IES182

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F-803-E
2-206-027

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Project Evaluation in Emerging Markets:
Exxon Mobil, Oil, and Argentina

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Early in 2006 a brief report arrived at Exxon Mobil’s headquarters in Irving,
Texas, with the results of geological tests in the south of Argentina. The
tests determined that the area explored seemed to be rich in oil and that,
subject to a proper cost-benefit analysis, it could be worth investing in the
necessary production facilities to extract oil from the ground. You have
been asked to evaluate this investment opportunity and report to
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management with your opinion about whether or not the company should
go ahead with this project.

1. The Company: Exxon Mobil

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Exxon Mobil is the world’s largest integrated oil company. It engages in oil
and gas exploration, production, supply, transportation, and marketing
around the world. It has 45 refineries in 25 countries and the capacity to
produce 6.4 million barrels per day. It supplies refined products to more
than 35,000 service stations in about 100 countries that operate under the
Exxon, Esso, and Mobil brands, and it provides fuel at 680 airports and 220
ports.
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In 2005, Exxon Mobil earned profits of $36.9 billion on revenues of

$328.2 billion, topping the Fortune 500 ranking. At year-end 2005, the
company boasted a market capitalization of $344.5 billion, making it the largest

This case was prepared by Professor Javier Estrada as the basis for class discussion rather than to illustrate
either effective or ineffective handling of an administrative situation. Lydia Nikolova and Gabriela
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Giannattasio provided research assistance. September, 2006.

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 F-803-E Project Evaluation in Emerging Markets: Exxon Mobil, Oil, and Argentina

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company not only by revenues but also by capitalization. Exhibits 1 to 3 show Exxon
Mobil’s balance sheet, income statement, and cash flow statement for the years 2003-
2005.

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2. The Investment Opportunity: Oil in Argentina
The report that arrived at Exxon Mobil’s headquarters recommended starting with a field of
100 wells, which required an initial investment of $130 million: $70 million for drilling the
wells and $60 million for the production facilities required to process and transport the oil.

Each of the 100 wells, the report estimated, could produce 60,000 barrels of oil over an
estimated life of six years, or 10,000 barrels per year. Operating costs were estimated at $7

yo
per barrel. Oil prices had been in an upward trend since the beginning of 1999, and at year-
end 2005 Brent crude stood at $58 per barrel. Exhibits 4 and 5 show nominal and real oil
prices between December 1987 and December 2005. Because of the difficulty of forecasting
oil prices, the report suggested estimating revenues based on a price of $58 per barrel, and
then to perform sensitivity analysis based on other probable prices.

Table 1
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Profits and Cash Flows: Annual Estimates, 2006-2011

Per Well Total

Production
Per well (barrels per year) 10,000
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Total (barrels per year) 1,000,000

Revenues
Per well $580,000
Total $58,000,000
Operating costs
Per well $70,000
Total $7,000,000
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Depreciation
Per well $100,000
Total $10,000,000
Pre-tax profit
Per well $410,000
Total $41,000,000
Taxes $14,350,000
After-tax profit $26,650,000
Depreciation add-back $10,000,000
Free cash flow $36,650,000
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Start-up costs of $130 million not included in the figures above. “Total” figures refer to 100 wells. Revenues based on a price
of $58 per barrel. Operating costs based on an estimate of $7 per barrel. Production facilities assumed to depreciate linearly
over six years. Profits and free cash flows assumed to be received at year end, beginning in 2006 and ending in 2011.
Corporate tax rate: 35%.

Table 1 summarizes some relevant information contained in the report. The project was
expected to generate after-tax profits and free cash flows of almost $27 million and $37

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 Project Evaluation in Emerging Markets: Exxon Mobil, Oil, and Argentina F-803-E

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million a year, respectively, for six years. No new capital investments were expected during
these six years; at the end of this period the production facilities would be fully depreciated
and the wells exhausted.

The obvious question about this investment opportunity was whether it made sense to
invest $130 million at the beginning of 2006 in order to obtain the estimated annual

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cash flows over the years 2006-2011. The analysis required the use of the standard
tools of project evaluation, particularly the calculation of the project’s net present
value (NPV) and internal rate of return (IRR), both of which are briefly reviewed in
Appendix 3. The implementation of both tools required not only the project’s expected
cash flows but also an estimate of the proper discount rate.

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3. The Discount Rate: Investing in Emerging Markets
Typically, an analyst evaluating this investment opportunity would first estimate the
project’s expected cash flows and then discount them at the company’s cost of capital
to obtain the project’s NPV. Alternatively, the analyst could calculate the project’s IRR
and compare it to the company’s cost of capital. This widely accepted practice,
op
however, is not so widely accepted when evaluating investments in emerging markets.
In this case, many companies often arbitrarily increase the discount rate over and
above the rate they would use for the same project in the home (developed) market.
This unfortunate practice may lead companies to bypass valuable investment
opportunities, particularly when the discount rate is increased arbitrarily.

Exxon Mobil finances its investment activities almost exclusively with equity. In fact,
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as shown in Exhibit 1, at year-end 2005 the company had just over $6 billion of long-
term debt out of over $200 billion in total capital, for a debt ratio of 3% at book value.
Considering that the market value of the company’s equity (almost $345 billion) was
over three times its book value (just over $111 billion), the debt ratio at market value
was even lower and, for all practical purposes, 0. In other words, Exxon Mobil was
basically an unlevered company and its cost of capital was essentially equal to its cost
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of equity.

Typically, companies estimate their cost of equity by using the Capital Asset Pricing
Model, or CAPM for short. (Both the cost of capital and the CAPM are briefly reviewed
in Appendix 1.) However, for many and varied reasons, this model is not very widely
used in emerging markets. One of those reasons, unfortunately, seems to be that the
CAPM yields discount rates that are “too low.” Some companies apparently prefer to
err on the side of caution and overestimate rather than underestimate the discount rate
for projects in emerging markets. Apparently, these companies think that bypassing
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valuable investment opportunities is not detrimental to their shareholders.

Given the rather infrequent use of the CAPM in emerging markets, many alternative
methodologies have been developed by academics and practitioners. Although no
model has yet emerged as a clear winner in the sense of being the most widely
accepted and used, four of them seem to stand out. These four models, proposed by

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 F-803-E Project Evaluation in Emerging Markets: Exxon Mobil, Oil, and Argentina

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Lessard, Godfrey and Espinosa, Goldman Sachs, and Salomon Smith Barney, are briefly
reviewed in Appendix 2.

Unlike the CAPM, which is solidly grounded in financial theory, these four models are
rather ad-hoc. In addition, because these models assess and incorporate risk in quite
different ways, they may also yield quite different estimates of the discount rate. In

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order to properly evaluate the investment opportunity considered in the report, then, it
was necessary to consider the discount rates obtained from these four different
methodologies and to assess the project in light of each of them. The financial
information necessary to estimate all four discount rates is provided in Table 2.

Table 2
Financial Information:

Risk-free rate
World market risk premium
Argentina’s yield spread
Oil industry beta
Argentina’s beta
yo 4.40%
5.00%
5.00%
0.69
1.10
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Argentina’s stock market volatility 40.60%
World stock market volatility 14.71%
Correlation between Argentina’s stock market and bond market 0.35

Risk-free rate is the yield on 10-year U.S. Treasury Notes at year-end 2005. Market risk premium estimated for the world
market over the 1900-2000 period. Yield spread calculated with respect to U.S. bonds at year-end 2005. Betas calculated with
respect to the world market over the Jan/96-Dec/05 period. Volatility measured by the standard deviation of returns over the
Jan/96-Dec/05 period, annualized. Correlation between Argentina’s stock market and bond market estimated over the Jan/96-
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Dec/05 period.

4. The Investment Decision: Evaluation and Recommendation

The report that arrived at Exxon Mobil’s headquarters had all the relevant information
but not the proper evaluation of the investment opportunity it discussed. Your ultimate
task is to report to management on the convenience of investing in this project. Base
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your final recommendation on the information provided, sound analysis, and your best
judgment of all the results you obtain.
Do

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 Project Evaluation in Emerging Markets: Exxon Mobil, Oil, and Argentina F-803-E

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Exhibit 1
Balance Sheet ($ millions)

Fiscal Year Ending Dec/31/05 Dec/31/04 Dec/31/03

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Assets
Cash 28,671 18,531 10,626
Net receivables 27,484 25,359 24,309
Inventories 9,321 9,487 8,957
Other current assets 7,866 7,000 2,068
Total current assets 73,342 60,377 45,960
Net fixed assets 107,010 108,639 104,965
Other noncurrent assets 27,983 26,240 23,353
Total assets
Liabilities and shareholders’ equity
Accounts payable
Short-term debt
Other current liabilities
Total current liabilities
Long-term debt
Other noncurrent liabilities
yo 208,335

36,120
1,771
8,416
46,307
6,220
20,217
195,256

31,763
3,280
7,938
42,981
5,013
20,462
174,278

15,334
4,789
18,263
38,386
4,756
17,721
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Total liabilities 97,149 93,500 84,363
Common stock equity 111,186 101,756 89,915
Total shareholders’ equity 111,186 101,756 89,915
Total shareholders’ equity and liabilities 208,335 195,256 174,278

Source: Hoover’s
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Exhibit 2
Income Statement ($ millions)

Fiscal Year Ending Dec/31/05 Dec/31/04 Dec/31/03

Revenues 328,213 263,989 213,199
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Costs of goods sold 213,002 163,547 129,928

Gross profit 115,211 100,442 83,271
SG&A expenses 14,402 13,849 13,396
Depreciation and amortization 10,253 9,767 9,047
Operating income 49,002 35,872 23,183
Non-operating income 11,725 6,783 9,684
Non-operating expenses 42,05 41,592 37,852
Income before taxes 60,231 42,017 32,66
Income taxes 23,302 15,911 11,006
Net income after taxes 36,929 26,106 21,654
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Source: Hoover’s.

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 F-803-E Project Evaluation in Emerging Markets: Exxon Mobil, Oil, and Argentina

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Exhibit 3
Cash Flow Statement ($ millions)

Fiscal Year Ending Dec/31/05 Dec/31/04 Dec/31/03

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Net operating cash flow 48,138 40,551 28,498
Net investing cash flow –10,270 –14,910 –10,842
Net financing cash flow –26,941 –18,268 –14,763
Net change in cash 10,140 7,905 3,397

Source: Hoover’s.

Exhibit 4

yo
Nominal Oil Prices, Dec. 1987–Dec. 2005

$80

$70
op
$60

$50

$40

$30
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$20

$10

$0
ec 7

ec 8

ec 9

ec 0

ec 1

ec 2

ec 3

ec 4

ec 5

ec 6

ec 7

ec 8

ec 9
ec 0

ec 1

ec 2

ec 3

ec 4

5
D 198

D 198

D 199

D 199

D 199

D 199

D 199

D 199

D 199

D 199

D 199

D 200

D 200

D 200

D 200

00
D 198

D 199

D 200
No

-2
-

-
-

-
-

-
ec
D

Brent crude, dollars per barrel. Source: Datastream.

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 Project Evaluation in Emerging Markets: Exxon Mobil, Oil, and Argentina F-803-E

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Exhibit 5
Real Oil Prices, Dec. 1987–Dec. 2005

$45

rP
$40

$35

$30

$25

$20

$15

$10

$5

$0
yo
op
ec 8

ec 9
ec 7

ec 0

ec 1

ec 2

ec 4

ec 5

ec 6
ec 3

ec 7

ec 8

ec 9

ec 0

ec 1

ec 2

ec 4

5
ec 3
D 198

D 198

D 199

D 199

D 199

D 199

D 199

D 199

D 199

D 199

D 199

D 200

D 200

D 200

D 200
00
D 198

D 199

D 200

-2
-

-
-

-
-

-
ec
D

Brent crude, dollars per barrel. Deflated by US CPI. Sources: Datastream and Global Financial Data.
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No
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 F-803-E Project Evaluation in Emerging Markets: Exxon Mobil, Oil, and Argentina

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Appendix 1
The Cost of Capital and the CAPM
Few variables are as critical for a company as its cost of capital, a magnitude needed
for company valuation, project evaluation, and capital structure optimization, to name

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but a few important activities. This cost of capital can be interpreted in different ways
and viewed from a variety of angles; three intuitive ways to think about it are the
following:

• It is a company’s hurdle rate, or the minimum return that should be required

from the projects in which the company invests.

• yo
It is the average cost of financing a company, taking into account how much
the company uses each source of capital, and the return required on each.

It is the average return required by investors, taking into account how much a
company uses each source of capital, and the return required on each.

As long as a company finances its activities only with debt and equity, its cost of
capital (RWACC) can be written as
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RWACC = (1–tc)·xD·RD + xE·RE

where tc denotes the corporate tax rate, xD and xE the proportions of debt and
equity in the company’s capital structure, and RD and RE the required return on
debt and equity. The inclusion of the corporate tax rate simply indicates that
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interest payments on debt (but not dividends on equity) are tax deductible, which
lowers the cost of this source of financing. That is why, although the cost of debt is
RD, the after-tax cost of debt is (1–tc)·RD.

It is widely accepted that the debt that needs to be considered for the calculation of the
cost of capital is interest-bearing (usually long-term) debt; that the required return on
debt should be captured by the yield on the debt, not by its interest rate; and that
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xD=D/(D+E) and xE=E/(D+E), where D and E denote debt and equity, should be
measured at market value, not at book value. Both academics and practitioners widely
agree on all three points.

A critical difference between the required return on debt and the required return on
equity is that the former is observable but the latter must be estimated. The required
return on equity of company i (REi) can be thought of as having two components:

REi = Rf + RPi
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where Rf and RPi denote the risk-free rate and the risk premium of company i. The former
is the compensation required for the expected loss of purchasing power, and the latter is
the compensation required for bearing the risk of investing in company i.

It is important to notice the subscript i on REi and RPi but not on Rf. Intuitively, this
means that regardless of the asset in which we invest, we always require the same
compensation for the expected loss of purchasing power. However, depending on the

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 Project Evaluation in Emerging Markets: Exxon Mobil, Oil, and Argentina F-803-E

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asset in which we invest, we require an additional compensation for bearing the risk of
that asset. In other words, when estimating the required return on two different assets,
in both cases we start from the same risk-free rate and then add different risk
premiums for each asset.

The model most widely used to estimate a company’s cost of equity is the Capital Asset

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Pricing Model (CAPM), which essentially provides a way to estimate the risk premium
of a security. More precisely, this model suggests that

REi = Rf + MRP·βi

where MRP denotes the market risk premium and βi the beta of company i.

yo
The market risk premium can be thought of as the extra compensation required by
investors for buying relatively riskier equity rather than relatively safer debt. The beta
of a company, in turn, can be thought of as the sensitivity of the returns of stock i to
changes in the returns of the market. If βi>1, the stock amplifies the fluctuations of the
market, and if βi<1 the stock mitigates the fluctuations of the market. For example, a
stock with a beta of 2 indicates that, as the market goes up and down 1%, this stock
goes (on average) up and down 2%; and a stock with a beta of 0.5 indicates that as the
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market goes up and down 1%, this stock goes (on average) up and down 0.5%. This is
why beta is sometimes called a measure of relative volatility.

As for the estimation of these inputs, theory is of little guidance. The consensus of
practitioners, however, seems to indicate the following: The risk-free rate is usually
approximated with the yield to maturity on government bonds at the time of
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estimation; among all the different maturities, the 10-year yield is the most widely
used. The market risk premium is usually estimated as a long-term (arithmetic or
geometric) average of the annual differences between the returns of the stockmarket
and those of the bond market. Finally, betas are usually estimated on the basis of five
years of monthly returns, and with respect to a broadly diversified stockmarket
benchmark.
No
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 F-803-E Project Evaluation in Emerging Markets: Exxon Mobil, Oil, and Argentina

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Appendix 2
The Cost of Equity in Emerging Markets
It is widely accepted that when evaluating potential investments, a company should
discount the expected cash flows of projects at its cost of capital. A critical input of

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this cost of capital is the required return on equity, which is usually estimated with the
CAPM. However, when estimating a discount rate for a project in an emerging market,
this widely accepted practice is often not followed; four possible alternative approaches
are discussed below.

These four approaches, though quite different among themselves, can be thought
of as variations of a general model in which the required return on equity (R) is
expressed as:

yo R = Rf + MRP·SR + A

where Rf denotes the risk-free rate, MRP the world market risk premium, SR a specific
risk of the investment, and A some additional adjustment.

Both the specific risk of the investment (SR) and the additional adjustment (A) differ
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across the four models considered below. All four models, however, share two inputs,
the risk-free rate (Rf) and the world market risk premium (MRP). The former
is approximated with the yield on government bonds at the time when the project is
evaluated; the latter with the long-term average difference between the returns on
stock and bond markets worldwide.
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1. The Lessard Approach1

This model proposes measuring specific risk somewhat differently from the CAPM.
More precisely, it proposes measuring specific risk as the product between a project
beta (βp) and a country beta (βc); that is,

SR = βp·βc
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where the first beta intends to capture the risk of the industry, and the second the risk
of the country in which the company will invest. In this approach, then, the cost of
equity when investing in industry p located in country c is given by

R = Rf + MRP·(βp·βc)

The project beta is usually estimated as the beta of the relevant industry with respect to
the world market; the country beta, in turn, is usually estimated as the beta of the
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relevant country also with respect to the world market. No further adjustments are
implemented in this approach and, therefore, A=0.

1 Lessard, Donald (1996), “Incorporating Country Risk in the Valuation of Offshore Projects,” Journal of Applied Corporate Finance, Fall,
52-63.

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2. The Godfrey-Espinosa Approach2
This model proposes two adjustments with respect to the CAPM. First, adjusting the
risk-free rate by the yield spread of a country relative to the U.S. (YSc); and second,
measuring risk as 60% of the volatility of the stock market in which the project is
based relative to the volatility of the world market (σc/σW). More precisely,

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A = YSc

SR = (0.60)·(σc/σW)

where σc and σW are the standard deviation of returns of country c’s stock market and
that of the world market. In this approach, then, the cost of equity when investing in
country c is given by

yo
R = (Rf +YSc) + MRP·{(0.60)·(σc/σW)}

The adjustment by the yield spread intends to reflect the additional risk of investing in
the country in which the project is based, and it is measured by the spread between the
yield at which the country borrows in dollars and the rate at which the U.S borrows (at
the same maturity). The specific risk, in turn, attempts to capture other sources of risk
op
specific to the country in which the project is based, with the coefficient 0.60
attempting to avoid double counting risk. This last number is a crude average across
emerging economies of the risk reflected by the stock market but not reflected by the
bond market.

Note that in this model the specific nature of the project is ignored. In other words, it
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makes no difference whether a company is evaluating a project in the oil, airline, or

telecommunications industries; all that matters is the country in which the project is
based.

3. The Goldman Sachs Approach3

This model can be thought of simply as proposing a better adjustment for double
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counting than that included in the Godfrey-Espinosa model. More precisely, Goldman
Sachs proposes replacing the fixed adjustment of 0.60 by one minus the observed
correlation between the stock market and the bond market of the country in which the
project is based. In other words, the investment bank proposes estimating the
specific risk as:

SR = (1– ρSB)·(σc/σW)

where ρSB denotes the correlation between the stock and bond markets of country
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c. In addition, as in the Godfrey-Espinosa model, the Goldman Sachs model

includes the adjustment:

2 Godfrey, Stephen, and Ramon Espinosa (1996), “A Practical Approach to Calculating Costs of Equity for Investments in Emerging
Markets,” Journal of Applied Corporate Finance, Fall, 80-89.
3 Mariscal, Jorge, and Kent Hargis (1999), “A Long-Term Perspective on Short-Term Risk – Long-Term Discount Rates for Emerging
Markets,” Global Emerging Markets Report, Goldman Sachs, Oct/26/1999.

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 F-803-E Project Evaluation in Emerging Markets: Exxon Mobil, Oil, and Argentina

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A = YSc

In this approach, then, the cost of equity when investing in country c is given by:

R = (Rf +YSc) + MRP·{(1–ρSB)·(σc/σW)}

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The intuition behind this more sophisticated double counting adjustment is as follows:
If the stock market and the bond market are perfectly correlated (ρSB=1), they both
reflect the same sources of risk; in that case, YSc will capture all the relevant risks of
investing in country c and, therefore, R = Rf+YSc. If, on the other hand, the stock
market and the bond market are uncorrelated (ρSB=0), each reflects different sources of
risk; in that case, YSc quantifies the risk reflected by the bond market, σc/σW the
additional risk reflected by the stock market and, therefore, R = (Rf+YSc)+MRP·(σc/σW).

yo
Because for all practical purposes it is the case that 0<ρSB<1, then this model
incorporates both the risk reflected by the stock market and the bond market but
without double counting sources of risk.

4. The SalomonSmithBarney Approach4

This model proposes accounting for the risk of investing in a specific industry, for the
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risk of investing in a specific country, and for some characteristics of both the project
and the company considering the investment. The first adjustment is implemented by
incorporating the project beta (βp) and the other two by incorporating an adjusted
political risk premium. This second adjustment requires some explanation.

The first step consists of estimating the unadjusted political risk premium, which is
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simply the yield spread discussed for the previous two models (YSc). The second step
consists of adjusting this political risk premium by three factors: A company’s access
to capital markets; the susceptibility of the investment to political risk; and the
financial importance of the project for the company. More precisely, in this model,

A = {(γ1+γ2 +γ3)/30}·YSc
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where each γ coefficient is measured on a scale from 0 to 10. In particular,

• γ1 captures a company’s access to capital markets, with 0 indicating best access

and 10 indicating no access;

• γ2 captures the susceptibility of the investment to political risk, with 0

indicating no susceptibility to political intervention and 10 indicating
maximum susceptibility to political intervention;
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• γ3 captures the financial importance of the project for the company, with 0
indicating that the project involves a small proportion of the company’s capital
and 10 indicating that the project involves a large proportion of the company’s
capital.

4 Zenner, Marc, and Ecehan Akaydin (2002), “A Practical Approach to the International Valuation and Capital Allocation Puzzle,” Global
Corporate Finance Report, SalomonSmithBarney, Jul/26/2002.

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Note that γ1 will usually be low for large international companies and high for small
undiversified companies. Note, also, that γ2 is a rough estimate of the probability of
expropriation; hence it will be high for projects in industries that are likely to be
expropriated (such as natural resources) and low for projects in industries that are
unlikely to be expropriated (such as retail). Finally, note that γ3 will usually be low for

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large companies investing in relatively small projects and large for small companies
investing in relatively large projects.

It should be clear that the sum of the γ coefficients will vary between 0 and 30, which
in turn implies that the adjustment to the yield spread will vary between 0 and 1. As a
result, in the worst-case scenario A=YSc and in the best-case scenario A=0. To
illustrate, a large international company investing a small proportion of its capital in

yo
an industry unlikely to be expropriated would have to make no adjustment for political
risk (A=0). A small undiversified company investing a large proportion of its capital in
an industry likely to be expropriated, in turn, would have to incorporate a full
adjustment for political risk (A=YSc).

This model further proposes quantifying the specific risk with the project beta which,
as mentioned above, is the beta of the relevant industry with respect to the world
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market; hence,

SR = βp

In sum, according to this approach, the cost of equity when investing in industry p
located in country c is given by
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R = Rf + MRP·βp + {(γ1+γ2+γ3)/30}·YSc

It is important to note that in this model, unlike in the previous three, the discount rate
for a specific project in a specific country may be different depending on the company
that considers the investment. In other words, according to the first three models, given
the project and the country in which the project will take place, the discount rate
would be the same regardless of the company that considers the project; in this fourth
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approach, in contrast, that is not necessarily the case.

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Appendix 3
Project Evaluation
The following material is excerpted and slightly adapted from Chapter 21 of Finance in
a Nutshell – A No-Nonsense Companion to the Tools and Techniques of Finance by

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Javier Estrada (Prentice Hall – Financial Times, 2005).

1. Basic Principles
Let’s start with three questions whose answers will lead us to three basic principles or
ideas implicitly built into many financial tools and methods. First question: Would you

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rather have $100 today or next year? No contest there, you prefer them today. (If not,
just send me those $100 bills you don’t want now and I’ll return them to you a year
from today.)

Inflation erodes the purchasing power of money. That’s why we don’t keep our money
under the mattress but deposited in the bank, where we earn interest on the capital
invested. The interest rate paid by the bank protects us against this loss of purchasing
power. Which brings us to another way of seeing why we prefer the $100 today:
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Because we can deposit it and start earning interest on that money immediately, which
implies that a year from today we will withdraw more than $100.

Second question: Would you rather have $100 one year from now or two years from
now? Again, no contest, you prefer the $100 one year from now. The reason is obvious
and follows from the argument above. The more time passes by, the more purchasing
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power we lose. In other words, given the amount of money, the sooner we get it, the
better.

Third and final question: Would you rather have $100 for sure, or accept the outcome
of the flip of a coin in which heads you get $200 and tails you get $0? This one
depends on your degree of risk aversion, but most people will pocket the certain $100,
though the expected value of the flip of the coin is also $100. (In fact, all risk averse
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individuals should chose the certain $100. Risk loving individuals would go for the
coin toss, and risk neutral individuals would be indifferent.) Just in case you’re
hesitating a bit on this one, change the $100 to $1 million and the $200 to $2 million.
What would you choose now?!

Now for the basic principles, which follow from the answers to the questions above.
First, $1 today is worth more than $1 in the future. Second, $1 in the future is worth
more than $1 in a more distant future. And third, both now and in the future, a certain
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$1 is worth more than an uncertain (or risky, or expected) $1. All basic common sense.
And yet essential to understanding the idea of present value, a central concept in
finance.

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2. Present Value
The idea of discounting is central to many methods in finance. It follows from the fact
that, as mentioned above, inflation erodes the purchasing power of money, which
means that dollars received at different times in the future have different purchasing
power. Therefore, adding dollars to be received one and two years away in the future is

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a bit like adding apples and oranges.

In order to add apples and apples we need to turn the oranges into apples. That sounds
kind of impossible, but not so much when it comes to turning future dollars into
current dollars. That’s where discounting, a simple but powerful idea, comes in. The
relevant question is, how much money should you ask for today ($x) in order to be
indifferent between receiving $x today or $100 a year from now?

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The answer, obviously, depends on the interest rate (I) you could earn in the bank.
Given I, you would be indifferent between these two propositions when $x(1+I) = $100,
from which it follows that $x = $100/(1+I). In words, $x is the present value of $100. If
the interest rate were 5%, then you’d be indifferent between receiving $93.2 (=
$100/1.05) today or $100 a year from today, simply because you could deposit the
$93.2 at 5% and withdraw $100 one year down the road.
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What about a two-year framework? That is, how much money should you ask for
today ($x) in order to be indifferent between receiving $x today or $100 two years
from now? Again very simple. You’d be indifferent between these two propositions
when $x(1+I)2 = $100, from which it follows that $x = $100/(1+I)2. Again, $x is the
present value of $100. And if the interest rate were 5%, then you’d be indifferent
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between receiving $90.7 today or $100 two years from now, simply because you could
deposit the $90.7 at 5% and withdraw $100 two years from today.

And how much money should you ask for today ($x) in order to be indifferent between
receiving $x today or $100 one year from now plus another $100 two years from now?
You only need to add the present value of $100 one year from now and the present
value of $100 two years from now; that is, $x = $100/(1+I)+$100/(1+I)2. And with
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interest rates at 5% you should ask for $185.9.

We could go on but hopefully you got the main two ideas by now: First, that the
present value of $1 to be received T years from now is given by $x = $1/(1+I)T. And
second, that present values are additive. This is due to the fact that when we divide
any amount to be received T years from now by (1+I)T we’re turning future dollars into
current dollars (that is, oranges into apples).

One more thing. So far we haven’t really dealt with risk. All those $100 we talked
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about were sure things, and that’s why we’ve been discounting at a rate that is also
risk free. When we deposit money in the bank, we know exactly how much we will be
withdrawing T years down the road. (Well, in some countries people only hope they’ll
be able to withdraw that “certain” amount…)

And yet, like we discussed above, you’re not indifferent between $100 for sure and
the 50-50 chance of $200 or $0 given a flip of a coin. Between those two, you

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prefer $100 for sure. Which is just another way of saying that, given a certain
amount $y to be received T years from now, and a lottery with an expected value
of $y also to be received T years from now, the present value of the lottery is lower
than the present value of the certain amount. (Read this last sentence again and
make sure you understand it.)

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Note that, mathematically, this can only be the case if you discount the lottery at a rate
higher than I. That is, $y/(1+I)T > $y/(1+DR)T only if DR > I, where DR is a discount
rate. The intuition here is clear. Everything else equal, the riskier the proposition (or
investment), the lower the value you place on it. Or, in other words, the riskier the
proposition the higher the discount rate you apply to it.

So, finally, we arrive at one of the most useful and widely-used expressions in finance.

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Given any investment expected to deliver the cash flows CF1, CF2, …, CFT in periods 1,
2, …, T, the present value (PV) of the investment is given by

PV =
CF1
+
CF2
(1 + DR ) (1 + DR ) 2
+ ... +
CFT
(1 + DR )T
(1)
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where DR is a discount rate that captures the risk of the investment. Think of this
discount rate as a hurdle rate; that is, the minimum acceptable return for a company to
invest in a project or for an investor to put his money in an asset.

3. Net Present Value

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Going from present value to net present value is straightforward. The latter only “nets”
from the former the initial investment required to start a project. Therefore, the net
present value (NPV) of an investment is given by

CF1 CF2 CFT

NPV = CF0 + + + ... + (2)
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(1 + DR ) (1 + DR ) 2
(1 + DR )T

Often, CF0 is expressed as a strictly-negative cash flow representing the amount of the
up-front investment required to start the project. There are, however, projects in which
the first cash flow can be positive (think, for example, of the typical executive-
education programs run by business schools), so let’s keep (2) as general as possible
and assume that all cash flows can be either positive or negative.
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Now, how do we decide whether or not to start a project by using the NPV approach?
The rule is simple and you’ve surely seen it (and probably used it) many times before:
Calculate the NPV of an investment using the expression above, and then

If NPV > 0 ⇒ Invest

If NPV < 0 ⇒ Do not invest.

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The intuition is straightforward: A positive NPV indicates that the present value of the
cash flows of the project outweighs the necessary investments; a negative NPV
indicates the opposite.

If two competing (mutually-exclusive) projects are evaluated, then the one with the
higher NPV should be selected. That is, given any two competing projects i and j,

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calculate the NPV of both and then

If NPVi > NPVj ⇒ Invest in i

If NPVi < NPVj ⇒ Invest in j

Of course, the devil is in the “details.” Throwing a bunch of numbers into a formula

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and coming up with a number is not difficult. The difficult part is to estimate correctly
the cash flows to be generated by the project, and to capture the risk of those cash
flows appropriately in the discount rate.

4. The Internal Rate of Return

There exist many rules for project evaluation, many of which are so simplistic that we
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won’t even bother to review them here. (Some of these include the payback period, the
discounted payback period, and the average accounting return.) The main contender to
the NPV approach is the internal rate of return (IRR), which is formally defined as the
discount rate that sets the NPV of a project equal to 0; that is,
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CF1 CF2 CFT

NPV = CF0 + + + ... + =0 (3)
(1 + IRR ) (1 + IRR ) 2
(1 + IRR )T

Note that although it is not trivial to solve this expression for the IRR, Excel (and
many other programs and even hand-held calculators) finds this number in the blink of
an eye. Note, also, that the IRR does not depend on market-determined parameters
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(such as the cost of capital); rather, it depends exclusively on the cash flows of the
project considered.

How do we decide whether or not to start a project using the IRR approach? Again, the
rule is simple and you’ve surely seen it (and probably used it) many times before:
Calculate the IRR of the project and then

If IRR > DR ⇒ Invest

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If IRR < DR ⇒ Do not invest

The intuition of this rule is also straightforward. Recall that the discount rate is also
the hurdle rate or the minimum acceptable return (and that in capital budgeting
decisions that is usually the cost of capital). Then the rule says that if the return of the
project is higher than the hurdle rate we should invest in the project; otherwise, we
should not.

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Another way to see the intuition behind the IRR rule is the following: By definition,
the IRR is the discount rate for which the NPV of a project is equal to 0. Then any
project with an IRR higher than the discount rate must have a positive NPV and should
be accepted. Any project with an IRR lower than the discount rate, on the other hand,
must have a negative NPV and should therefore be rejected. In other words, the two

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rules lead to the same decision. (Be careful, though; this statement is not always true.)

Finally, if two competing (mutually-exclusive) projects are evaluated, then the one
with the higher IRR should be selected. That is, given any two projects i and j,
calculate the IRR of both and then

If IRRi > IRRj ⇒ Invest in i

yo If IRRi < IRRj ⇒ Invest in j

Note, obviously, that for a company to invest at all, the higher of the two IRRs must be
higher than the discount rate.
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No
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