Net Present Value and Other
Investment Rules
Why Use Net Present Value?
Accepting positive NPV projects benefits
shareholders.
NPV uses cash flows
NPV uses all the cash flows of the project
NPV discounts the cash flows properly
Reinvestment assumption: the NPV rule
assumes that all cash flows can be
reinvested at the discount rate.
The NPV Rule
Net Present Value (NPV) =
Total PV of future CFs + Initial Investment
Estimating NPV:
1. Estimate future cash flows: how much? and when?
2. Estimate discount rate
3. Estimate initial costs
Minimum Acceptance Criteria: Accept if NPV > 0
Ranking Criteria: Choose the highest NPV
Calculating NPV with Spreadsheets
Spreadsheets are an excellent way to
compute NPVs, especially when you have
to compute the cash flows as well.
Using the NPV function:
The first component is the required return
entered as a decimal.
The second component is the range of cash
flows beginning with year 1.
Add the initial investment after computing the
NPV.
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The Payback Period Method
How long does it take the project to pay
back its initial investment?
Payback Period = number of years to
recover initial costs
The Payback Period Method
Disadvantages:
Ignores the time value of money
Ignores cash flows after the payback period
Biased against long-term projects
Requires an arbitrary acceptance criteria
A project accepted based on the payback
criteria may not have a positive NPV
Advantages:
Easy to understand
Biased toward liquidity
The Discounted Payback Period
How long does it take the project to pay
back its initial investment, taking the time
value of money into account?
Decision rule: Accept the project if it pays
back on a discounted basis within the
specified time.
By the time you have discounted the cash
flows, you might as well calculate the NPV.
The Profitability Index (PI)
Total PV of Future Cash Flows
PI
Initial Investent
Minimum Acceptance Criteria:
Accept if PI > 1
Ranking Criteria:
Select alternative with highest PI
Proje
ct
C0
Cash Flows
(Rs.000)
C1
C2
PV @ 12%
post
initial
investme
nt
PI
NPV @
12%
The Profitability Index
Disadvantages:
Problems with mutually exclusive investments
Advantages:
May be useful when available investment
funds are limited
Easy to understand and communicate
Correct decision when evaluating
independent projects
The Internal Rate of Return
IRR: the discount rate that sets NPV to zero
Minimum Acceptance Criteria:
Accept if the IRR exceeds the required return
Ranking Criteria:
Select alternative with the highest IRR
Reinvestment assumption:
All future cash flows assumed reinvested at the
IRR
IRR: Example
Consider the following project:
0
-$200
$50
$100
$150
The internal rate of return for this project is 19.44%
$50
$100
$150
NPV 0 200
2
3
(1 IRR) (1 IRR) (1 IRR)
NPV Payoff Profile
If we graph NPV versus the discount rate, we can see the IRR
as the x-axis intercept.
IRR = 19.44%
Calculating IRR with Spreadsheets
You start with the cash flows the same as
you did for the NPV.
You use the IRR function:
You first enter your range of cash flows,
beginning with the initial cash flow.
You can enter a guess, but it is not necessary.
Problems with IRR
Multiple IRRs
Are We Borrowing or Lending
The Scale Problem
The Timing Problem
Multiple IRRs
There are two IRRs for this project:
$200
$800
1
$200
Which one should
we use?
3
$8
00
100% = IRR2
0% = IRR1
Modified IRR
There should be only one change in sign
of cash flows
Done by discounting and then combining
cash flows
Benefits: single answer and specific rates
for borrowing and reinvestment
IRR = 38%, 104.35 = 800+(-800/1.15)
-200
200 104.35
Investing or Financing
Project A
Cash Flows
Project B
-100
130
100
-130
IRR
30%
30%
NPV @ 10%
18.2
-18.2
< 30%
> 30%
Investing
Financing
Accept if Market
Rate
Financing or
investing
The Scale Problem: Incremental IRR
Would you rather make 100% or 50% on your
investments?
What if the 100% return is on a $1 investment,
while the 50% return is on a $1,000 investment?
C0
C1
NPV@25%
IRR
-10,000
30,000
14,000
200%
-25,000
60,000
23,000
140%
The Timing Problem
$10,000
$1,000
$1,000
Project A
0
Project B
$10,000
$1,000
$12,000
0
$10,00
0
$1,000
2
The Timing Problem
Cash Flow
Year
NPV
@0%
@10%
IRR
Investment A
-10,000
10,000
1000
1000
2000
669
16.04%
Investment B
-10,000
1000
1000
12,000
4000
751
12.94%
NPV versus IRR
NPV and IRR will generally give the same
decision.
Exceptions:
Non-conventional cash flows cash flow
signs change more than once
Mutually exclusive projects
Initial investments are substantially different
Timing of cash flows is substantially different
The Practice of Capital Budgeting
Varies by industry:
Some firms use payback/discounted payback,
others use profitability index.
The most frequently used technique for
large corporations is IRR or NPV.
Thank you!!!
