Risk-Free Projects

Knut P. Heen PhD

Associate Professor
Molde University College
Road Map
Based on HGT chapter 10
Cash Flows
Net Present Value
Economic Value Added (accounting stuff, self-study)
Internal Rate of Return
Popular but Incorrect Methods

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Cash Flows of a Project
Incremental cash flows

Important implications
Sunk cost does not matter
Synergies between the new project and the firm’s existing projects
should be “allocated” to the new project entirely

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Net Present Value
Real arbitrage opportunity
Find tracking portfolio of the project’s cash flow
Present value of project = value of tracking portfolio

NOTE
Positive NPV is an arbitrage opportunity
No arbitrage opportunities in the market for financial assets
Arbitrage opportunities in the market for real assets

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Risk-Free Discount Rate
Yield to maturity (zero-coupons)
Solve for rt

Term structure
Year 1:
Year 2:
Year N:

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Example
Project cash flows

Zero-bond prices

Net present value

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Arbitrage Opportunity
Arbitrage portfolio
Take project
Issue 0.55 ZB1 and 0.7 ZB2
Date 0: (borrow)
Date 1: (pay back ZB1)
Date 2: (pay back ZB2)
Portfolio cash flows
Date 0: (= NPV = free-lunch)
Date 1:
Date 2:

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What about Time Preferences?
People’s time preferences are revealed by the term
structure of zero-coupon prices
The firm’s manager does not need to know the time
preferences of the firm’s owners
Knowing the zero-coupon prices is enough

The NPV criterion boils down to the following

Can we sell the future cash flows from the project for more money
today than the investment the project requires today?

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Value Additivity
Present values add

Important implication
If projects are mutually exclusive for business reasons
Choose the project with the highest NPV

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NPV with Capital Constraints
The profitability index
Not enough money to take all positive NPV projects
What should we do?
A “bang-for-the-buck” measure

Problem
You cannot set up the arbitrage portfolio if there are capital constraints
NPV no longer an arbitrage opportunity
This creates many problems the profitability index cannot solve

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NPV and Repeated Projects
Mutually exclusive projects
Machine A lasts two periods
Machine B lasts one period
We need only one machine

Pitfall
Machine A may have higher NPV than machine B because it last two
periods
Must compare NPV of machine A with a two-period NPV of machine B

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Example 10.5
Cash flows
Machine A:
Machine B:
Risk-free rate:

Naïve NPV
Machine A:
Machine B:

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Example 10.5 cont’d
Correct procedure
Machine B two-period cash flows
Date 0: -1.9
Date 1: 3.3 – 1.9 = 1.4
Date 2: 3.3
Correct NPV machine B

The NPV of mutually exclusive projects must be compared for an entire

investment cycle

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The IRR-Method
Intuition
Calculate the return of the project
Compare with the required rate of return (hurdle rate)
Accept projects which offer higher return than the hurdle

Problem
What is the return of a project?

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One-Period IRR
Cash flows

IRR

Compare IRR with hurdle rate

Easy

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Two-Period IRR
Cash flows

IRR

Two-periods → up to two-solutions
N-periods → up to N-solutions
Which solution should we compare with the hurdle rate?

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IRR and Mutually Exclusive Projects
Return is not money
The one-period project A has an IRR of 100 percent
The one-period project B has an IRR of only 25 percent
Which project do you prefer?
A is better than B if the investments are of equal size
But B may be better than A if the investment in B is sufficiently larger than
the investment in A

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The IRR-Method Summary
One-period
Convenient method
Gives usually the same answer as NPV

More than one-period

No longer convenient method
Gives frequently the wrong answer
USE NPV

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Other Incorrect Procedures
The Payback Method
Ranks projects based on how long it takes before the investment “pays
for itself”
Obviously “dumb”-method
Putting money in the wallet pays for itself immediately
Is money in the wallet the best project?

The Accounting Rate of Return Criterion

Compare accounting return on asset with a hurdle rate (à la IRR)
Based on acc. earnings instead of cash flows (problematic)

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Summary
The NPV criterion measures the wealth created by
the project
The other methods measures something else
If you want wealth, measure wealth, and let the
measure guide you towards it

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