Lecture 2 Ch8

Chapter Outline
8.1 The NPV Rule

8.2 Using the NPV Decision Rule
8.3 Alternative Decision Rules
8.4 Choosing Between Projects
8.5 Evaluating Projects with Different Lives
8.6 Choosing Among Projects When Resources Are
Limited
8.7 Putting it All Together
Copyright © 2023 Pearson Canada Inc. 8-1

8.1 The NPV Rule
• NPV rule: When choosing among investment
alternatives, take the alternative with the highest NPV.
• Choosing this alternative is equivalent to receiving its
NPV in cash today.

8.2 Using the NPV Decision Rule (1 of 7)
• A take-it-or-leave-it decision:
– Researchers at Saskatchewan Fertilizer Ltd. (SFL)
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 (C0). Estimated return
on the new fertilizer will be $28 million after the first
year, and last four years. (C1,2,3)

8.2 Using the NPV Decision Rule (2 of 7) NOTE
• Computing NPV
– The following timeline shows the estimated return:
C0: Initial Cost (Chi phí ban đầu)

• Given a discount rate r, the NPV is:
• We can also use the annuity formula:

• If the company’s cost of capital is 10%, the NPV is

$7.2 million and they should undertake the
investment.

• The NPV Profile

– The NPV depends on cost of capital.
– NPV profile graphs the NPV over a range of discount rates.
– We simply repeat our calculation of the NPV above using a
range of different discount rates instead of only 10%.

• NPV of SFL’s New Project

– The NPV is positive, only for discount rates that are
less than 14%, the internal rate of return (IRR).
– The discount rate that sets the net present value of
the cash flows equal to zero is an investment’s
internal rate of return (IRR).
– We can also compute the IRR without graphing the
NPV by using a financial calculator or a
spreadsheet’s IRR function.
IRR là một chỉ số đo lường lợi nhuận của một khoản đầu tư. Nó cho biết tỉ lệ lợi nhuận mà một dự án hoặc khoản đầu tư
mang lại, so với chi phí ban đầu của nó. Nó được sử dụng để đánh giá tính khả thi của một dự án hoặc khoản đầu tư so với
các lãi suất khác.

• Alternative Rules Versus the NPV Rule

– The NPV rule indicates that SFL should undertake
the investment in fertilizer technology.
– Sometimes other investment rules may give the
same answer as the NPV rule, but at other times
they may disagree.
– When the rules conflict, always base your
decision on the NPV rule.

8.3 Alternative Decision Rules (1 of 10)
• The Payback Rule
– Based on the notion that an opportunity that pays
back the initial investment quickly is a good idea.
▪ Calculate the amount of time it takes to pay back the
initial investment, called the payback period.
▪ Accept if the payback period is less than a prespecified
length of time.
▪ Reject if the payback period is greater than a
prespecified length of time.
▪ Dựa trên quan điểm rằng cơ hội trả vốn nhanh là ý tưởng tốt. Ta tính thời gian trả vốn và chấp nhận dự
án nếu nó trả vốn trong thời gian ngắn hơn một mức đặt trước. Nếu thời gian trả vốn lớn hơn mức đặt
trước, ta từ chối dự án. Điều này giúp ta ưu tiên các dự án có khả năng trả vốn nhanh, vì chúng ít rủi ro
hơn và có thể mang lại lợi nhuận sớm hơn.
Copyright © 2023 Pearson Canada Inc. 8 - 10

Example 8.2: Using the Payback Rule
• Assume SFL requires all projects to have a payback
period of two years or less. In this case, would the firm
undertake the project under this rule?

Example 8.2: Using the Payback Rule: Plan
• In order to implement the payback rule, we need to

know whether the sum of the inflows from the project
will exceed the initial investment before the end of 2
years. The project has inflows of $28 million per year
and an initial investment of $81.6 million.
• Để áp dụng quy tắc trả vốn, ta cần biết tổng số tiền thu từ dự án có đủ lớn để trả lại khoản đầu tư
ban đầu trong 2 năm không. Dự án này có $28 triệu mỗi năm và đầu tư ban đầu là $81.6 triệu. Nếu
tổng số tiền thu trong 2 năm đầu tiên đủ lớn để trả lại đầu tư ban đầu, dự án sẽ được chấp nhận.
Ngược lại, dự án có thể bị từ chối.

Example 8.2: Using the Payback Rule: Execute NOTE
• The sum of the cash flows from year 1 to year 2 is

$28m × 2 = $56 million, this will not cover the initial
investment of $81.6 million. Because the payback is >
2 years (3 years required $28 × 3 = $84 million) the
project will be rejected.
• In this case, tổng số tiền thu từ năm 1 đến năm 2 là $28 triệu nhân 2, tức là $56 triệu. Tuy nhiên, số
tiền này không đủ để trả lại khoản đầu tư ban đầu là $81.6 triệu. Vì vậy, thời gian để thu hồi vốn
(payback period) là hơn 2 năm (trong trường hợp này cần 3 năm với tổng cộng $84 triệu). Do đó, dự
án sẽ bị từ chối.

Example 8.2: Using the Payback Rule:
Evaluate
• While simple to compute, the payback rule requires us
to use an arbitrary cutoff period in summing the cash
flows.
• Further, also note that the payback rule does not
discount future cash flows.
• Instead it simply sums the cash flows and compares
them to a cash outflow in the present.
• In this case, SFL would have rejected a project that
would have increased the value of the firm.

• 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

• The Internal Rate of Return Rule
– Take any investment opportunity where IRR exceeds
the opportunity cost of capital.
– IRR là một chỉ số đo lường lợi nhuận của một khoản đầu tư. Nó cho biết tỉ lệ lợi nhuận mà một dự án
hoặc khoản đầu tư mang lại, so với chi phí ban đầu của nó. Nó được sử dụng để đánh giá tính khả thi
của một dự án hoặc khoản đầu tư so với các lãi suất khác.

• Weakness in IRR
– In most cases IRR rule agrees with NPV for stand-
alone projects if all negative cash flows precede
positive cash flows.
– In other cases the IRR may disagree with NPV.

• Delayed Investments
– Two competing endorsements:
▪ Offer A: single payment of $1million upfront
▪ Offer B: $500,000 per year at the end of the next three years (Cash flow)
▪ Estimated cost of capital is 10%
– Opportunity timeline:
– Trong tình huống này, số tiền -$500,000 đại diện cho việc chi ra tiền. Trong gói Offer B, nhà đầu tư phải chi ra
$500,000 mỗi năm trong ba năm tới. Do đó, dòng tiền là -$500,000. Dấu âm chỉ ra rằng tiền đang được chi ra
thay vì nhận vào.
– Tinh NPV

• The NPV is:
• Set NPV to zero and solve for r to get IRR.
Blank N I/Y PV PMT FV

Given: 3 1,000,000 −500,000 0
Solve for: 23.38
Excel Formula: =RATE(NPER,PMT,PV,FV) = RATE(3,−500000,1000000,0)

• 23.38% > the 10% opportunity cost of capital, so
according to IRR, Option A best.
• However, NPV shows that Option B is best.
• To resolve the conflict we can show a NPV Profile.

NPV Profile

• For most investments, expenses are upfront and cash
is received in the future.
• In these cases a low interest rate is best.
• When cash is up front, a high interest rate is best.

• Multiple IRRs
– Suppose the cash flows in the previous example
change.
– The company has agreed to make an additional
payment of $600,000 in 10 years.

• The new timeline:
• The NPV of the new investment opportunity is:
• If we plot the NPV profile, we see that it has two

IRRs! Because there is more than one IRR, we
cannot apply the IRR rule. Khi vẽ đồ thị NPV, nếu có hai IRR, chúng ta không thể
áp dụng quy tắc IRR vì sẽ gây ra sự phức tạp và không chắc chắn trong đánh giá dự án hoặc khoản đầu tư.

8.4 Choosing Between Projects (1 of 8)
• Mutually exclusive projects: Projects that compete
with one another; by accepting one, you exclude the
others.
– 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.

Example 8.3: NPV and Mutually
Exclusive Projects (1 of 5)
• 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 $220,000. You are also considering three
alternative uses yourself: a bar, a coffee shop, and an
apparel store.
• NPV sell the land= $220,000

• 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?
Cash flow in
Initial Growth Rate Cost of
the First Year
Investment (g) Capital (r)
(CF)
Bar $400,000 $60,000 3.5% 12%
Coffee shop $200,000 $40,000 3% 10%
Apparel Store $500,000 $75,000 3% 13%

Exclusive Projects: Plan (3 of 5)
• 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). The NPV of each investment will be
• Vì bạn chỉ có thể thực hiện một dự án, nên các dự án này cạnh tranh với nhau. Để quyết định
dự án nào có giá trị nhất, bạn cần xếp hạng chúng theo NPV. Mỗi dự án (ngoại trừ việc bán
đất) có dòng tiền mà có thể được đánh giá như một chuỗi lợi nhuận không ngừng tăng, giá
trị hiện tại của các dòng tiền vào là CF1 / (r − g). NPV của mỗi khoản đầu tư sẽ là...

• The NPVs are:
Alternative NPV
Coffee Shop $371,429
Bar $305,882
Apparel Store $250,000
Sell the Land $220,000
• Based on the rankings, the coffee shop should be chosen.

• All of the alternatives have positive NPVs, but you can only take one of them,
so you should choose the one that creates the most value.
• Even though the coffee shop has the lowest cash flows, its lower start-up cost
coupled with its lower cost of capital (it is less risky), make it the best choice.
• Trong trường hợp này, dự án quán cà phê được chọn vì hai lí do chính:
• 1. Chi phí khởi đầu thấp hơn: Dự án quán cà phê đòi hỏi ít vốn ban đầu hơn so với các lựa chọn khác. Điều này có
nghĩa là cần ít tiền đầu tư ban đầu hơn. Chi phí khởi đầu thấp giúp nhanh chóng đạt đến điểm cân bằng và giảm thiểu
rủi ro tài chính.
• 2. Chi phí vốn thấp (rủi ro thấp hơn): Dự án quán cà phê được coi là ít rủi ro hơn, dẫn đến chi phí vốn thấp hơn. Chi
phí vốn thấp hơn có nghĩa là tỉ lệ lợi nhuận mà nhà đầu tư hoặc người cho vay mong đợi cũng thấp hơn. Chi phí vốn
thấp dẫn đến giá trị hiện tại của dòng tiền trong tương lai cao hơn.
• Những lí do này giúp dự án quán cà phê trở thành lựa chọn tốt nhất dù có doanh thu tiền mặt thấp hơn.

• Differences in Scale
– A 10% IRR can have very different value implications
for an initial investment of $1 million vs. an initial
investment of $100 million.

8.4 Choosing Between Projects (3 of 8) (Page
33)
• Identical Scale
– NPV of Marek’s investment in his girlfriend’s business:
– NPV of Marek’s investment in the Internet café:

• Identical Scale
– 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)
IRR of internet cafe:

Given: 3 −10,000 5,000 0
Solve for: 23.4

• Change in Scale:
– Marek 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.

• Change in Scale
– IRR is unaffected by scale.
– IRR of girlfriend’s business is the same.

Given: 3 −50,000 25,000 0
Solve for: 23.4
Excel Formula: =RATE(NPER,PMT,PV,FV) = RATE(3,25000,−50000,0)

Example 8.4: IRR of Incremental Cash
Flows and Computing the Crossover Point
• Solve for the crossover point for Marek from Figure
8.7.

Example 8.4: IRR of Incremental Cash Flows
and Computing the Crossover Point: Plan
• The crossover point is the discount rate that makes
the NPV of the 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.

Example 8.4: IRR of Incremental Cash Flows and
Computing the Crossover Point: Execute (1 of 2)
• Setting the difference equal to 0:
• As you can see, solving for the crossover point is just like
solving for the IRR, so we will need to use a financial calculator
or spreadsheet:
Computing the Crossover Point: Execute (2 of 2)
• And we find that the crossover occurs at a discount
rate of 20% (20.04% to be exact).

Given: 3 −40,000 19,000 0
Solve for: 20.04
Excel Formula: =RATE(NPER, PMT, PV,FV) = RATE(3,19000,−40000,0)

Computing the Crossover Point: Evaluate (1 of 2)
• Just as the NPV of a project tells us the value impact
of taking the project, so the difference of the NPVs of
two alternatives tells us the incremental impact of
choosing one project over another.

Computing the Crossover Point: Evaluate (2 of 2)
• 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.

Example
The Canadian Space Agency is considering two mutually exclusive
projects code named Mars and Venus. The Mars project has an internal
rate of return (IRR) of 10% while the Venus project has an IRR of 8%.
The cross-over rate is 6%. If the appropriate discount rate is 4%, which
project(s) should the Canadian Space Agency accept:
• Draw the graph and see:
Venus (higher NPV)

• Timing of the Cash Flows
– Suppose Marek could sell the Internet café business
at the end of the first year for $40,000.
– Should he plan to sell it?

• The Bottom Line on IRR
– Picking the investment opportunity with the largest
IRR can lead to a mistake.
– In general, it is dangerous to use the IRR in choosing
between projects.
– Always rely on NPV.

8.5 Evaluating Projects with Different
Lives
• 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.
• One method that is used to evaluate projects that
have different lives is to compute the equivalent
annual annuity for each project, which is the level
annual cash flow with the same present value as the
cash flows of the project.

46
Evaluating Mutually Exclusive Projects with

Unequal Lives
• The equivalent annual NPV (EANPV) approach compares projects by
finding the NPV of the individual projects and then determining the
amount of an annuity that is economically equivalent to the NPV
generated by each project over its respective time horizon.
• Công thức EANPV (Expected Average Net Present Value) được sử
dụng để tính toán giá trị trung bình của NPV (Net Present Value) trong
điều kiện xác suất. Đây là cách đánh giá dự án với sự biến động của
các yếu tố và rủi ro.
NPV là giá trị hiện tại của dòng tiền thu về Annuity Factor
trừ đi chi phí ban đầu.
k là tỉ lệ chiết khấu, tức là mức lợi nhuận mà
nhà đầu tư mong đợi.
n là thời gian của dự án.

47

48

49

50

51

8.6 Choosing Among Projects When
Resources Are Limited (1 of 3)
• Sometimes different investment opportunities demand
different amounts of a particular resource.
• If there is a fixed supply of the resource so that you
cannot undertake all possible opportunities, simply
picking the highest-NPV opportunity might not lead to
the best decision.

8.6 Choosing Among Projects When Resources Are Limited (2 of 3)
NOTE
• Profitability Index
• Chỉ số lợi nhuận (PI) là một công cụ đánh giá khả năng sinh lợi của một dự án đầu tư. Nó so sánh giữa giá trị hiện tại
của các dòng tiền thu về và chi phí ban đầu của dự án. Nếu PI lớn hơn 1, dự án được xem là sinh lợi nhuận. Nếu PI
bằng 1, dự án chỉ phù hợp với chi phí ban đầu. Nếu PI nhỏ hơn 1, dự án có thể không sinh lợi nhuận đủ để vượt qua
chi phí ban đầu.

Example 8.6: Profitability Index with a
Human Resource Constraint (1 of 2)
• Your division at NetIt, a large networking company,
has put together a project proposal to develop a new
home networking router. The expected NPV of the
project is $17.7 million, and the project will require 50
software engineers. NetIt has a total of 190 engineers
available, and is unable to hire additional qualified
engineers in the short run. Therefore, the router
project must compete with the following other projects
for these engineers:

Human Resource Constraint (2 of 2)
• How should NetIt prioritize these projects?
Project NPV ($ millions) Engineering Headcount

Router 17.7 50
Project A 22.7 47
Project B 8.1 44
Project C 14.0 40
Project D 11.5 61
Project E 20.6 58
Project F 12.9 32
Total 107.5 332

Human Resource Constraint: Plan
• The goal is to maximize the total NPV we can create
with 190 employees (at most). We can use Eq. 8.4 to
determine the profitability index for each project. In
this case, since engineers are our limited resource,
we will use engineering headcount in the denominator.
Once we have the profitability index for each project,
we can sort them based on the index.

Example 8.6: Profitability Index with a Human Resource Constraint:
Execute
Chỉ số lợi nhuận với hạn chế về nhân sự là cách đánh giá dự án dựa trên lợi nhuận và khả năng sử dụng nhân lực. Điều
này giúp xác định liệu dự án có phù hợp với số lượng nhân lực có sẵn hay không.
NPV ($ Engineering Profitability Index Cumulative EHC

Project millions) Headcount (EHC) (NPV per EHC) Required
Project A 22.7 47 0.483 47
Project F 12.9 32 0.403 79 (47 + 32)
Project E 20.6 58 0.355 137 (79 + 58)
Router 17.7 50 0.354 187 (137 + 50)
Project C 14.0 40 0.350 Blank
Project D 11.5 61 0.189 Blank
Project B 8.1 44 0.184 Blank
PI= NPV/ Engineering Headcount (EHC)

Example 8.6: Profitability Index with a Human
Resource Constraint: Execute (1 of 2)
• We now assign the resource to the projects in
descending order according to the profitability index.
• The final column shows the cumulative use of the
resource as each project is taken on until the resource
is used up. To maximize NPV within the constraint of
190 employees, NetIt should choose the first four
projects on the list.
• Để tối đa hóa NPV voi 190 nhân viên, NetIt nên chọn bốn dự án đầu tiên theo thứ
tự chỉ số lợi nhuận. Điều này giúp đảm bảo tận dụng tối đa lợi nhuận mà không
vượt quá nguồn lực nhân sự.

Example 8.6: Profitability Index with a Human
Resource Constraint: Evaluate (2 of 2)
• By ranking projects in terms of their NPV per
engineer, we find the most value we can create, given
our 190 engineers.
• There is no other combination of projects that will
create more value without using more engineers than
we have.
• This ranking also shows us what the engineering
constraint costs us—this resource constraint forces
NetIt to forgo 3 otherwise valuable projects (C, D, and
B) with NPV of $33.6 million.

Example
The Hazeldean Computer Corporation is trying to choose between the
following two mutually exclusive design projects:
a) If the required return is 10 percent and the company applies the

profitability index decision rule, which project should the firm accept?
b) If the company applies the NPV decision rule, which project should it
take?
c) Explain why your answers in (a) and (b) are different?
Example NOTE
•

8.6 Choosing Among Projects When
Resources Are Limited (3 of 3)
Shortcomings of the Profitability Index
• In some cases, it does not give an accurate answer.
• When choosing projects based on the profitability index
ranking leaves some of the resource unused, it becomes
necessary to evaluate all feasible combinations of
projects that can be accepted given the resource
constraint.
• The feasible combination that results in the highest
combined NPV is the combination of projects that should
be chosen.

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Chapter Outline

8.1 The NPV Rule

Copyright © 2023 Pearson Canada Inc. 8-1

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C0: Initial Cost (Chi phí ban đầu)

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• Given a discount rate r, the NPV is:

• We can also use the annuity formula:

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• If the company’s cost of capital is 10%, the NPV is

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• The NPV Profile

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• NPV of SFL’s New Project

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• Alternative Rules Versus the NPV Rule

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• In order to implement the payback rule, we need to

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• The sum of the cash flows from year 1 to year 2 is

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• Set NPV to zero and solve for r to get IRR.

Blank N I/Y PV PMT FV

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• To resolve the conflict we can show a NPV Profile.

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• The NPV of the new investment opportunity is:

• If we plot the NPV profile, we see that it has two

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• NPV sell the land= $220,000

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• Based on the rankings, the coffee shop should be chosen.

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– NPV of Marek’s investment in the Internet café:

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Blank N I/Y PV PMT FV

IRR of internet cafe:

Blank N I/Y PV PMT FV

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Blank N I/Y PV PMT FV

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Copyright © 2023 Pearson Canada Inc. 8 - 36

Copyright © 2023 Pearson Canada Inc. 8 - 37

Blank N I/Y PV PMT FV

Copyright © 2023 Pearson Canada Inc. 8 - 39

Copyright © 2023 Pearson Canada Inc. 8 - 40

Copyright © 2023 Pearson Canada Inc. 8 - 41

• Draw the graph and see: