Dr.

Thomai Filippeli
Lecture 4
NPV and Stand-Alone Projects
The Internal Rate of Return Rule
The Payback Rule
Choosing Between Projects
Project Selection with Resource
Constraints
1. Define several commonly used techniques
Net Present Value (NPV)
Internal Rate of Return (IRR)
Payback Rule
Profitability Index
Incremental IRR
2. Describe decision rules for each technique
stand-alone projects
mutually exclusive projects.

3. Compare each technique and tell why
NPV always gives the correct decision.
4. Discuss the reasons IRR can give a
flawed decision.
5. Describe situations in which
profitability index cannot be used to
make a decision.

NPV of a project or investment:
NPV = PV (Benefits) PV (Costs)

Or

NPV = PV (All project Cash flows)
Your computer manufacturing firm must
purchase 10,000 keyboards from a supplier. One
supplier demands a payment of $100,000 today
plus $10 per keyboard, payable in one year.
Another supplier will charge $21 per keyboard
also payable in one year. The risk free interest
rate is 6%.
a) What is the difference in their offers in terms of
dollars today? Which offer should your firm take?
b) Suppose your firm does not want to spend cash
today. How can it take the first offer and not spend
$100,000 of its own cash today?
You have been offered a unique investment
opportunity. If you invest $10,000 today, you
will receive $500 one year from now, $1,500
two years from now and $10,000 ten years
from now.
a) What is the NPV of the opportunity if the
interest rate is 6%? Should you take the
opportunity?
b) What is the NPV of the opportunity if the
interest rate is 2% per year? Should you take
it now?
A perpetuity is a stream of equal cash flows
that occur at regular intervals and last
forever.
Present Value of Perpetuity
PV (C in perpetuity) = C/r
An annuity is a stream of N equal cash flows
paid at regular intervals (annuity ends after a
some fixed number of payments)
Present Value of an Annuity
PV = C*(1/r) *(1 1/(1+r)


Perpetuities
When a constant cash flow will occur at regular
intervals forever it is called a perpetuity.


The value of a perpetuity is simply the cash
flow divided by the interest rate.
Present Value of a Perpetuity

( in perpetuity) =
C
PV C
r
Annuities
When a constant cash flow will occur at regular
intervals for a finite number of N periods, it is
called an annuity.

Present Value of an Annuity

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N N
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What is the present value of $1000 paid at
the end of each of the next 100 years if the
interest rate is 7% per year?

You want to endow an annual MBA graduation
party at the university you graduated. You
want to be a memorable one so you budget
$30,000 per year forever for the party. If the
university earns 8% per year on its
investments and if the first party is in one
years time how much will you need to donate
to endow the party?

In some situations you know the PV and the
Cash Flows of an investment opportunity but
you dont know the interest rate that equates
them.
Internal Rate of Return: Interest Rate that sets
the net present value of cash flows equal to
zero.
Example 5
Jessica has just graduated with her MBA. Rather
than take the job she was offered at a
prestigious investment bank she has decided
to into business for herself. She believes that
her business will require an initial investment
of $1 million. After that it will generate a cash
flow of $100,000 at the end of one year and
this amount
Example 6
The firm that offered Jessica a job was so
impressed with Jessica that it has decided to
fund her business. In return for providing the
initial capital of $1 million, Jessica has agreed
to pay them $125,000 at the end of each year
for the next 30 years. What is the internal rate
of return on firms investment in Jessicas
company assuming she fulfils her
commitment?
NPV and stand alone Projects
Consider a take-it-or-leave-it investment
decision involving a single, stand-alone
project for Fredricks Feed and Farm (FFF).
The project costs $250 million and is expected to
generate cash flows of $35 million per year,
starting at the end of the first year and lasting
forever.
When making an investment decision
take the alternative with the highest
NPV. Choosing this alternative is
equivalent to receiving its NPV in cash
today.
The NPV of the project is calculated as (perpetual
cash flow stream):

The NPV is dependent on the discount rate
For risk free investment the cost of capital will be equal to
the risk free interest rate r.
35
NPV 250 = +
r
If FFFs cost of capital is 10%, the NPV is $100 million and they should
undertake the investment.
NPV is positive only for discount rates less than
14%
When r = 14%, NPV = 0
IRR: The discount rate that sets the NPV of the
projects cash flows equal to zero
IRR provides useful information regarding the
sensitivity of projects NPV to errors in estimate
the cost of capital. The difference between the
cost of capital and the IRR is the maximum
estimation error in the cost of capital that can
exist without the original decision.
Sometimes alternative investment rules may
give the same answer as the NPV rule, but at
other times they may disagree.
When the rules conflict, the NPV decision rule
should be followed.
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 projects negative
cash flows precede its positive cash flows.
In Figure 1, whenever the cost of capital is below
the IRR of 14%, the project has a positive NPV and
you should undertake the investment.

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
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%.
Delayed Investments
Should you accept the deal?
Calculate the IRR.
The IRR is greater than the cost of capital. Thus, the
IRR rule indicates you should accept the deal.
When the benefits of an investment occur before the costs, the NPV is
an increasing function of the discount rate.
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?
Multiple IRRs
The cash flows would now look like:
The NPV is calculated as:
2 3 4
500, 000 500, 000 500, 000 1, 000, 000
550,000 - - -
1 (1 ) (1 ) (1 )
NPV
r r r r
=
+ + + +
Multiple IRRs
By setting the NPV equal to zero and solving for r,
we find the IRR. 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.
Multiple IRRs
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.
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.
No IRR exists because the NPV is positive for all values of the discount
rate. Thus the IRR rule cannot be used.
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.
The payback period is 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.
Assume Fredricks requires all projects to
have a payback period of five years or less.
Would the firm undertake the fertilizer project
under this rule?
Problem
Projects A, B, and C each have an expected life
of 5 years.
Given the initial cost and annual cash flow
information below, what is the payback period for
each project?
A B C
Cost $80 $120 $150
Cash Flow $25 $30 $35
Solution
Project A
$80 $25 = 3.2 years
Project B
$120 $30 = 4.0 years
Project C
$150 $35 = 4.29 years
Pitfalls:
Ignores the projects cost of capital and time value
of money.
Ignores cash flows after the payback period.
Relies on an ad hoc decision criterion.
Mutually Exclusive Projects
When you must choose only one project among
several possible projects, the choice is mutually
exclusive.
NPV Rule
Select the project with the highest NPV.
IRR Rule
Selecting the project with the highest IRR may lead
to mistakes.
If a projects size is doubled, its NPV will
double. This is not the case with IRR. Thus,
the IRR rule cannot be used to compare
projects of different scales.
When projects differ in their scale of
investment, the timing of their cash flows or
their riskiness, then their IRRs cant be
meaningful compared.

Bookstore
Coffee Shop
Initial Investment $300,000 $400,000
Cash Flow
Year 1
$63,000 $80,000
Annual Growth Rate 3% 3%
Cost of Capital 8% 8%
IRR 24% 23%
NPV $960,000 $1,200,000
Consider two of the projects from Example 7.3
Another problem with the IRR is that it can be
affected by changing the timing of the cash flows,
even when the scale is the same.
IRR is a return, but the dollar value of earning a given
return depends on how long the return is earned.
Consider again the coffee shop and the music store
investment in Example 7.3. Both have the same
initial scale and the same horizon. The coffee shop
has a lower IRR, but a higher NPV because of its
higher growth rate.
An IRR that is attractive for a safe project
need not be attractive for a riskier project.
Consider the investment in the electronics
store from Example 7.3. The IRR is higher
than those of the other investment
opportunities, yet the NPV is the lowest.
The higher cost of capital means a higher IRR
is necessary to make the project attractive.
Incremental IRR Investment Rule
Apply the IRR rule to the difference between the
cash flows of the two mutually exclusive
alternatives (the increment to the cash flows of one
investment over the other).
Generally, if the incremental internal rate of return
is higher than the minimum acceptable rate of
return (cost of capital), the more expensive
investment is considered the better one.
Shortcomings of the Incremental IRR Rule
The incremental IRR may not exist.
Multiple incremental IRRs could exist.
The fact that the IRR exceeds the cost of capital for
both projects does not imply that either project has
a positive NPV.
When individual projects have different costs of
capital, it is not obvious which cost of capital the
incremental IRR should be compared to.
Evaluation of Projects with Different Resource
Constraints
Consider three possible projects with a $100 million
budget constraint

Table 7.1 Possible Projects for a $100 Million Budget
The profitability index can be used to identify
the optimal combination of projects to
undertake. It measures the value created in
terms of NPV per unit of resource consumed.
From Table 7.1, we can see it is better to take
projects II & III together and forego project I.
Value Created NPV
Profitability Index
Resource Consumed Resource Consumed
= =
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 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
Solution
Compute the PI for each project.

Project NPV Square feet
needed
Profitability Index
(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 2.10
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
feet
needed
Profitability
Index
(NPV/Sq. Ft)
Cumulative total
space used
Project 5 12,000 1,000 2.5 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
In some situations the profitability Index does
not give an accurate answer.
Suppose in Example 7.4 that NetIt has an additional
small project with a NPV of only $120,000 that
requires 3 engineers. The profitability index in this
case is
0.1 2/ 3 = 0.04, so this project would appear at the
bottom of the ranking. However, 3 of the 190
employees are not being used after the first four
projects are selected. As a result, it would make
sense to take on this project even though it would
be ranked last.
With multiple resource constraints, the
profitability index can break down
completely.