FINA 5120

FINA 5120
Corporate Finance
Veronique LAFON-VINAIS
Associate Professor of Business Education, Dept of
Finance
Fall 2022
INVESTMENT DECISION RULES
Key Concepts
• NPV Decision Rule
• Payback Rule
• IRR Rule
– IRR
– Crossover Point
• Profitability Index
The NPV Decision Rule
• Most firms measure values in terms of Net Present
Value (NPV) – that is, in terms of cash today
NPV = PV (Benefits) – PV (Costs)

• Logic of the decision rule:
– When making an investment decision, take the alternative
with the highest NPV, which is equivalent to receiving its NPV
in cash today
• This is based on our Valuation Principle and
Cost/Benefits Analysis framework
Copyright ©2015 Pearson Education, Inc. All rights reserved.
FINA 5120 – The NPV Decision Rule

• A simple example:
– In exchange for $500 today, your firm will receive $550 in one
year. If the interest rate is 8% per year:
• PV(Benefit)= ($550 in one year) ÷ ($1.08 $ in one year/$ today) = $509.26 today
– This is the amount you would need to put in the bank today to
generate $550 in one year (the amount you need to invest at
current interest rates to recreate the cash flow)
– NPV= PV (Benefit) $509.26 – PV (cost) $500 = $9.26 today
• As long as NPV is positive, the decision increases the
value of the firm regardless of current cash needs or
preferences

Illustration
Problem:
• After saving $2,500 waiting
tables, you are about to buy a
50-inch LCD TV.
• You notice that the store is
offering “one-year same as
cash” deal. You can take the TV
home today and pay nothing
until one year from now, when
you will owe the store the
$2,500 purchase price.
• If your savings account earns
4% per year, what is the NPV
of this offer? Show that its NPV
represents cash in your pocket.

Solution
• You are getting something (the TV) worth $2,500 today and in
exchange will need to pay $2,500 in one year. Think of it as getting
back the $2,500 you thought you would have to spend today to get the
TV. We treat it as a positive cash flow.
Today In one year

Cash flows:
$ 2,500 –$ 2,500
• The discount rate for calculating the present value of the payment in
one year is your interest rate of 4%.
• You need to compare the present value of the cost ($2,500 in one
year) to the benefit today (a $2,500 TV).

Solution
• Execute: NPV  $2,500  $12,500  $2,500  $2,403.85  $96.15
1.04
• You could take $2,403.85 of the $2,500 you had saved

for the TV and put it in your savings account.
• With interest, in one year it would grow to $2,403.85 
(1.04) = $2,500, enough to pay the store.
• The extra $96.15 is money in your pocket to spend as
you like.
Food for thought: why do stores
offer this kind of deal? In which
circumstances would it make no
senseCopyright
for you to take the deal?
©2015 Pearson Education, Inc. All rights reserved.

Using the NPV Rule for a Stand Alone Project
• A take-it-or-leave-it decision:
– Fredrick’s Feed & Farm, a fertilizer company, believe they can
create a new environmentally friendly fertilizer at a large
savings over the company’s existing fertilizer
– The fertilizer will require a new factory that can be built at a
cost of $81.6 million.
– Estimated return on the new fertilizer will be $28 million after
the first year, and last four years.
FINA 5120 – Using the NPV Rule

Using the NPV Rule
• The cash flows are an immediate $81.6M outflow and an annuity inflow of
28M per year for 4 years.
• Given a discount rate r, the NPV is:
28 28 28 28
NPV  81.6    
1  r (1  r ) 2 (1  r )3 (1  r ) 4
• We can also use the annuity formula:
28  1 
NPV  81.6  1  4 
r  (1  r ) 
• To apply the NPV rule, we need to know r, the company’s cost of capital
(a.k.a. discount rate).
• If the company’s cost of capital is 10%, the NPV is $7.2 million and they
should undertake the investment

Using the NPV Rule
• NPV of Fredrick’s project
– The NPV depends on the cost of capital
– We can compute an NPV Profile, which graphs the project’s
NPV over a range of discount rates.
– Based on this data, the NPV is positive only when the
discount rates are less than 14%, which is the IRR of the
project

NPV of Fredrick’s New Project
Reminder! The IRR is the

discount rate r such that
the PV of the benefits
equals the PV of the costs,
i.e. NPV = 0

Using the NPV Rule
• We can compute the IRR of Fredrick’s project either by
using our NPV profile, or directly in our calculator:
Given: 4 -81.6 28 0
Solve for: 14
Excel Formula: =RATE(NPER,PMT,PV,FV)
= RATE(4,28,-81.6,0)
• As long as our cost of capital is less than the IRR of the

project, the NPV will be positive and we should
undertake the project

The Payback Rule
• The payback period is the 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, you accept the project. Otherwise, you reject
the project.
– The payback rule is used by many companies because of its
simplicity.
FINA 5120 – Payback Rules

Illustration
Problem:
• When choosing between two projects, assume a company chooses
the one with the lowest payback period. Which of the following two
projects would the firm undertake the project under this rule?
Year Project A Project B
Expected Net Expected Net
Cash Flow Cash Flow
0 -$10,000 -$10,000
1 $1,000 $5,000
2 $1,000 $5,000
3 $8,000 $5,000
4 $1,000,000 $5,000
FINA 5120 – Alternative Decision Rules

Solution
• For Project A:
– The sum of the cash flows from years 1 - 3 is $10,000.
– This will cover the initial investment of $10,000 at the end of year 3.
• For Project B:
– The sum of the cash flows from years 1 and 2 is $10,000.
– This will cover the initial investment of $10,000 at the end of year 2.
• Because the payback for Project B is faster than for Project A, Project B
will be chosen, even though the 4th cash flow for Project A is very high!

Alternative Decision Rules : Payback Rule
• Weakness of the Payback Rule
– Ignores the time value of money
– Ignores cash-flows after the payback period
– Lacks a decision criterion grounded in economics
• Alternative: discounted payback rule: only accepts
projects where the sum of the discounted cash flows
within the payback period are greater than the initial
investment.
– Problem: still ignores Cash Flows after the payback period
and the decision criterion of the period itself still not grounded
in economics

The Internal Rate of Return (IRR) Rule
• Internal Rate of Return (IRR) Investment Rule
– Take any investment where the IRR exceeds the cost of
capital.
– Turn down any investment whose IRR is less than the cost of
capital.
• 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.
FINA 5120 – IRR Rule

Applying The IRR Rule: Pitfalls
• In other cases, 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:
– Delayed Investments
– Nonexistent IRR
– Multiple IRRs

Pitfall 1: Delayed Investments
• Assume you have just retired as the CEO of a successful
company. A major publisher has offered you a book deal.
• The publisher will pay you $1 million upfront if you agree
to write a book about your experiences. You estimate that
it will take three years to write the book.
• The time you spend writing will cause you to give up
speaking engagements amounting to $500,000 per year.
• You estimate your opportunity cost to be 10%.
• Should you accept the deal?
– Calculate the IRR and NPV

Pitfall 1: Delayed Investments (cont'd)
NPER RATE PV PMT FV Excel Formula
Given 3 1,000,000 -500,000 0
Solve for r 23.38% RATE(3,-500000,1000000,0)
– At 23.38%, the IRR is greater than the cost of capital.

– Thus, the IRR rule indicates you should accept the deal
– Should you accept the deal?
500, 000 500, 000 500, 000
NPV  1,000,000   2
 3
  $243,426
1.1 1.1 1.1
– Since the NPV is negative, the NPV rule indicates you should
reject the deal.

NPV of Star’s $1 Million Book Deal
• When the benefits of an investment occur before the costs, the NPV
is an increasing function of the discount rate.

Pitfall 2: Multiple IRRs
– Suppose Star informs the publisher that it needs to sweeten
the deal before he will accept it.
– The publisher offers $550,000 advance and $1,000,000 in
four years when the book is published.
– Should he accept or reject the new offer?
– The cash flows would now look like
– The NPV is calculated as
FINA 5120 – IRR Rule Copyright ©2017 Pearson Education, Inc. All rights reserved.
Pitfall 2: Multiple IRRs (cont'd)
– By setting the NPV equal to zero and solving for r, we find the
IRR.
– But in this case, there are two IRRs: 7.164% and 33.673%.
– Because there is more than one IRR, the IRR rule cannot be
applied.
– Between 7.164% and 33.673%, the book deal has a negative
NPV. Since your opportunity cost of capital is 10%, you should
reject the deal.
FINA 5120 – IRR Rules

NPV of Star’s Book Deal with Royalties

Pitfall 3: Nonexistent IRR
• Finally, Star is able to get the publisher to increase his
advance to $750,000, in addition to the $1 million when
the book is published in four years.
• With these cash flows, no IRR exists; there is no
discount rate that makes NPV equal to zero.

NPV of Star’s Final Offer
• No IRR exists because the NPV is positive for all values of
the discount rate. Thus the IRR rule cannot be used.

Mutually Exclusive Projects
• When you must choose only one project among
several possible projects, the choice is mutually
exclusive.
– NPV Rule
• Can’t just pick the project with a positive NPV
• The projects must be ranked and the best one chosen
• Pick the project with the highest NPV
– IRR Rule
• Selecting the project with the highest IRR may lead to mistakes.

Illustration
Problem:
• You own a small piece of commercial land near a university. You are
considering what to do with it. You have been approached recently with an
offer to buy it for $300,000. You are also considering three alternative uses
of the land for yourself: a bar, a coffee shop, and an apparel store. You
assume that you would operate your choice indefinitely, eventually leaving
the business to your children. You have collected the following information
about the uses. What should you do?
Initial Cash flow in the Growth
Cost of capital
Investment First Year rate
Bar $425,000 $65,000 5.0% 12.0%
Coffee shop $250,000 $45,000 5.5% 12.5%
Apparel Store $700,000 $90,000 4.5% 13.0%

Solution
• Since you can only do one project (you only have one piece of land),
these are mutually exclusive projects.
• In order to decide which project is most valuable, you need to rank them
by NPV.
• Each of these projects (except for selling the land) has cash flows that
can be valued as a growing perpetuity, the present value of the
inflows is CF1 / (r-g).
CF1
• The NPV of each investment will be  Initial Investment
rg

Solution
The NPVs are:
$65,000
Bar : - $425,000  $503,571
0.12 - 0.05
$45,000
Coffee Shop : - $250,000  $392,857
0.125 - 0.055
$90,000
Apparel Store : - $700,000  $358,824
0.13 - 0.45
Alternative NPV
Bar $503,571
Coffee Shop $392,857
Apparel Store $358,824
Sell the Land $300,000
Based on the rankings the bar should be chosen.


Choosing Between Projects: IRR v. NPV – Impact of
Scale
• Differences in Scale
– Do you prefer a 200% return on $1 or a 10% return on $1
million?
• In net cash terms the first gives you $2 and the second $100,000. Reasoning
only in terms of IRR is not sufficient.
– A 10% IRR can have very different value implications for an
initial investment of $1 million vs. an initial investment of $100
million
– The IRR is not affected by the scale of the investment
opportunity because the IRR measures the average return of
the investment, so IRR rule cannot be used to compare
projects of different scale
FINA 5120 – Choosing Between Projects

Illustration: Javier’s Choice – Part 1
• Identical scale
• Javier is evaluating two investment opportunities
– If he goes into business with his girlfriend, he needs to invest
$10,000 and the business will generate $6,000 per year for 3
years
– If he starts a two computers Internet café, the setup cost is
$10,000 and will generate $5,000 for 3 years
• Opportunity cost of capital is 12% for both
• Which should Javier choose?

Javier’s Choice Part 1 (Ct’d)
• NPV of Javier’s investment in his girlfriend’s business:
6000 6000 6000
NPV  10,000     $4, 411
1.12 1.12 1.12
2 3
• NPV of Javier’s investment in the Internet café:

NPV = -10,000+ + + = $2,009
• Based on the NPV rule, Javier should invest with his

girlfriend

Javier’s Choice Part 1 (Ct’d)
• Let’s compute the IRR of his girlfriend’s business:
Given: 3 -10,000 6,000 0
Solve for: 36.3

Excel Formula: =RATE(NPER,PMT,PV,FV) =
RATE(3,6000,-10000,0)
• If we calculate the IRR for the internet café we find

23.4%, which is lower than the girlfriend business

NPV of Javier’s Investment Opportunities
• The NPV of the

girlfriend’s business is
always higher than
the NPV of the
internet café
• The IRR of the
girlfriend business
(36.3%) is higher than
that of the café
(23.4%)

Illustration: Javier’s Choice – Part 2
• Change in Scale:
– Javier realizes he can just as easily install five times as many
computers in the Internet café
– Setup costs would be $50,000 and annual cash flows would
be $25,000
– What should he do now?
– When we calculate the NPV of the revised internet café
project we find the NPV is now five times larger as it is
affected by scale
25,000 25,000 25,000
NPV  50,000     $10,046
1.12 1.12 2
1.12 3

Javier’s Choice – Part 2
• However, IRR is unaffected by scale (23.4%)
because we are scaling all the cash flows up by a
factor of 5
• IRR of girlfriend’s business is the same (36.3%)
Given: 3 -50,000 25,000 0

Solve
23.4
for:
Excel Formula: =RATE(NPER,PMT,PV,FV) =
RATE(3,25000,-50000,0)

NPV of Javier’s Investment Opportunities
• IRR for the café stays at
23.4%
• IRR for the girlfriend business
is still 36.3%
• In this case the NPV of the
girlfriend’s business is larger
than the NPV of the 10
computers internet café only
for discount rates (opportunity
cost of capital) over 20%
• The crossover point is the
discount rate that makes the
NPV of the two alternatives
equal.

Computing the Crossover Point
• The crossover point is the discount rate that makes the NPV
of two alternatives equal.
– We can find the discount rate by setting the equations for the NPV of
each project equal to each other and solving for the discount rate.
• In general, we can always compute the effect of choosing
Project A over Project B as the difference of the NPVs.
– At the crossover point the difference is 0.
• The crossover point is the discount rate at which we would be
indifferent between the two projects because the incremental
value of choosing one over the other would be zero
• Solving for the crossover point is just like solving for the IRR

Illustration: Crossover point for Javier’s Choice
• Setting the difference equal to 0:
NPV Internet cafe NPV girlfriend business
25, 000 25, 000 25, 000  6, 000 6, 000 6, 000 
NPV  50, 000   2
 3
   10, 000   2
 3 
 0
1 r (1  r ) (1  r )  (1  r ) (1  r ) (1  r ) 
We can simplify the 19, 000 19, 000 19, 000
40, 000   2
 3
0
equation as follows: (1  r ) (1  r ) (1  r )
• we can need to use a financial calculator or spreadsheet:
-
Given: 3 19,000 0
40,000
Solve
20.04
for:
Excel Formula: =RATE(NPER, PMT, PV,FV) =
RATE(3,19000,‑40000,0)
FINA 5120 – Choosing Between Projects Copyright ©2015 Pearson Education, Inc. All rights reserved.
IRR Versus the IRR Rule
• While the IRR rule has shortcomings for making
investment decisions, the IRR itself remains useful.
• IRR measures the average return of the investment
and the sensitivity of the NPV to any estimation error in
the cost of capital.
FINA 5120 – IRR v IRR Rule

Choosing Between Projects: IRR v. NPV – Impact of
Timing of Cash Flows
• The IRR is expressed as a return, but the dollar value
of earning a given return, and therefore the NPV,
depends on how long the return is earned =>
sensitivity to timing of cash flows
– A high IRR project with cash flows paid back quickly may have
a lower NPV than a lower IRR project whose cash flows are
paid pack over a longer period

Illustration: Javier’s Choice – Part 3 - Timing of the
Cash Flows
• Suppose Javier could sell the Internet café business at
the end of the first year for $40,000 while staying on to
manage the business
• Should he plan to sell it?
– Counting his first year profit of $25,000, he would earn a total
of $65,000 after one year (25+40), his cash flow timeline is:
0 1
-$50,000 +$65,000

NPV With and Without Selling
• The IRR from selling after one
year (30%) is larger than the
IRR without selling (23.4%).
• However the NPV from selling
after one year exceeds the
NPV without selling only for
discount rates that >16.3%
(blue area), so with a cost of
capital of less than 16.3%
(yellow area) it is better not to
sell the café, despite the
higher IRR.

The Bottom Line on IRR
• Picking the investment opportunity with the largest IRR
can lead to a mistake
• We can only compare returns if the investments:
– Have the same scale
– Have the same timing
– Have the same risk
• In general, it is dangerous to use the IRR in choosing
between projects
• Always rely on NPV

Challenge 1: Evaluating Projects with Different
Lives - EAA
• Often, a company will need to choose between two
solutions to the same problem
• A complication arises when those solutions last for
different periods of time
• Example: a firm considers two vendors for its internal
network servers. Each vendor offers the same level of
service, but they use different equipment.
– Vendor A offers a more expensive server with lower per-year
operating costs that it guarantees for 3 years
– Vendor B offers a less expensive server with higher per-year
operating costs that it guarantees for 2 years
FINA 5120 – Evaluating Projects with Different Lives

Evaluating Projects with Different Lives - EAA
• The costs are shown below along with the PV of the costs of
each option discounted at a 10% cost of capital
• We note that all the cash flows are negative, and so is the PV.
This is because there are no specific benefits, but we must
take the project, and we need to minimize the cost of service.
• Option A is more expensive in terms of PV than option B; but
option A lasts for 3 years and option B only 2. Is it worth
paying an extra $2,000 in PV terms for an extra year of
service?

• One method used to evaluate alternatives with different
lives is the equivalent annual annuity (EAA) which is the
level annual cash flow that has the same present value
as the cash flows of a project.
• We can think of the cost of each solution as the constant
annual cost that gives us the same present value of the
lumpy cash flows of buying and operating the server. On a
timeline EAA cash flows would appear as follows:
0 1 2 3
NPV = -12.49 EAA EAA EAA


• When you have a level cash flow at a constant interval you
are dealing with an annuity.
– We know the PV (-12.49), the number of years (3) and the discount
rate (10%) we can solve for the cash flow of an equivalent annuity.
We find the cash flow for option A is -5.02.
– We can do the same for option B, we find the cash flow is -6.03
– Option A is equivalent to spending $5,020 per year and option

B is equivalent to spending $6,030 per year.
– From this perspective, option A is cheaper
Illustration
• You considering a maintenance contract from two vendors.
• Vendor Y charges $100,000 upfront and then $12,000 per year for the
three-year life of the contract.
• Vendor Z charges $75,000 upfront and then $35,000 per year for the
two-year life of the contract.
• Compute the NPV and EAA for each vendor assuming an 8% cost of
capital.
0 1 2 3
Vendor Y
-$100,000 -$12,000 -$12,000 -$12,000
0 1 2
Vendor Z
-$75,000 -$35,000 -$35,000
FINA 5120 – Evaluating Projects with Different Lives Copyright ©2015 Pearson Education, Inc. All rights reserved.
Solution
 1 1 
PVY  $100,000  $12,000   3
 $130,925
 .08 .08(1.08) 
PVY  $130,925
Cash Flow Y    $50,803
 1 1   1 1 
 .08  .08(1.08)3   .08  .08(1.08) 3  The annual cost of
    Vendor Z is greater
than the annual
 1 1  cost of Vendor Y,
PVZ  $75,000  $35,000   2
 $137,414 so we should
 .08 .08(1.08)  choose Vendor Y.
PVZ  $137,414
Cash Flow Z    $77,058
 1 1   1 1 
 
 .08 .08(1.08) 2   .08 .08(1.08) 2 
   
Project Selection with Resource Constraints: the
Profitability Index
• The profitability index can be used to identify the
optimal combination of projects to undertake.
Value Created NPV
Profitability Index  
Resource Consumed Resource Consumed
• Given three possible projects with a $100 million
budget constraint, we can see it is better to take
projects II & III together and forgo project I:
FINA 5120 – Projects with Resource Constraints Copyright ©2017 Pearson Education, Inc. All rights reserved.
Illustration
• Problem
– Suppose your firm has the following five positive NPV projects to
choose from. However, there is not enough manufacturing space in
your plant to select all of the projects. Use the profitability index to
choose among the projects, given that you only have 100,000
square feet of unused space.
Project NPV Square feet needed
Project 1 100,000 40,000
Project 2 88,000 30,000
Project 3 80,000 38,000
Project 4 50,000 24,000
Project 5 12,000 1,000
Total 330,000 133,000
FINA 5120 – Profitability Index

Solution
– Compute the PI for each project.
Project NPV Square feet Profitability Index

needed (NPV/Sq. Ft)
Project 1 100,000 40,000 2.5
Project 2 88,000 30,000 2.93
Project 3 80,000 38,000 2.11
Project 4 50,000 24,000 2.08
Project 5 12,000 1,000 12.0
Total 330,000 133,000

Solution
• Rank order them by PI and see how many projects you
can have before you run out of space.
Project NPV Square Profitability Cumulative total
feet Index space used
needed (NPV/Sq. Ft)
Project 5 12,000 1,000 12 1,000
Project 2 88,000 30,000 2.93 31,000
Project 1 100,000 40,000 2.5 71,000
Project 3 80,000 38,000 2.11
Project 4 50,000 24,000 2.08
• We should include project 4 if we want to completely

use the space despite the lower PI
Shortcomings of the Profitability Index
• Constraints:
– The set of projects taken following the PI ranking completely
exhausts the available resource
– There is only one resource constraint
• With multiple resource constraints, no single index works –
linear and integer programming techniques can be used to
calculate the set of projects that maximize total NPV while
satisfying multiple constraints

Summary of Decision Rules
FINA 5120 – Putting It All Together

Summary of Decision Rules (cont.)

Your Turn!
• You are considering two mutually exclusive projects
with the following cash flows. Will your choice between
the two projects differ if the required rate of return is
8% rather than 11%? If so, what should you do?
A) Yes; Select A at 8% and B at 11%.

B) Yes; Select B at 8% and A at 11%.
C) Yes; Select A at 8% and select neither at 11%.
D) No; Regardless of the required rate, project A always
has the higher NPV.
Answer A
E) No; Regardless of the required rate, project B always
has the higher NPV.
FINA 5120 – Investment Decision Rules Questions
Solution to Question 1
• If the required rate of return is 8%:
325,000
$315 ,000
PVA  $240,000  3
 $10,057.16
17,995.48
1.08
$110,800 $82,500 $45,000

PVB  $198,000   2
 3
 $11,045.50
1.08 1.08 1.08
• Since Project A has a higher NPV, we should choose Project A.

• If the required rate of return is 11%:
$315 ,000
325,000
PVA  $240,000  3
 $9-2,362.8
,674.71
1.11
$110,800 $82,500 $45,000

PVB  $198,000   2
 3
 $1,682.28
1.11 1.11 1.11
• Since Project B has a higher NPV, we should choose Project B.

• Therefore, we should Select Project A at 8% and Project B at 11%.

Your Turn!
• The two fatal flaws of the internal rate of
return (IRR) rule are:
A) Arbitrary determination of a discount rate
and failure to consider initial
expenditures.
B) Arbitrary determination of a discount rate
and failure to correctly analyze mutually
exclusive investment projects.
C) Arbitrary determination of a discount rate
and the multiple rate of return problem.
D) Failure to consider initial expenditures
and failure to correctly analyze mutually
exclusive investment projects.
E) Failure to correctly analyze mutually
exclusive investment projects and the Answer E
multiple rate of return problem.

Your Turn!
• Boston Chicken is considering two mutually
exclusive projects with the following cash
flows. What is the crossover rate? If the
required rate of return is lower than the
crossover rate, which project should be
accepted?
A) 14.72 percent; A
B) 14.72 percent; B
C) 15.99 percent; A
D) 15.99 percent; B Answer C
E) 16.08 percent; B
Setting the difference equal to 0,(A-B):
$31,000 $26,000 $27,000 $42,000 $21,000 $18,000

NPV  $50,000     ( $50, 000    )  $0
(1  r ) (1  r ) 2 (1  r ) 3 (1  r ) (1  r ) 2 (1  r )3
 $11000
18,000 $5,000 $9,000
NPV     $0
(1  r ) (1  r ) 2 (1  r )3
Using CF function in Financial calculator

CF0 = 0, CF 1 = -11,000, CF 2 = 5,000, CF 3 = 9,000, solve for IRR
The crossover rate is 15.99%. Therefore, if the required rate of return is lower
than the crossover rate, Project A should be selected.

Your Turn!
• A company is comparing the cost of buying two
different machines. Model A will cost $40,000,
require servicing of $2,000 every year, and last
for 2 years. Model B will cost $30,000, require
servicing of $1,600 per year, and last eight
years. If the cost of capital is 7%, which is the
better option, given that the firm has an
ongoing requirement for the machine?
A) Model A, since it has an equivalent annual
annuity of -$4,678.
B) Model A, since it has an equivalent annual
annuity of -$6,624.
C) Model A, since it has an equivalent annual
annuity of -$6,660.
D) Model B, since it has an equivalent annual
annuity of -$4,994.
E) Model B, since it has an equivalent annual Answer E
annuity of -$6,624.

Model A
$40,000 $2,000 $2,000
 1 1 
PV A  $40,000  $2,000  2
 $43,616
 .07 .07(1.07) 
PV A  $43,616
Cash Flow A    $24,124
 1 1   1 1 
 .07  .07(1.07) 2   .07  .07(1.07) 2 
   

8
Model B
$30,000 $1,600 $1,600 $1,600
 1 1 
PVB  $30,000  $1,600  8
 $39,554
 .07 .07(1.07) 
PVB  $39,554
Cash Flow B    $6,624
 1 1   1 1 
 
 .07 .07(1.07)8   .07 .07(1.07)8 
   
Since the EAA of Model B is lower, we should choose Model B.

SUMMARY
• Most firms measure values in terms of Net Present
Value (NPV) – that is, in terms of cash today
NPV = PV (Benefits) – PV (Costs)

• Logic of the decision rule:
– When making an investment decision, take the alternative
with the highest NPV, which is equivalent to receiving its NPV
in cash today
• This is based on our Valuation Principle and
Cost/Benefits Analysis framework

The Payback Rule
• The payback period is the 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, you accept the project. Otherwise, you reject
the project.
– The payback rule is used by many companies because of its
simplicity.
FINA 5120 – Payback Rules

The Internal Rate of Return (IRR) Rule
• Internal Rate of Return (IRR) Investment Rule
– Take any investment where the IRR exceeds the cost of
capital.
– Turn down any investment whose IRR is less than the cost of
capital.
• 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.

Profitability Index
• The profitability index can be used to identify the
optimal combination of projects to undertake.
Value Created NPV
Profitability Index  
Resource Consumed Resource Consumed

Summary of Decision Rules

Summary of Decision Rules (cont.)

FINA 5120 - Fall (1) 2022 - Session 3 - Decision Principles - 26aug22

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NPV = PV (Benefits) – PV (Costs)

FINA 5120 – The NPV Decision Rule

FINA 5120 – The NPV Decision Rule

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FINA 5120 – The NPV Decision Rule

Today In one year

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FINA 5120 – The NPV Decision Rule

• You could take $2,403.85 of the $2,500 you had saved

FINA 5120 – The NPV Decision Rule

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FINA 5120 – Using the NPV Rule

• We can also use the annuity formula:

FINA 5120 – Using the NPV Rule

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FINA 5120 – Using the NPV Rule

Reminder! The IRR is the

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FINA 5120 – Using the NPV Rule

• As long as our cost of capital is less than the IRR of the

FINA 5120 – Using the NPV Rule

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FINA 5120 – Payback Rules

FINA 5120 – Alternative Decision Rules

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FINA 5120 – Alternative Decision Rules

FINA 5120 – Alternative Decision Rules

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FINA 5120 – IRR Rule

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FINA 5120 – IRR Rule

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FINA 5120 – IRR Rule

– At 23.38%, the IRR is greater than the cost of capital.

FINA 5120 – Alternative Decision Rules

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FINA 5120 – Alternative Decision Rules

– The NPV is calculated as

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FINA 5120 – IRR Rules

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FINA 5120 – IRR Rules

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FINA 5120 – IRR Rule

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FINA 5120 – IRR Rules

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FINA 5120 – Alternative Decision Rules

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FINA 5120 – Alternative Decision Rules

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FINA 5120 – Alternative Decision Rules

Based on the rankings the bar should be chosen.

FINA 5120 – Alternative Decision Rules

FINA 5120 – Choosing Between Projects

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FINA 5120 – Choosing Between Projects

• NPV of Javier’s investment in the Internet café:

• Based on the NPV rule, Javier should invest with his

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FINA 5120 – Choosing Between Projects

Given: 3 -10,000 6,000 0