cash flow method
• Discount net cash flow method
• Internal rate of return(IRR)
• Profitable index(PI)
• Modified internal rate of return(MIRR)
• AAR
 Types of Projects

• Independent project:
• Those project whose cash flows are independent of
each others
• Mutually exclusive project:
• Mutually exclusive means that if one project is
accepted, the other must be rejected.
• Decisions based on NPV
 Net Present Value(NPV)

• NPV is sum of the present values of all the expected

gradually increasing cash flows inflows”if the project is
undertaken”
CF1 CF2 CFn
• NPV = CFO  1
 2
 ....
(1  r ) (1  r ) (1  r ) n

• CFo indicate the cash out flow(Capital expenditure), while

CF1 or CF2 indicates the after tax Cash inflows( Profit).
• The value of CFo will always be negative, because it shows
the company investment on a project.
 Net Present Value(NPV)

• Positive NPV indicates Profit( Accept the

project) :
• A positive NPV project is expected to increase share
holder wealth
• Negative NPV indicates Loss (Reject the
project):
• A negative NPV project is expected to decrease share
holder wealth
•
Payback
Payback period:
Period
• It is defined as the expected number of years required to
recover the original investment or initial investment.
 Payback periods ( Con’t)

• There are two approach for Payback period approaches:

• Cumulative/Ordinary net cash flows based approach:
• When payback period is calculated without discounting the future
cash inflows or in other words, when time value of money concept
is excluded.
• Discounted net cash flows based approach:
• When payback period is calculated by discounting the future cash
inflows 1st or
• In other words, when time value of money is considered.
 Profitability Index
• Profitability Index(PI):
• The PI is the present value of a project’s future cash flows divided by the initial investments .Present
value of (future cash flows) per $ or Rs of initial Cost.
N
CF
 t 1 (1  r ) t
PI 
CFo

• OR NPV
PI  1 
CFo

• Accept the project: PI>Rs/$1.00

• Reject the project : PI<Rs/$1.00
 Internal Rate of Return(IRR)
• Internal rate of return
• IRR is the discount rate that makes the present value of expected incremental after tax
cash flows just equal to the initial cost of the project..
• It is the discount rate that makes the PV of a project’s estimated cash inflows equal to
the PV of project’s estimated Cash outflows

• Decisions based on Internal rate of return:

• IRR> Cost of capital/required rate of returns ( Opportunity cost) ( accept the project )
• IRR <Cost of capital/required rate of returns ( Opportunity cost) ( Reject the project)
 Internal Rate of Return(IRR)
Con’t
• IRR rate of return is generally calculated through trial and
error method.
• IRR through this method is calculated either through
manually, financial calculator or Excel function= IRR
• IRR can also be calculated through interpolation method:

(iH  iL ) * (NPVL  NPVC )

IRR  iL 
NPV L  NPV H
 Example of IRR

• Consider a project that costs $100 today and

pays $120 in one year.
• What is the return on this investment? Or calculate
the IRR
• If required rate of return is 5%..Should we accept
the project ?
 IRR and NPV rules always
lead to identical decisions. If …
• IRR and NPV rules always lead to identical decisions. If …
• The project’s cash flows is conventional( first cash flow
negative and the rest cash flows are positive)
• The projects are independent of each other and not mutually
exclusive.
• Then IRR and NPV rules will lead to same the results.
 Example # 1 of IRR and NPV
(independent and conventional cash flows projects)

• An investment costs $100 and has a cash flow of $60 per year for
two years.

• Calculate the Internal rate of return

• Calculate the NPV if required rate of return is 10%.
• Show graphically the relationship between the IRR and NPV or show the NPV
profile.

Hint : 13.1%
Example of IRR and NPV (Con’t)
IRR and NPV rules always lead to different
or confusing decisions. If …

• IRR and NPV rules always lead to different or

confusing decisions. If …
• The project has unconventional cash flow
• The projects are mutually exclusive
• How….??
• Q13 &Q14
 Example # 4 of IRR and NPV
(Mutually exclusive projects) –Calculate IRR for A and B, also calculate NPV,
Hint : 24%,21%( If the required rate if return is 10%)
 Example # 4 of IRR and NPV
(Mutually exclusive projects) –Calculate IRR for A and B,
also calculate NPV

• NPV Profile:
 Crossover Rate

• Cross over rate:

• It is discount rate, where NPV of one project is
equal to the NPV of another project
CFA,1  CFB,1 CFA,2  CFB,2 CFN,t  CFN,t
0  ..
(1  CR ) (1  CR ) (1  CR )
 Example # More than one IRR
• Suppose we have a strip-mining project that requires a $60 investment. Our cash
flow in the first year will be $155. In the second year, the mine will be depleted,
but we will have to spend $100 to restore the terrain. If the required rate of returns
is 10%

• Calculate the NPV and IRR

• Make NPV profile
• Hint: 25% and 33.33%
 Modified internal rate of
returns(MIRR)
• Modified internal rate of return( MIRR) is used to address the
problem of unconventional cash flow through the following
methods:
1) Discounting approach:
2) The Reinvestment approach:
3) The combination approach:
 Modified internal rate of
returns(MIRR) ( Con’t)
1) Discounting approach:
• All the negative cash flows are discount by required rate of return and
added to initial cost and then IRR is calculated
2) The Reinvestment approach:
• All the negative and positive cash flows are compounded by required
rate of return to the end of project’s life except the first cash flow( initial
investment) and IRR is calculated
3) The combination approach:
• All the negative cash flows are discounted and positive cash flows are
compounded by required rate of return and then IRR is calculated.
 NPV Versus IRR In mutually
exclusive
• The NPV and IRR would have different decision in
mutually exclusive project due to two reasons
• Size of the project (Scale)
• Timing of the Project
• Therefore, the following methods should be used
• Incremental NPV
• Incremental IRR
Example: Scale Problem
Example : The Timing
Problems
Solution
 Size of the Project (Scale)

• Decision :
• Compare the NPVs of the two choices .
• Calculate the incremental NPV
• Compare the incremental IRR to the discount rate .
 Incremental NPV(INPV)

• Incremental NPV
CFA,1  CFB,1 CFA,2  CFB,2 CFN,t  CFN,t
INPV  CFo , A  CFo ,B   ..
(1  CR ) (1  CR ) (1  CR )
 Incremental IRR(IIRR)

• Incremental NPV
CFA,1  CFB,1 CFA,2  CFB,2 CFN,t  CFN,t
INPV  CFo , A  CFo ,B   ..
(1  IIRR) (1  IIRR ) (1  IIRR)
 Average Accounting
returns(AAR)
• Average Accounting returns(ARR)
• Based on the average accounting return rule, a project is
acceptable if its average accounting return exceeds a target
average accounting return.
AvgNI
AAR 
AvgBookof ( II )