Investment Decision Rules

Investment Decision R.
ules
'estment?
N CHAPTERS 8 and 9. rve developed a process for estimating hurdle rates for pro.l-
ects and for measuring the earnings and cash flows from new investments. The hur-
d1e rates and earnings are not directly comparable, however, since the hurdle rates
are percentage returns and the earnings and cash flows are dollar values. Knowing,
for instance, the right hurdle rate to use for the Boeing SuperJumboJet project and
the earnings and cash flows on the prqect over its .25-year life does not teil us
whether accepting the project will create va1ue forBo'eing. In this chapter, we com-
plete the process of investment analysis by looking at different investment decision
rules that can be used to compare hurdle rates rvith the expected earnings and cash
florvs on a project.
arnings and cash
\X/e begin our discussion r,vith accounting decision rules. In particuiar, w'e iook
at how accounting earnings can be used to compute returns on equirv and capital
and to make investrnent decisions.'We then turn our attention to cash flolv-based
rules, such as payback and how the shift to cash flows can change decisions. The
ot in significant
fina1 and most detailed part of the chapter looks at investment decision rules that
,ril1 the iootnotes
not only consider incremental cash flows but also time-weight them. The most
widel,v used of these rules are the net present value and the internai rate of return.
We consider their manv similarities as well as their significant differences, and whv.
we might choose one approach over the other. We complete the discussion with a
revier,v of the rules firms actuallv use to make investment decisions.
and Seurity Analysrs,
rc Analysts and tjse oJ What Is an {nvestrrrent Decision Rule?

& Sons.
When laced with nerv investments and projects, firms have to decide rvhether or
nor to invest in them. Although we have been leading up to this decision over the
last fe.,v chapters, investment decision rules allolv us to formaiize the process and
specrfi, what condrtion or conditions need to be met for a project to be acceptable.
For instance, an investment decision rule may specify that only projects that recover
rhe amount invested in them in iess than five years rvrll be accepted or that on-1y
projects that earn a return on capital grearer than their cost of capital are good
proj ects.
Nrhough we rlu'ill be looking at a variefv- of investment decision rules in this sec-
iion, we should be aw'are of the characteristics a good investment decision rule
'' sfrould have:
285
286 CHAPTER TEN / INVESTMENT DECISIoN RULES
' First, a good investmenr decision rule has to maintain a fair balance between
ing a manager analyzing a prqece ro bring in his or het subjectiue assessffenrs
inls ti Figfie 10
decision and ensuring that different projects arejudged consistently, Thus, an on capita
inveo
ment decision rule that is too mechanical (by not arlowing for subjective inpur,i,i- lnventory
too ma11eab1e (where managers can bend the rure ro march their biases) ;, Managen
good ru1e. ";;
second, a good investmenr decision rule will allow the firm to further our :
stated
objecrive in corporate finance, which is to n.taximize the ualue of thefrm. proj.",irro
.i
are acceprable, using the decision rule, should increase rhe vaiue of*r. fi.*
....ft_ ;
ing them, while projects rhat do nor meet the requirements lvould a"rooy ,aoi'lr
i
' Third. a good invesrnrenr decisron ruie shouid work across a uariety oJ inveument5.
Invesrments can be revenue-generating rnvesrments isuch as The uo-a
Dapot
opening a new store), or they can be cost-saving investments (as would be the
case .
if Boeing adopred a new sysrem ro manage inventory). Some project, hrr. 1r.g.
uf_
front costs (as is the case r,vith rhe Boeing SuperJumbo),..vhereas othe. prolects
rx*y
haic cc;;s spread out across time. A good investment rule will provide ,r, *r*.,
oi i
all of these di{ferent kinds of invesrments
Does there have to be onl,v one invesrment decision rule? Although many firrns
tnalyze projects using a number of different investment decision rules, one rule
has to
dominate. In other r,vords, when the investmenr decision rules lead to di{Ierent con-
clusions on whether rhe prgect should be accepted or rejected, one decision rule
has
to be the rie-breaker and can be viewed as the primary ruie.
cr 10.1: Firms with good managers do not need investment decision rules. lsthis
statement true? Why or why not?
Categori zing Investment Decision Rules

In the last chapter, rve measured a project's returns initialiy using accounting earnings:
then we moved to incremental cash flows and closecl rhe discussion r,vith time-
weighted incremental cash flor'vs. The investment decision rules in this section parai-
1el that discussion. We begin by presenting accounring earnings-based
decision rules,
cash flow-based rules, and end ri,'ith a discussion of time-weighted cash
il"*t.#r:"
Accounting Incorne-Based Decision Rules

Many of the oldest and most established investment decision rules have been drarvn
ltrom the accounting stalements and, in particular, from accounting measures of
income. Some of these rules are based on income to equiq/ investors (i.e., net income),
others are based on operating income. In each case, the return is compared
r'r,'hereas
to appropriate hurdle rate to decide whether rhe invesrment is worthrrr.hile.
tr(eturn on Capital when pro3ect analysis rs based on rhe return on capiral, the
afler-tax return on capital is compared to the cost of caprtal. If it exceeds tne cost of
capital, the projecr is view'ed as a good project. The expecied returfl on capital oo a
CAIEGORIZING INYESTMENT DECISION RULES 287
rlance between allow-
:iue assessments into th. Figure 10.1 Return Earnings before interest and taxes (EBIT) = $30O,OOO.
on capital on 1
tently. Thts, an i
lnventory
,r subjective inputs)
Management System
L their biases) is
Book Value (BV) = $1 ,000,000 Salvage Value = $800,000
L to further our Average Book Value of Capital =

$1,000,000 + $800,000
= $900,000
,f the
furm. Projects that
ue ofthe firm accept*
would destroy value if project is a function of both the total investment required on the project and its capac-
iry to generate operating income. Defined generally,
t uariety of inuestmenk. Earnings before interest and taxes
rs The Home Depot Return on Capital (Pre-tax) =
Average Book Value of Total investment in Prqect
(as would be the case
Earnings before interest and taxes (1 - tax rate)
rrojects have large up- Return on Capital (After-tax) =
'eas other projects may Average Book Value of Total Investment in Project
provide an answer on
--^.,i,1^ To illustrate, consider a one-year investment in a new computer system to manage
inventory, with an initial investment of $1 million and earnings before interest and
Nthough many firms taxes of $300,000. Assume thar the system can be sold at the end of the year for
r rules, one rule has to $800,000 (salvage value) and that the tax rate is 40%. In terms of a time line, the com-
lead to different con- plrter system has the cash flor,vs shown in Figure 10.1. The pre-tax and after-tax
one decision rule has
retllrns on capital can be estimated as foilows:
, .:al
$300,000
Return on Capital pre-tax) = _ JJ-JJ7O
$900,000
decision rules. ls this $300'0- tl
Rerurn on Capital ,Alter rax) = : "J0) = 2no,o
$900.000
Nthough these calculations are straight{bnvard lor this one-year investment, they
become more involved for multiyear projects, for which both the operating income
I accounting earnings; and the book valre of the investment change over time. In these cases, either the
liscussion w-ith time- return on capital can be estimated each year and then averaged over time, or the aver-
s in this section paral-
age operating income over the life of the project can be used with the average invest-
;-based decision rules, ment during the period to estimate the average return on capital.
>f time-weighted cash Consider, for instance, a four-year inve5tment by Broderbund in a new children's
computer game. The investrnent will require an initiai investment of $1,500 miliion,
and the investment will have the operating income over time shown in Figure i0.2.
The book value of the capitai decreases over time, as the assets are depreciated down
uies have been drawn
to a salvage value of $700. The return on capital (ROC) can be estimated each year
jounting and then averaged over time as depicted in Table 10.1. The arithmetic average pre-tax
measures of
;tors (i.e., net income), return on capital over the four years is 41.94ol,,while the after-tax return on capital is
26.96%.
re return is compared
12.869/0 + 20.00% + 30.00% + 45.0096
rvorthwhile. Arithmetic Average after-tax ROC = 26.96%
4
return on crpital, the The geomerric averages are 43.58Yo for the pre-tax return on capital and 26.40%{or
'it exceeds the cost of the after-tax return on capital.
. retuln on capital on t
Geometric Average after-rax ROC = [(1.1286) (1.20) (1.30) (1.45)]1ir - I = 26.40%
288 CHAPTER TEN / INVESTMENT DECISION RULES
Figure 10.2 A FBIT $300

Multiyear Project (in $400 $500 $600
Milions) EB|T (1-t) $180
1
$240
2
$300
3
$360
4
ETH
BV of Capital $1,500 $1,300 $1,100 S900 $700
Pre.tax
Return on Capital =300/1,400 =40011,200 =s00/1,000 =600/800
21.43% 33.33% 50.00% 75.000/"
Table 10.1 EBIT on Four-year

Year 1
EBIT $300 $400 $500 $600

Average BV of Assets $1,400 $1,200 $1,000 $800
Pre-tax ROC 21.43% 33.33% 50.00% 75.00%
A1ier-tax ROC 12.86% 20.a0% 30.00% 4s.00%
The return on capital can also be estimated from the average operating income
and
rhe average book value of assets over time:
Average EBIT = $450 million

Average after-tax EBIT = $270 million
Average Book Value of Investmenr = ($1,500 + $700)/2 = $1,100 miltion
Table 10.2 Retu
Return on Capital =
' _jj:o = 10 910'o
$1,100
Year EB|T (l
After-tax Return on Capitai = g270 1 $(140.S3
z (202.58
$1,100 = 24.51% 3 (290.55
4 (369.93
The differences befween the approaches will widen if we use accelerated 5 (18.77
deprecration
methods, with the arithmetic averages providing higher estimates 6 609.28
of the return on 7 551.82
capital. 8 694.02
The after-tax return on capitar on a project has to be compared to a hurdle 9 736.04
rate '10
778.01
that is defined consistently. The after-tax rerurn on capital is estlmared
using the pre- 11 820.05
debt earnings and the total capital invested in a project. consequentry,, 12 852.32
it can be vier,ved t5 904.89
as return to the firm rarher thanjust to equiry invesrors. consequendy, the 14
cost ofcap- 947.88
ital should be used as the hurdie rate. 15 99 1.39
16 1,143.U
Ifthe > Cost ofCapital 17 j,204.91
after-tax return on capital -+ Accept the projecr 18 1,265.13
If rhe after-tax return on capital < Cost of Capital 19 1 j24.76
J Reject the project 20 1,384.00
21
For instance, if Broderbund, in the preceding example, had a cost 1,1 30.1 5
of capital o{ 1,2%,it 22 1,179.85
would view the investment in rhe new soffware as a good o,e. 23
when choosing 24
1,229.47
berween mutrually exclusive projects of equivalent risk, the project 1,279.15
with the higher 25 1,329.04
'zzi.i3
return on capital wiil be viewed as the better project. ar"r"g"
3
Return on Capital
= EBI-
CATEGORIZING INVESTMENT DECiSION RULES 289
so6o
$360
4
6 s[ BI a* ffe-mmtiss €ffi"$: Elurdle Rales lon Prolerts
ln Chapter 8, we developed a process for estimating the costs of equity and capital for
projects and investments. Applying this process to the three projects which we will be ana-
ri iyzing in this chapter: we estimate the costs of equity and capital as follows:
$700 . For the lnfoSoft Online store, we will not use the costs of equity and capital that we
estimated for lnfoSoft as a firm, since they were based on software companies. Because
the cost of equity and capital should reflect the riskiness of the project being analyzed,
800 rather than that of the firm doing the analysls, we will use the averagb beta of 1.725 of
0o/o retail companies that derive all or the bulk of their revenues from online commerce as
the beta for equitY:
Cost of Equity = 5o/o + '1.725 (5.5%) = 14'49o/o
pre-tax
Using the debt ratio of 6.520/o that we used for lnfosoft as a firm and lnfoSoft's
cost of debt of 7Vo, we can estimate the cost of capital for the online store:
Cost of Capital = 14.49o/o (0.9338) + 7

o/o (1 - 0'42) (0'0662) = 1 3'80%
. For the Boeing Super Jumbo, we used the cost ot capital estimated for the commercial
$600 aircraft division, estimated in Chapter 8 to be 9.32%.
$800 r For The Home Depot's new store, we will use the cost of equity of 9,78% estimated in
7s.00% Chapter 7 for the entire firm, on the assumption that its investments are almost entirely
45.00% in home imfrovement stores.
:
Lring income and

I
ffi g* Ps*mmBE*m ?ffi"ffi: *stEmatillg art$ llsilt$ iletunrl qn &a$ital
ilt llesisioll tulakim$
-
ln Practice 9.3 estimated the operating income from an investment by Boeing in the
$sein$
Super Jumbo Jet. We will estimate the retuln on capital on this investment in this
)0 million
Table 10.2 Return on Capital for Boeing Super Jumbo
Begining
-iV' ' Capital Ending Avgrag.e ryo'flng Return on
y.., eeff (t - t) rxpe;iditures oepreciation eook VaTue Book Value Capitgl CaPital"
(? 7a? 33 4.15%
1 $(140.83) $3,000.00 4.$1,000
^^^ ralr <7
$216.67 $3,783 1? {? ?q1 67
$3,391 67
4,377'50
$0.00
000
2 (202.58) 3,783.33 1,500 311.67 4,971'67 -4'53
3 (290.66) 4,971.67 1,500 M7.17 6,024 50 5,498'08 0',00 -529
(359.93) 6,024.50 1,000 569.12 6,455.38 6,239'94 0 00 -s 93
4
Lted depreciation
5(18.77)6,455.38250628.876,0765',15,265'951',000',00426
6509.286,076'51250607.655,718'865,897.692,575,007.19
rf the return on 7651.825,718.86250588.555,380.3,]5,549'582,652.257.95
8694'025,380'31250571.365,058.945,219.632,731.828.73
g736.045,058.94250555.894,753.054,906.002,813.779.53
to a hurdle rate 10778.014,753.05250541.974,461.084,607.062,898.1910.37
d using the pre- 11820.064,461.08250529'444,181.644,321'362,985,13|1.22
12852.324,181.64250518.163,913.474,047.553,074.6812.11
it can be viewed 13904'893,913.47250508'013,655.463,7uA73,166.9313.02 3',261',93
14 947.88 3,655.46 2s0 498.88 3,406 58 3,531 02 13'9s
the cost ofcap-
,
15ggr,:s:,aoo.sa25o490-653,165.923,286.253,359.7914.92
161,'143.843,165.920316.592,849333'007633',460'581768 40
11 1,204.91 2,M9.33 0 284.93 2,564'4Q 2,706 86 3',554 19 21
.e project 18].265.132,564.400256.442,307.962,436.183,571.3320.11
191,324.762,307.960230,807'077'162,192'563',781'472218 3,894,9?
e project 20 ,384.00 1 2,077 ,16 o 2o7 .72 1;869.45 ,973.30 1
23.58
211,]30'161,869.450,186.94,1,682.501,175.973,209'4122.67
:apital of l2%,rt 221,179,861,682.500168'251,514.251,598.383,305.7024.06
23 1,229.47 1,514.25 0 151 43 1,352'83 1,438'54 3'404'87 25 38
il7hen choosing 0 136.28 1,22654 1,29468 3'507 01 2664
24 1,?79.15 1,362.83
with the higher 251,329.041,226.540122.651,103.891,155.223,512.2221.82
a Return on Capital = EBIT (1 - t)/(Average BV + Working Capital)
29A CHAPTER TEN / INVESTMENT DECISION RULES
illustration. ln Table 10.2, we estimate after-tax operating income. average book value
of capital, and return on capital for the Boeing Super Jumbo investment. The book
value of capital includes all capital investments made by Boeing in the Super Jumbo]eq
net of depreciation, and includes working capital investments in the project. The aver-
age after-tax return on capital, using the arithmetic average, is 12.75o/o.1 Here, thd
return on capital is greater than the divisional cost of capital for the commercial aircraft
division that we estimated to be 9.3270. Note that in computing the return of capital,
we have used the entire book value of the investmenl including the $2.5 billion in
research and development costs that are sunk.
Return on Equity The return on equity measures the return to equiry

investors, using the accounring net income as a measure of this return. Again,
defined generally,
Net Income
Rerurn on Equirv =
Average Book Value ofEquity Investrnent in Project
To illustrate, assume that America Online is considering investing in a new e-mail serv-
ice thar wilt be offered to its customers. The investment wili require an initial equity
investment of $8C0 million in computer hardware and can be expected to generate
profits for-four years. Figure 10.3 reveals the net income from the investment in each
ofthe four years. Like the return on capitai, the return on equitl tends to increase over
the life of the project,as the book vaiue of equiry in the prqect is reduced.
Just as the appropriate comparison for the return on capital is lhe cost of capital,
the appropriate comparison for the return on equiry is the cos/ of equity, which is the
rate of return equiry investors demand.
If Return on Equiry > Cost of Equiry*-) Accept the project
If Return on Equiry < Cost of Equiry -+ Rejecr the project
The cosr ofequiw should reflect the riskiness ofthe project being considered and the
financiai leverage taken on by the firm. In the preceding example, for instance, assume
that Arnerica Online has a cost of equiry of I4%. The investment in the new e-mail
service yields a return on equiry that is higher than the cost of equiry and rvould
therefore be considered a good iru-estment.'W.hen choosing between mutually exclu-
sive projects of similar risk, the firm choosing ber',veen the prqects will view the prq-
ect r,vich the higher return on equiry as the better proJect.
Figure 10.3 Return Real Estate lnvestment

on Equity
Computation (in $140 $170 $210
Net lncome
Millions)
BV of Equity $8oo
Return on Equity 18.67% 26.157o 38.18%
1 If we use the arcrage operating income an.i book vah'e oi capital over the period to compute the return on
capital, we.estimate rt to be 12.411l0.
i
CATEGORIZING INVESTMENT DECISION RULES 291,
/erage sook value

stment. The book
I Super Jumbo Jet,
H Hr* Fs**uEs*s B#.#: f$t{esge{frffi# ffie&rxa*rs ms? ilffiw?gy: B*maesm &e$48 ffitrys'e
we started in ln
project. The aver- consider again the analysis of the new store for The Horne Depot that
practice g.a. table ]0.3 summarizes the book value of equity and the estimated net
1.75o/o.1 Here, the net of debt
income (from Table 9.5) for each of the next 1 0 years. The book value of assets
ommercial aircraft the book
return of capital, i;;;;ilil each period by subtracting the remaining debt on the project from
.rpitul it added to the average book value of fixed
:he $2.5 billion in value of fixed assets. The working
of debt to arrive at the book value of equity. The increase in the return on
assets net
while the book value of equity
equity over time occurs because the net income rises,
remains stagnant'
'eturn to equity
is return. Again, Table 10.3 Return on Equity at Home Depot Store
Average BV of Average
BV of Return on
Fixed Assets
Net lncome Equ
Net of Debt
$17,766,4s9 ,599,000 9.OO%
n Project 1 $14,556.459 $3,200,000 $ 1
17,070,481 1,'743,436 10.21

7 1 3,710,481 3,360,000
new e-mail serv- 3,528,000 16,405,356 1,895,209 11.55
3 12,877,356
3,704,400 15,772,810 2,054,693 13.03
: an initial equity 4 12,068,410
15,1'74,665 2,222,281 14.64
5 1 1,285,045 3,889,620
*'cted to generate 10,528,745 4,084,101 14,612,846 2,398,385 16.41
6
2,583,438 18.34
rvestment in each 7 9,801,080 4,288,306 14,089,386
4,502,721 1 3,606,43 1 2,777,898 ?0.42
[s to increase over 8 9,103,710
4,727,857 13,166,249 2,982,242 22.65
9 8,438,392
duced. 4,964,250 12,771,236 3,1 96,975 25.03
10 7,806,986
15,043,592 2,34\,355 16.13
re cost of capital, Average
rlry, which is the
The average return on equity of 16.130/o on the store is compared to the cost of equity
forthisstore,whichisg.TE%.Thesefiguressuggestthatthisisagoodinvestment'
rject
je* AssessingAccountingReturnApproachesHolt.weLldojccountingreturns
decision rule? In
measure up to th. three criteria that *'e listed for a good investment
rnsidered and the
terms of maintaining balance betr,veen allorir'ing managers to
bring into the analysis
' instance, assume
analysis' the
r the new e-mail
their judgments abouc the project and ensuring consistency betrveen
accounring returns ,ppro*.h fal1s short. It fails because it is significantly
aft-ected by
luity and would deprecia-
accounting choices. For instance, changing trom straight-line to accelerated
mutually exclu- time, thus altering returns'
tion affects both the earnings and the book value over
il1 view the proj- proj-
Unless rhese decisions are taken out of the hands of individual managers assessing
will be no consistency in the wav returns are measured on difiêrent prq-

ects, there
ects.
Does investing in projects that earn accounting returns exceeding
their hurdie
rates lead to an increase in finn value? The value of a firm,as we noted in chapter 5,
$2s0 firm over its lifbtime' Since account-
is the present value of expected cash flows on the
r+ irrg r"trr.r, are based on earnings rather than cash 11or,vs
money, investing in projects that earn a return grealer
and
than
ignore
the
the
hurdle
time
rates
value of
1l'i11 not
$4oo
ere rejected because
necessarily in..ease firm value- Converseiy, some projects'that
increased'firm value'
their accounting rerurns fall short of the hurdle rate may have
the book valde
This problem is compounded by the fact that the returns are based on
of investmenrs rather than the cash invested in che assets'
up-front
Finailx the accounting return r,vorks better for prqects that have a large
mpute the return on
generate income over time. For projects that do not rcquire a signifi-
inr.,estment and
For instance,
cant initiai investment, the return on capital and equiw has less meaning.
a retail firm chat leases store space for a

new store win not have a significant
investment and may have a very high return ' initial
on capital ,, . .o.rr.q,r.n-...
Notethata11the1imitationsofthereturnoncapitalmeasurearevisibleintheBoe.
ing Super Jumbo anarysis. First, the analysis
does not differentiate benve
already spent and money
monev still to he
be enFnr.r.1116-
,p.rr; .rth.., rL^ ..- 't'
^.---r cost of g2.5 .Orrr"" -onty
freadV the sunk ,rT^l,tI
:ij::,::'il:r'::Yf T-1"of.t:'o"d,'s
over dme, largely as a consequence
,he book ;; ;;;;;;, il::.:
depreciarion, rhe operating ,r."*.lrlo r.rtot]
:T,,:"'::T::':.::'":::::::jl'io'.'':Tni:d,
th: o*'", ,.. ,.",;il'; ,he depre-
5t1
SL.l spreadsheet
*
ment
;:!::.,1'rH;1,jIfl;1"x.::1r5';;,1i:;.;::';;;il;.;:"..:::;
Norwithstanding these concerns, accounting fileasures
of return endure in invest_
.rpa"ag.;;uo; yo, analysis' Aithough this fact can be pardy attribured
to the unrvillingness of finan*
cial managers to abandon familiar measures, it
::"'.::T*rtl'"" ,1ro ..fl..t, the simpliciri.rra irrruirir.
;;;;ri;;;#t appeal of these measures- More importantly, as iong as invesrors
.nd .qriw ry lcsearch
research
analysts use accounting measures to assess the overall performance of frrms, these
same
measures of return lr,-ill be used in project analvsis.
Cash Flow-Based Decision Rules

In the last chapter, we considered why accounting
earnrngs deviate from cash flows,
and we argued that when the two are different,
cash flows .shourd be used to
measure
returns. In this section, we consider two cash
flor,v-baseci investment decision
rules.
The first is a simple modifrcation of the accounting
retr-rrn rures, so tha! r.ve measure
returns based on cash earnings rather than accountrng
earnings. The second is a pay_
back measure thar looks at hor,v quickiy a
oroject generates cash flows to cover the
tial investment. ini_
cash Flow Returns on Equity and capitar one simpre

modification to the
accounting returns on equiry and capital is to
use the cash ."..rr.rg, ,o .o-p.rr.
returns rather than the accounting earnings. ,h.r.
Adding the noncash i.orrrrirrg expenses
to operating earnings yields the cash operating earnings:
Cash Operatrng income = EBIT (1 -, + Depreciarion and orher Noncash
Charges
when the cash operating earnings are divided by
the average book value of capiral
invested in the project, we obtain a cash
return on capital:
ROC = Cash Operating Income,/Average Book
Cash
valr.re of Capital
This cash return on capitai can be compare<J ro
the cosr of capitai to yieid our deci_
sion rule:
If the cash rerurn on capital > Cost of Capirai -+ Accept the project
If the cash return on capital < Cosc of Capital -, Reject the project
This approach can be generaiized to ipok at
the rerurn ro equlty investors. The cash
equiw income can be estimated uy depreciation and bther noncash charges
net income: "Jairrg to
Cash Equity Income = Net Income * Depreciation and other Noncash Charges
CATEGORIZING INVESTMENT DECISION RULES 293
we a significant i The cash return on equiq/ can be computed by dividing this cash equity income by
rsequence. the ar,'erage book value of equiry:
are visiblein the Cash Equity Income
Cash ROE =
tiate berween Average Book Value ofEquiry
-l
gj.) brl.hon is shown
This cash return on equiry can be compared to the cost of equiry to yield our deci-
ofthe assets decreases
sion rule:
rg rncome rises,
,ensirive to the depre_ If the cash return on equiry > Cost ofEquiry -+ Accept the project
chedule will increase If the cash return on equiry < Cost of Equiry -) Reject the project
Those who use this measure argue that it preserves the simplicity of the accounting
rrn endure in invest_
return measures, while using a more reasonable measure of earnings.
rwiliingness offinan_
nplicirrT and intultive
and equiry research
of firms, these same H *m ffirmmtEcm tffi.4: Sash ffi{!8fos,tsoelltg $uper Jum[u lmuestmnnt
Tabte 10.4 presents the after-tax operating income that we used to estimate the return on
capital for the Boeing Super Jumbo in the last section, and contrasts it with the cash oper-
ating income, obtained by adding back the depreciation and amortization each period.
Note that the cash return on capital for the project'is 18.59o/o,,higher than the 12.75% we
rte irom cash flows, obtained with accounting earnings. When compared to the cost of capital of 9.32%, this
result would suggest that Boeing should accept the project.
be used to measure
rent decision rules.
so that we nleasure
he second is a pay- Table 10.4 Cash Return on Capital: Boeing Super Jumbo Jet
,vs to cover the ini_ Depreciation Cash
Noncash Operating
and Average BV Cash Return
Year EBIT (t - t) Charges lncome of Capital on Capital
1 $(141) 5217 t76 $3,391.67 2.24o/o
rodification to the 2 (203) 3',t2 109 4,377.50 2.49
r to compute ) (2s1) 447 157 5.498.08 2.85
these
4 (370) 559 199 6,239.94 3.19
counting e,tpenses 5 (1e) 629 510 7,265.95 8.40
6 609 608 1,217 8,472.69 14.36
7 652 589 1,240 8,201.83 15.12
rncash Charges I 694 57'l 1,265 7,951.44 15.91
9 736 556 1,292 7,719.77 16.74
k value of capitai 10 774 542 1,320 7,505.25 17.59
tt 820 529 1,350 7,306.49 18.47
12 862 518 r,380 . 7,122.24 19.38
Capital 13 905 508 1,413 5,951.39 20.33
14 9rt8 499 1,M7 6,792.95 21.30
o yield our deci- 15 991 491 1,482 6,646.04 22.30
lo 1,'lM 317 '1,460 6,468.21 22.58
17 1,205 285 1,490 6,271.27 23.76
't8 1,25s 256 1,522 6,1 07.51 24.91
project
19 1,325 231 1,556 5,974.03 26.04
prqject 20 1,384 208 1,592 s,868.22 27.12
21 r,'130 187 1,317 4,985.39 26.42
/-estors. The cash )') 1,180 168 1,348 4,904.O7 27.49
23 1,229 151 't,381 4,W3.40 28.51
ncash charges to
24 1,279 136 1,415 4801.70 29.48
25 1,329 123 1,452 4,777.44 30;39
Average 1,164 6,257.78 18.69
rsh Charges
294 CHAPTER TEN i INVESTMENT DECISIoN
RULES
Assessing cash Returns cash returns take a partial

ing earnings to cash OoTrl .Although"rrot step frora account-
added back, as they shourd :n"I
do *; ;. disrance. if,. ,.r.iri- expenses
are
be, bu, ,rr" expenses (such as capitar
nance expendirures and investmenrs "ir*r-.lsh
in working iapiral) are not rror.rlr.a.
mainte_
quen,'v' trris approach w,1,lead.to Conse_
o".ôrirg-rrrl ..,,-,.r* on projects.
returns are st*r computed In addition, the
based on the book"varue
this book value might nor of capitar,.ri ao roc indi.rr.
reflecr the cash value of rhe th"t
In terms of the balance berweenAexibility i.rv.sr-..,c - ,i.'p*..,
and consisiency, the cash return
ures are less affected by meas_
accounting decisions on depreciation,brr-ri"
sider capital maintenance expenditures iir.. ro con-
and working capital investmen*-arows
agers to show much higher man_
returns on some inr.esrments.
rha_r investipg in proje..rs
Thrs same failure win arso
lean with a crsh flo;;,
of capirai w,r noi n.'..,,..,r, yield
approach' firnrs r'v,r tend ro
decision, ;::"#i.1?1'.iltXT,::t?:l;iil
invest in .*pitrl-irtensive projects ,irr,
ing' since adding back rhe depreciation ,.. destroy_
i.r....r., ".t,r.
measured rerurns. Finary.
return, iike rhe accou,ting
return, tencis to u,ork better the cash
f.. p..1..,, ,irrl"rr" ,O_
wirh returns spread our ,.-rr-,i*.
,r.h ,, ,, inu.r,-.n, ^., in
ff;il[::t"n.' new
y' cc to't: The goeing super iu.mbo

Jet project w,as anaryzed
ciation' Assume that you switched using accererated depre-
to str;iEht-tine aeireciatio;:il;;
that swirch have on ti" effect would
'"trrn'on-.;;jilil*e cash return on capitar?
Payback The payback on project is a measure of horv
a
quickly the cash flows
genlrlted bv rhe project cover the initial invr
Intuitivetli p,q..[ ,ir, return
ttreir ,r*rrrr"l'rTil:Jrt:rfi:r.r]:,::.:]TJ.:
a*racdve projects, since ar1 cash flows .r.n.J b.yo,ra
that point in rime can be con_
\idered as profit on the projecr. ft can
aiso be argued that prqects
invesrmenr sooner that return their
'.. l.ss risk1, projects,-;;;., significant componenr of risk is the
that the firm can 1or. sorr.
or ar of ,h. *o,.., t. irr-tr".,r.d in the
;.:;:ltt
The compuration of pavback
is extrenery sirnpre. For insrance,
with an initial investment of .",,r,
consider a project
$1,000 and rhe f"ir.*,r*.^;;;;r:.
Cash Flows $3oo $4oo $5oo
o1e^ r4
$600
investment
t l'+;=@
$1,c00
The payback on this project

is berw.een ft,"-o and three
flows, can be approximated vears and, based on the cash
to be ?.6 vears.2
Like rhe other meas,res. rhe
pavback can be esdmated
in the project (equin invesrors either rbr an craim hoiders
and render$ or for just rhe
mate the payback for the entire equirv* invesrors. To esti-
firm. the .arh flo*, to the firm
are cumulated until
2Thisassumesthatcashflowsoc.l,rtlni+l.-L.^..^.._
weeks oreach year, ior Ir 50% or rhe cash liows occur
insrance, ,i:'r]}lt:jff;:::;':L::: in the rast rwo
tep frorn account- thev cover the total inrtial investment. To estilnate payback just for the equity
lcash expenses are investors, tl're cash flor.vs to equiry are cumulated until they cover the initial equiry
as capital mainte- invesrrnent irr rhe project.
.ubtracted. Conse-
rs. In addition, rhe
c not indicate rhat
in the project.
ffiil* fiy,*s:iia;* iffi.fi: {.rtfrntt*ffaffi F*vhasiq {x;a-t*cw !re$m$mffi
cash return meas- .I}rttres $?*x,s

.he failure ro con- The following eiample estimates the payback from the viewpoint of the firm, using the
nents aliows man- lnfoSoft Online Software cash flows estimated in ln Practice 9.5. The cash flows for each
re faiiure will aiso year of the four-year investment in the online store are reported in Table 10.5. We see
:ater than the cost that the initial investment of $5.45 million is returned by the beginning of the fourth year,
vaiue. Wiih rhis leading to a payback of just over three years.
are value destroy-

Table 10.5 Cash Flows for lnfosoft Online
r. Finally, the cash to Firm
Year tuture Cash Flow to Firm Cumulated Cash Flow
i that have an up-
0 $(5,4s0,000) $(5,a!o;ooo)
rvestment in new 1 1,508,000 (3,942,000)
2 1,173,100 (2,1 68,900)
1 ,897,91 0 (270,990)
4 2,7 53,941 2,482,951
ccelerated depre-
lhat effect would Akhough flrnrs seldom make invesrment decisions based so1e1v on the pa-vback.
apital? sllrveys sliggest that sorne businesses do in iacr i:se it as their primar,v decision ru1e. In
those situations r.vhere payback is used as rhe prirnarr'' crilerion for accepting or reject-
-1v the cash flows ing projects, the firm usually sets a maximunt payb:rck period ior projects- It would
this be relevant? then accept projects thar pay back rheir rnitiai investment sooner than this tlrx.irtlun
considered more and reject projects that do not.
time can be con- Firms are much mole iikel-v co employ payb:rck as a secondary investment deci-
that return their sion rule and nse it as a constraint in decision making. For instance, the decision rr-rle
rent of risk is the for the firm might srate thar aii pro.lects that earn a return on capital oiat least 15%
s invested in the lvil1 be accepted as long as the pavb;rck is less than 10 vears. Alternativeh, r'r'hen choos-
rng betrveen projects that have the salne return on capital. u'e would rccept the proj-
;onsider a project ect lr,ith the shorter pavback period.
The payback rule is a sirnple and rnruitively appeaiing clecision rule, but it does not
$6oo use a signrficant proporrion oithe iniormation that is avaihble on a project. The pay-
4 back rule restricts decision rnakers loo rluch b,v preventing thern from bringing inlo
rhe decision their assessment of rvhat might happen after the inirial inr':srment is
4 recovered. This is a significairt shortcoming r.vhen deciding betr,veen mutuallv exclu-
sive projects. To provide a sense of the rbsurdities rhis can lead to, asslime thal ,vou have
$1 million and are choosing betrveen tu,o projects. The first project requires an invest-
ased on the cash ment of $1 million in hnd and buildings,:rnd ploduces renlrl incotne of $300.000 in
the t-irst rwo 1,sx1s :rnd $-100,0011 in the next.two years. The original investment of $1
all claim holders million c:rn be recovered lt the end oiVear.l r,vhen the rerl estate is sold. The second
nvestors. To esti- project requires rhe same investment of $l million initrally in compllters that rvril be
cumulated until leased to businesses. The computers generate cash income of $500,000 in the first two
years and $100,000 in the next two,vears and rre expected to have no value at the end
of the tourth,vear. The cash florvs on the lwo investnrenrs are shown in Figure 10.'{.
occur in the last tlvo
On the basis oithe payback alone,investing in computers is preferable to rnr-esting in
296 CHAPTER TEN / INVESTMENI DECISION RULES
Figure 10.4 Using

Payback for Mutually Real Estate lnvestment
Exclusive Projects $300 $300 $400 $1,400
Cash Flow 0 .,
2 3 4
lnvestment $1,OOO
Payback = 3 years
Computer lnvestment
$5oo $500 $100
Cash Flow 2
1
3
investment $1,000
Payback = 2 years
real esrare because it has a shorrer payback period. Most

of us would pick the real
estate investmen! as rhe better one,however,because
of the high cash flois generated
after the initla.l investment has been paid back.
The pavback rule uses nominar cash flo,ls and equates
cash flow-s in the eariy years
with cash flolvs in rhe later years. consequendy, choosing projects
rvith a 1ow payback
period may not lead to increases in firm vaiue for rwo reasons.
The first is that.monev
has time value. and recouping the nominal initiar investmenr
is not qrir. ;;";;;^;; ELJ Spreadtshe€
create value for the firm, since that amount could have
been investei eisewhere and <apbudg,xls allows yo
earned a significant return. The second is thar ignoring to estimate the NpV
cash flo,uvs after the initial
investment has been recovered is not compatibre with maximizing from cash flows to thc
firm value, since firm on a project.
firm value is the present value of cash flows orre, the firm,s life.
Fina1ly, the payback rure is desrgned
to cover the conventional project that invorves
a largeup-fronr invesrment followed by positive operating cash flows.
it breaks down,
howel'er, vrhen the investment is spread over time or w-hen
there is no initiai invest_
ment. Thus, the payback rure breaks down on aI three
counrs. [t is roo inflexibre in
its application, does not lead to firm varue maximization,
and does not work for all
kinds ofprojects.
Discounted Castr Flow Measures

Investment decision rules based on discounted cash florvs
not only replace accounting Figure 10.5
income rvith cash flows but explicitly consider the NPV of a
time varue of money. The tv,,o most Project
widely used discounted cash flows rules are net present
value and the internal rate of
return.
Net Presenr value The net

l)f,esent varue (Npv) of a project is the sum of the
Present values of each gf the cash flows positive as well as negative _- rhat occur
over the liG of the pljere t rhe general-equation for
I rhe Npv rule is as folows:
, ', -'
t
,,' .',
3 The net prernt value.rule wds 6rst discussed in llinhieiiir (195g).

'f ',, -
Npv of proiec,
- = ,-.',''
(t f /)'
Initial Investmenr
$1,400 t=1
4
+ where
CF, = Cash flow' in period
r = Discount rate
r
-V = Life oithe project

Using this equation, we can calculate the net present value of a prgect with the cash
flows depicted in Figure 10.5 and a discount rute o{ 12"/o.
The net present value of a project can be computed tiom one of two standpoints.
$100 . It can be calculated
from the perspective ofal1 ini'estors in the project, by discount-
4
ing cash flows to the firm at the cost of capitai and netting our the total initial
+ investment in the project.
. It can also be caiculated from the perspective ofequiry investors in the project by
discounting cash flows to equiry at the cost of equiry and netting out the initial
equit-v investment in the project. The cost of equity should reflect the riskiness of
the project.
rld pick the reai .,,=
flows generated
The key is to remain consistent in matching discount rates with cash flor"r's. Once
the net prelent value has been computcd, the decision rule ts simple srnce the dis-
.n the early years
count rate already factors in what the firm needs to make on the investment-to
low payback break even.
;h a
rst is that-money Decision RuleJor NPVfor lndependent Projects
quite enough to Effi rrn .o,*".*

if the NPV > 0 -+ Accept the project
d eisewhere and capbudg.xls allows You
to estimate the NPV If the NPV < 0 -+ Reject the prqect
after the initial lrom cash flows to the
,irm on a project.
[irm value, since Note that a ner present value greater thanzero implies that the project makes a return
greater than the hurdle rate.
iect that involves
, Ir breaks down, { CC tO.Z: Assurne that you have analyzed a 5100 million investment in a new online
no initial invest- venture, using a €ost of capital of 15% and have (orne up with a net present value
too inflexible in of 9t million. The manager who has to decide on the project argues that this is tos
not rvork for all small a NPV for a project of this size and indicates that it is an unwise investment.
ls this true?
rlace accounting Figure '!0.5 NPV of a Cash Flow

:y.The two most Project
+l
: internal rate of lnvestment $1,000
$268
; the sum of the
ue that occur
$31 I
-
is as foilows:
$356
$381
NPV = $324
@@e@ry ?ffi,ffi; fipU fi,sm the tirne,s $[aldpsiffit: Irl$c$af[

Table 10.5 shows the present value carculations for the cash flows to
rnfosoft. .
usins the project,s cost of ca;i; ", tir,
Il:Tl:,:j."f.:1"I,: ::Y:i: :::.e.cash ilows
the discount rate on the cash flows.,(The "r
,r.ro.rn,,
were estimated in ln praaiceffi
or.capitat.) rhis project has a net present varue
:1jiiT:.:.].9:l::1lT:t,:d-,,n:.:o:,
$174,479, which suggests that it shourd be accepted,'baied on the projected ;"ff;:
anC the cost of capital of 13.80%. l
Table 10.6 Future Cash Flows to the Firm from lnfoSoft Online
Cumulated PV of Future
Cash Flows Cash Flows Cash Flows
Year to Firm to the Firm to the Firm
0 $(s,4s0,000) $(s,4s0,000) $(5,4s0,000.00)
I.508,000 (3,942,000)
w
1
1,325,164.42
2 1,773,100 (2,1 68,900) 1,369,210.06
3 1,897.910 (270,990) 1,287,895.29
4 2,753,941 2,482,951 1,642,208.65
NPV
174,479.41
HIAsa ps,m*g$ffim gm.?: Hp!tr from

tfte tirm,s ${asadpslglE: $se!ll$,s
$uper Jumfts
To estimate the net present value of the super Jumbo to Boeing. we start with the
flows projected in Table 9.10, and we use the cost of capital of i..zao/o tt"t *"
for the -commercial aircraft division. Table '10.7 summarizes the calculations.
.o*i
Table 10.7 NpV of suier Jumbo Jet project

Year. lncremental Cash Flow pV at Cost of Capital
o g(s00) $(soo)
1 (983) (8ee)
2 (1,349) (1,213)
3 (1,402) (1,073)
4 (1,8s9) (1,302)
5 (1.100) (7041
6 1,278 749
7 1,312 703
8 1,349 661
9 1,387 622
10 1,427 585
11 1,469 ssf
12 r,51 3 519
13 1,558 489
14 1.606 461
15 1,555 435
16 1,956 470
17 2,001 440
18 2,048 412
19 2,098 386
2A 2,952 497
21 1,777 ' 274
22 t:,822 257
23 1,869' 241
24 '1,918 226
6,794
." NPV 4,0 r 9.15
C}JEGORIZ1iNG INI\,GSTMENT DECISION RULES 299
The net present value of this project suggests that it is a Eood project that will earn about
iltt f,mfe$uft $4 billion in surplus value for Boeing.
rws to lnfoSoft, a5 6
st of capital of 13.80%
In the last rwo illustrations, rve estimated net present value from the firm's stand-
ted in ln Practice 9.5, point b1, discouniing cash flows to the firm by the cost of capital. The net present
s a net present valug I value can also be estimated from the equity investors'standpoint bv discounting cash
the projected cash I1ows to equiry at the cost olequiry and netting out'the equiry investment in a proj-
ect. The nvo approaches will generally result in the same decision in terms of the net
Snline present values being positive or negative. The net present values using the two
approaches can be different if the financing mix used for the project is different from
PV of Future
Cash Flows that used for the overall firm.
to the Firm
l(5,4so,ooo.oo)
1,325,164.42
&N $m ffipmmx*mm
1.369.2 10.06
1,287,896.29
1,642,208.65
€ffi"ffi trFll[r,om tfie fquily lnuestors'$tandpoilll
Ihe llome 0eilot $lsre
-
174,479.41
The net present value is computed from the equity investors'standpoint for the proposed
store for The Home Depot, using the cost of equity of 9.78o/o for Home Depot as a firm,
in Table 10.8: The cash flows were estimated in ln Practice 9.8. The net present value of
glk B{lsi'l$'s $4,101,613 suggests that this is a good croject for The Home Depot. The new store, will
create value for the firm.
Table 10.8 Equity NPV of New Store

g, we start with the
).38% that we Year Future Cash Flows to Equity PV at Cost of Equity
:alculations. 0 $(1 8,200,000) $(1 8;200,000)
1 2,306,083 2,100,640
2 2,420,309 2,008,281
3 2,540,185 1,919,976
cf Capital 4 2.565,989 't,835,547
)) 5 2,798,014 1,754,82s
r) 6 2,936,556 1,677,646
j) 7 3,081,958 1,603,856
l) 8 3,234,557 1,533,307
l) 9 3,394,589 1,465,855
0 10 16,275,198 6,401,68',l
) NPV 4,101,613
]
I
I Net present value has severai important properties that make it an attractive deci-
;
sion ru1e.
I
) 1. Net present ualues are additive. The net presen! values of individuai projects can
)
be added to arrive at a total net present value for a business or a division. No other
;
investment decision rule has this properry The properry has a number of implications.
)
' The value of a firm can be expressed in terms of the net present values of the proj-
)
ects it has aiready taken on as rvell as the net present values of prospective future
; projects.
i
Value of a Firnr =E Prescnr V'.rlue oiProjects in Place - I NpV of expected tuture projects
The first term :in this equation captures the vaiue tI assets-in-plare, and the second
;
:
term measures the value o{ expected Juture grouth. Note that the present value of
r.'l 6 projects in place is based on anticipated future cash florvs on these projects.
.
L
3OO CHAPTER TEN / INVESTMENT DECISION RULES
when a firm terminates an existing project thar has a negative present value
on antrcipated flrture cash flows, rhe value of the firm will increase by the
a
of the negarive NPV Thus, if The Home Depot decides to close 50 unp
stores that were generating negative cash flows and a negative n., p..r.rr,
of
million, the value of the firm will increase by rhat amounr. Similarly, when
a
accepts a new project r,vith a negative net present value, the value or th.
fi.m ,r11 , .
decrease by that amount. -.
'when a firm ;;
divests itself of an existing asser, rhe price received for that asset
wt
affect the vaiue of the firm. If the price received exceeds the present value
to 1\s .
firm of the anticipated cash flows on thar project, the value oithe firm *il lr.*rr. ',
with the divestiture; otherwise, it will decrease. As an example, assume thrt no.ini :.
decides to sel1 its defense business for $4.5 biliion, and the presenr vaiue
of thl I
expected crrhtflo*,s that Boeing wouid har,:e generared from keeping ,rr. u"rir.*
* ,
$'1billion. The value of Boeing as a firm will increase by $o.s biliion on the divesri-
ture. a,
when a firm makes an acquisition at a price that exceeds the present..alue of

the ,
expected cash flows from rhe firm being acquired, it is the equivalent ofaccepting
a negative ner presenr value project and will lead ro a drop in value. The a.op
in
stnrL price
stock nri.o tLrt
that r,,- ^l-."--,.^ a^-
we observe for many ^^^--i,-i-,, .
-^.^-, acquiring firms, rvhen rhev announc. ,.qui-
sitions, can be viewed as a reflection of the market,s belief that they are pal,ing
roo
much.
2. Intermediate cash flows are inuested at the hurdle rate. Irnpilicit in all present value
calculations are assumptions about the rare at which cash flou,s that occur during
the
project liGtime, that is, intermediate cash flows, get reinvested. The net present i.alue
rule assumes
rsrL dJJulrlrr that !d)rr lruw5
LlrdL cash florvs chat occur betrveen
Lrlal Occur the lnltlahon
Dettrveen ane initiarion and end of the project
prqect
are reinvested at the hurdle rale, wirich is the cosr of capital ilthe cash flows are ro
ihe
firm,
firm, and the cost of equiw
eouiw if il:rhe
the cash r.. to
flour< are
cesh flor,vs ra equitv
cn,rirr: investors. 1t;-.^- 11-.-r
inrrocr^-" Given thar L^.1
both
the cost of equiry- and the cost of ca,oital are based on the returns rhrt can be
made on
alternative investments of equivaient risk, this assumption should be a reasonable one.
3. NPV calculations allow-fbr expectetl term structure and interest rate shiJts. In all the
examples in this chapter, we have assumed that the discounr rate remains unch.rnged
over time: This is not ah.l-ays the case, horvever; the net present value can be com-
puted using time-varying discount rates. The general formulation for the Npv rule ..
is rs foiiorr-s:
CF. CFz
NPV ot'Prqecr = -
(1 + r,) (1 + 11) (1 + r)2
Cr"
t (1 + /1) (1 + r2)2 (1 + r:)3 . (1 * r),,
- Irritial Investment
where
CF, = Cash flor.v in period r
r, = One-period discount rate that applies to period r
fi - Llre oI tne projcct.
The discount rates Inav vary across time for three reasons. First, the level of inierest
rates may change over time. Second, the risk characteristics ol the prgect
r*ay be
t
CAIEGORIZING INVESTMENT DECISION RULES 301
expecred ro change in a predictable way over dme, resulting in changes in the

discount
/e present value
rate. Third, the financing mix lbr the project may change over time, resulting in
crease by rhe
changes in both the cost ofequiry and the cost ofcapital'
ciose 50 unp
ve net present of 950
iimilarly, when a
vaiue of the firm *ra ffis-asBEce *#=&: l{PU $alculatEclt wilh lime'Uaryim$
rpi11
$iscsunt fiates
ved for that asset that you are analyzing a four-year project that requires investing $'! billion in
Assume
-' present value to .o*prt", ,oft*"r" development today. The proiect will generate cash flows of 5300 rnil-
in year 4' The
the firm wrll i lion in year I, $/t00 million in year z, $ioo million in year 3, and $600 million
associqted with the
e, assume that Boeing cost oicapital for year t is tO"Z", but the technological uncertainty
year 2, 12o/o in.
present value of the software industry leads to higher discount rates in future years - 11o/o in
year 3, and 13% in Year 4.
ieeping the business rs ' The present value of each of the cash flows can be computed as follows:
billion on the divesti-
$300
PV of Cash Flow in Year , = 1272'72
e present value of the
=
lr,
luivalent of accepting PV of Cash Flow in year 2 = --140t = $327'50
in va1ue. The drop in -
they announce acqui-
at they are paying too PV of cash Flow in year 3 = ---!:00-
(1.10) (1.11) (1.12)
= $365'63
$600
it in all present value PV of Cash Flow in Year 4 = = $388.27
(1.10) (1.11) (1.12) (1.13)
lhat occur during the
The net present value NPV of Project =i272.72 + $327.60 + $365'63 + $388'27 - $!'000'00 = $354'23
tnd end of the project
CC tO.S: Assume that for ln Practice'!0.9 you had been asked to use
: flows are to the one discount
cash I
rate that wouid yietrd the sarne flIPV a
stors. Given that both rate for all of the cash flows. ls there a discount
s that can be made on as the one above? lf yes. how would you interpret this discount rate?
I be a reasonable one.
I
The net present value rule srtislies many of the conditions we laid out for
good
st rate shifts. In all the
investment decision rule. It allows managers who are assessing projects
to bring their
ie remains unchanged
nt value can be com- judgments about them into the discount rate and the cash flo1'rrs. By allowing for a ter-
the NPV
ion {br the NPV rule minai value that captures expecrations beyond the time horizon of the analysis,
very long-term a way of bringing that value into
rule gives managers assessing Projects
the analysis. Ar the same time, the rule that only prqects that have net present values
greater than zero applies across all investments and brings consistency
lo the process.
Because net presenr values are additive, the net present value rule is rhe decrsion
proj-
rule most consisrenr wirh the objective of maximizing present value' Accepting
- Initial lnvestment
ects wich a positive ner present value wili increase firm vaiue, and
accepting projects
Jr
with negative net Present value will decrease firm value'
prqects
Finally, the net present value rule can be used to analyze all kinds of -
revenue-generating projects, cost-saving projects' projects requiring up-tiont costs' and
prqects with costs spread over time. It is flexible enough to allow for time-varying
used? when
Given these advantages, why is rhe net present vaiue rule not ahvays
rt, the 1evel of interest Two problems
access to ne.r capital is unrestricted, we rvouid argue that it should
be.
rf the project rnav be
302 CHAPTER TEN / INVEST,MENT DECISIoi.i 1ILILES
associated with the net present value rule, one cosnletic

ancl one real, can operate as a tigure 19.6
roadblock ro its acceptence.
Profile
' The fact that it is an absolute rather than a percentage measure of returns
makes
some managers uncomibrrable. N{any managers. lor i.stance,
are rruch nlore com_
fortable wrth an assessment that a project will earn a retlrrn of 230,4,
rather than
knowing that it has a ner presenr value of g50 mil1ion.
' The rule that projects r.virh a net presenr val-re greater than zer-o shoulil
be accepted
and that they will increase filn value is based on the assurnption rh.rt
the firm can
raise the capital it needs to finance any good investments. To the
extent that a firrn
mav har,'e limired access ro capital. this assur'r',prion n-right not hold.
Th,s, a fir.m that
is constrained ro invesr only $100 million mav have ro pick projects.that
1,ierd the
maximum value added for the firm rather rhan invest in everv project thar has a
pos_
itive net present value.
trnternal rtate of R.eturn The internal rate of return (lRR) is rhat discounr
rate
that makes the net present value zero. Intuitively, it is the measure
of the ret,rn that
yolr are earning on an investment, considc-ring both how much the cash
tlorvs on the
lnr'rstments will be and when thev r'vi1l be received. It is the discounted
cash florv .rna-
log to the accounting rates ofreturn. To illustrate. consider again the
project described
at the beginning of the ner presenr value discussion (Fieure 10.5).
Cash Flows $s00 $400 $5oo $600

01 2 J 4
lnvestment $
j,OO0
IRR = 24.89%
At the internai rate of relurn. the netpresent value of this project is zero. The linkaee
betrveen the net presenl vr.lue and the internal rate of leturn
rs nrost visible rvhen the
net present value is graphed as a function of the discollrr,.rr" in
r net present value
profile' A net presenr value profile for the project described is rllustrared rn Fieure
10.6. The discounr rare is varied, keeping cash florvs fixed,
lrom 0?6 co 3r,)9/0, and the
ner present value is computed at elch discount rlte.
The ner present value profile provides several insrghrs intc the project\ viabiliry
First, the internal rate oirerurn is crear.. fiom the graph
Wt*
capbudg.xls. al
it is the poi,.,, r, *,irich the to estimatl
profi1e crosses the r-axis- Second, the profile provides a-n')easlrre
You
of horv selsitive rhe internal rate 01
NPV and, b,v exrension, the project clecrsron based on cash.
- is to chlnses in the discount rare. the firm on a p
The slope of the NPV profi1e x a me:lsure ot the- discount rare sensitivrw
of the pro-i*
ect- Third, when m,ruailv excl,sive proje.ts are being rnalr,.zet1, qraphing
borri Npv
profiles together provides a measure oi the brerkeven discount r..,.
the ,re ;]t
which rhe decision maker rviir be rnditTerent ber*eerr rhe r*o projecrs.-
one advantage touted for rhe rnternal nce oi return is thrt ii .an be used even
v','hen rhe discount rate is unknorvn..while this is trr:e for the
calculation of rhe IRR.
it is not rrue when the mrnager has to use rhe IRR ro t1eci.le r,vherher or nor ro
underteke a project. At thar stage in the process, rhe internal
rare of retr:rn ira-. to be
CAIEGORIZING INVESTMENT DECISION RULES 303
al, can operate as a Figure 10'6

Profile
: of returns $500
makes
much more co1n_
400
[239lo rather than
o
5
300
As the discount rate increases,
hould be accepte<1 G the net present value decreases.
> 200
that rhe film can tr
o
extent that a firm o
E 100
. Thris, a firn'r that o.
o
3cts rhar ,vield the z0
ect that has a pos_
(1 00)
(200)
that discount rate
cf the return Discount Rate (%)
that
cash florvs on the
ed cash florv ana-
project described
compared to the discount rate. If the IRR is grearer than the discount rate, rhe projecr
is a good one;if the IRR rs less than the discount rate, the project should be rejected.
$600
Like the net present r,'alue, the internal rate of return can be computed in nvo w-ays:
4
' The IRR can be calcuiated based on the cash flows to the firm and the total invest-
@d ment in the project. Then ir is compared to rhe cost of capiral.
IRR is computed on cash_flotus to theJirm
lFrhc IRR > Co>r of C.rpital -) Accept rhe project

rero.The linkage If the IRR < Cost of Capital *) Reject the project
visible when che
t present value ' The IRR can be calculated based on the cash flows to equiry and the equiry invesr-
str;lted in Figrlre inent in the project. If it is estimared rvith these cash flows, it has ro be compared
to 30?i,, ancl the
to lhe cost ofequiry rvhich shouid reflect the riskiness ofthe project.
,roject's viabilifi,.. Gffil ,r,."..r"., IRR is conputerl on ushJTows to eEtiy

capAudg.rls. allows If the IRR > Cost of Equiry -+ Accept the project
'inr ar which the you to €stimate the
olv sensitive che internal rate of return {f the IRR < Cost olEquit_v -+
based on cash flows to
Reject.the project
le discount rate. the firm on a project.
viw" of the pro.1- V'hen choosing between proJccts of equivalent risk, lve should view the project nitl:
hrng botii NpV the higher IRR as the berrer invesrmenr.
-' the ritte at
-
ts.
ilE.
rn be used even
ion of the IRR,
Es E$E Pq'mu$Esm Effi"Bffi: Estl$atiug tlte lRR $ased ull $asil tlows
ether or not to ts lhs Firell: Boain$ $u$er,lumha
:eturn has to be The cash flows to the firm from the Boeing Super Jumbo project are used to arrive at a
NPV profile for the project in Figure 10.7. The internal rate of return on this project is
!
!:
-E--
Figure 10.7 NpV

Profile: Eoeing SUper $
Jumbo Jet { $35,000 tigure'r0.8
$
g Profile: The H
E
*
30,000 Depot
&
E
4
25,000
* o
fi 3
S ,r .E 20,000
*
c
f .. o
o 15,000
$.l
E. E
o. 10,000
4:
I:'':r
6.," zo
*:
q.. 5,000
E ...:
g i.
E.
0
(s,000) r
12 14 16 ,18 20
22 24 26 28 30
Dlscount Rate {y.)
14.88o/o, which is higher than.the.cost

of capitar of 9.32yo. These resurts are consistent
with the findings from the NpV rure, which
aiso reiommended investing in the new jet.
S $re Prmmg$*e €ffi"€B; Estimatin$ |ftfi Basad 0n Ga$ft flsws xo tquity:

?lro llome lleps{
The net present varue profire depicted
in Figure 10.g is based on the equity invertment
and the free cash flows to equity estimatedior
the Home Depot,s new store. The inter_
nat rate of return on lhis project is 13.53%,
9.78o/o. Again, these resurts arj consistent
*r.,iir, i,
nigne, iiii
ir,i ..ri'ot equity of
recommended accepting this investment.
*iit
tt tinaings from the Npv rure, which arso
"
The internal rate of return is the most widery
used4 discounted cash flow rule in
investment analysis among firms in the
united states, but does it p.r, oo. test for a
good investment decision rule? Like the
net present varue rure, the internar rate of,
return rule maintains a good balance betweeo
aflowing managers *rr" lr" assessing:
projects to bring their views of the project
into the discount r"-t. *d tfr..r* Ao*r]
and arriving ar a consistent rule. This is
trr., however, onry if the IRR is compared
to the cost of capital 0r equiry. I{ as is sometimes
the case, the internal rates of return
are compared to those on other projects,
it can lead to inconsistent conciusions.
Does invesring in projects with an internar
rate of return greater rrrr" ,i"'rr*a.
rate lead to firm varue maximi zation?
The
nificant exceprions.'when.managers anaryzeprojects
answer, in g..r.rJ ;';;;;.re
are sig-
that are *,rirrlly exclusive,pick-
ing the project'with the higher interna
or.
For insrance, a $5 million investment with "r..i*;;;;;;";l'fir*
a 50% IRR wilr,creare ress value.for
urr.r..
a firm
than a 950 million investmenr with a
30% IRR.
I In a 1986 suruey offinancial managers, abour

50% ofthem reported that they used the
as their.pnm1ry decision rule. In contrast, inrernal rate ofre&lrn
uulrasr, onty
only about 2)70
25% used the
tl net present value ruie,4p their primary deci,
sion rule.
Figure 10'8
NPV
Profile: The Home $30
DePot
25
620
c
g
E1s
t0
t10
o
\ lnternat rateof return
=
,Eo \./
o 8 10 12 | 2A 22 24 26 28
cz (5)
(10)
\
(15)
sults are consistent Discount Rate (o/o)
ing in the new jet.
IIU$ l0 [uuity: The biggest problem with the internai rate of return measure is that there are
entire classes of investments where the internal rate of return cannot be assessed cor-
rectly. In particular:
equity investment . some investments can have more than one internal rate of return, in which case it
w store. The inter-
1 cost of equity of is not clear which IRR should be used in the decision making;
PV rulg which also ' the internal rate of return cannot be reasonably assessed on an investment that does
not have an up-front cost. If a firm is abie to spread its up-front cost over time and
cash flow rule in end up with positive cash flows in every period, there is no internai rate of return.
)assour test for a Mathematicaily, the internal rate of return is the root (or roots) of the present value
e internal rate of equation for cash flows.
who are assessing
rd the cash flows, I ,.1o'' =o:Solveforr
r=u (r r r)'
RR is compared
For a conventional project, there is an initial investment and positive cash l1ows there-
ral rates ofreturn after (i.e., cash flows go from negative to positive and stay positive), and only one IRR.
:onclusions. 'When
there is more than one sign change in the cash flows, that is, cash flows go from
c than the hurdle
negative to positive and go back to negative, there will be more than one internal rate
but there are sig-
of return.5
y exclusive, pick- Lest this be vierved as some strange artifact that is unlikely to happen in the real
mize firm value.
world. note that manv long-cerm projects require substantial reinvesrments ar inrer-
i value.for a frm
mediate points in the project and that these reinvestments may cause the cash flows in
those veais to become negative. For instance, Boeing, on its SuperJumbo investment,
nternal rate of return

5While the number of internal rates of return will be equal to the number of sign changes, some internal rates
p cheir primary deci.
olreturn may be so far out ofthe realm ofthe ordinarv (e.g.,10,00rJ%) that they may not create the kinds of
prcblems described here.
willhave to make additional invesrrnenrs in retooring and updating

prants ag some drner
during the life of rhe investment, leading ro cash outflows in that period.
*t.;;d:
happens, we can get more than one internal rare of rerurn
for th" srm. ,*;i."h
flows. -*
' i
A number of solutions have been suggested to the multiple IRR probrems. ComParin
ons,
is to use the hurdle rare to bring the negative cash ffows from .:
intermea*. p.rio*
back to the present. Another is to construct an Npv profile. In
either .rr", i, i, friil l
ably much simpler to estimate and use the net present value. :
frm Psus*E$se $ffi.€P: lt{rltiBle |fifi pnsiects

Aslume that Mattel is planning to manufacture a new toy based
on a popular childrenl
televispn program. The investment is expected to have a irurdle rate oi
1)o/o, a four-year
life, and the following cash flows over.those four years. The trademark
has to be licensed.
and this requires a large payment at the end of the fourth year.
Cash Elows $800 $1,000 $1,300 <$2,200>
i lnvestment $1,000
The net present value profile for this project (Figure 10.9) reflects the problems that
arise
with the IRR measure.
-, Arthe
since
you can see, this project has two internal rates of return
hurdle rate falls between these two lRRs, the decision - 8.607o and 3G,55%.
whether or not to
accept the project will change depending on which IRR is used.
ln order to nrake the
right decision on this,project, Matter wouid have to rook at the Npv profile-
rf, as in this
the net present value is positive at the hurdle rate, Mattel should make
case,
the invest-
ment' lf the net present value is negative at the hurdle rate, the proj;
should be
rejected.
Table 10.9 H(
Figure 10.9 NPV

Profile for Multiple Balance
IRR Project $80
benveen flexi-
60
bility and con-
40 sistency
Internal rates of return
920
6
B Leads to firm
o.- tzot value maxi-
$ t+01 mization
= {oo)
(80)
(r00)
'Works
{120) on all
rypes of prg-
ects
COMPARINGINVESTMENTDECISIONRULES 307
g plants af some dme
.When cr '10.2: Do discounted cash flow rules require
more information than accounting
at period. this income-based rules? lf yes, what additional information do they require?
the same set of cash
IRR problems. gq. Compafing fnvestrnent Decision Rules

intermediate periods We have considered a series of investment decision rules in this chapter and assessed
:ither case, it is prob_ each one separately. We bring these assessmenrs togerher in Table 10.9. Based on this
analysis, the net present value rule comes closest to firlfilling our requirements
for a
good investment decision rule, especially for firms without constraints on capital
investments. For firms with significant restricrions on capital, the internal rate of
return is a good alternative.
1a popular children,s
e of12o/o, a fouryear
Net PresentValue and Internal Rate of Return: A
rrk has to be licensed, Closer Look
Although net present value and rhe inrernal rate of return are viewed competing
0 <$2,200>
as
investment decision rules, they generally yield similar conclusions in most cases. The
differences belween the two rules are most visible when managers are choosing
berween mutually exclusive projects.
-{
e problems that arise Differences in Scale The net present value of a project is stated in dollar terms
and does not consider the scale of the project. Thus, a net present value of
.6.600/o and 36.55%. $50 mil-
l whether or not to lion on a $100 million investment could be compared to a net present value of g75
1 order to rnake the million on a billion dollar investment. The internal rate of return, by contrast, is a per-
/ profile. lf, as in this: centage rate of return, which is standardized for the scale of the project. When we are
,uld make the invest-'
e project should be
Table 10.9 E{ow Investment Decision ltules Measure Up

Accounting Returns Cash Returns Payback NPV IRR
Balance Not enough A little more Too inflexible, Good balance Good balance
benveen flexi- consistency consistent, since rvhat berween flexi- between flexi-
biiiry and con- across projects; since deprecia- happens after bility and con- biliry and con-
sistency accounting tion cannot be prqect ends is sistency sistency
decisions can used to change ignored
change returns returns
Leads to firm Not necessar- Not necessarily; Not necessar- if the firm
Yes, Yes, ifprojects
value maxi- i1y; focuses on not ful1y
does ilv; does not has access to are not being
mization earnings and consider cash consider all capital compared to
does not con- flows and does cash flows or each other
srder cash flows not reflect time time value of
or time value value of money money
Works on a1l No.'Works No. Works No. Wbrks Yes No. Needs at
types ofproj- only on proj- only on proj- only on prq- least one sign
ects ects with initial ects with initial ects r,vith initial change in the
investments investments investments cash flows
choosing between mutually exclusive projects

with very different investments, the
ference in the way the two lpproaches
measure returns can read to very dif*
results.
RE$re Fs'mmtise t$.1$: f,trpu and lftE lor Fnojecrs of ,iffernnl $eales
ffiffiJ:i[:x,::*::?'",^T:liT:: ?:,t.j :,:r" and that vou are comparins 6,o:

jSji*:,lli3:r"j:i,;h,.*;;",h",ill,".i#ff;il:?:|ll;,Y:
,ffixT*:#:T,J'T::.::::,d,#;;;;,";;il;T;."J:trj:".,"f,
;:$'i:11;;'I'lJ.l,
j',',",j;:ffi ::::;
II"XJ:H x:: j::IJ.ll :f :."
o o *, i"io'J r li
"
r r
jiit';iJft
"i', fl::,IT;
ffill[[n'#
J'Jffi ill
r,Jff
:::,H*,H:ff:::1:11i:,::*'""jr'$
*'1*i:,:,',"^:l?y
'ilfl :;
re,r o o. *r e ; r"i"." i;,;Jr"
#ff"[.,fr:*:
j tJ'v;J'
y r rr tvt uetlr
;d
The two decision ll, Il ? rtrvesrmenrs.
rureslierd different ."rrrti ro,. two projects. The net present
re rrrle sraaacrc +h,+ +r.r^
HTI]:f :1',,::'l,lPl"'1".r:::xr:il,_:;t;;*l;,h;i##1"r"ff
_te
,':?:'i#
:::ij:":,: j:'.T: j:j:l::T-':-*:rdiheress;;;;;';;;"";##xJ'i5;T"ffi
prising, given the differences in scale. I.
which rure yierds the better decision? The answer
depends on the constraints faced
the business in raising capitar to make investmeîs.u by
raise
wii"n tne tirm;;;; capacity to
as much capitar as it neerr.s to invest in prosfeaive projects,
rule provides the right answer: the more the net present varue
ryrtem shourd be picked over the ress
expensive system. rf there are restrlctions""p"nriuJ
on how much capital the'firm can raise
invest' however, investing.in the more and
,lartem may.read to the rejection of other
"rp"nrir.
good projects rater on. rn those cases, the
internai rate of return rure may provide
ter solution' The capitar rationing question the bet-
is deart with in more detait ir;a;;pter 12.
Differences in Reinvestment Rate Assumption Arthough

the differences.
berween the NPV and the IRR rules due
to scale are fairry obvious, there is a subtrer
difference berween the fwo rules, relaring
to the reinvestment of intermediate cash
Figure 10.10 NpV

and Simple Computerized lnventory System
IRR
- Different
Scale Projects Cash Flow $350,000 $45O,OOO $600,000
@*"1, 1 j
$750,000 Figure 10.
7
and IRR -
'Reinvestn
lnvestment $1,OOO,O0O
Assumptir
NPV = $467,937
IRR = 33.667.
Sophisticated Connputerized lnformation

Systenn
cash Flow $s,ooo,0oo $3,500,000 $45O,OO0,0oo $5,500,000
$,",nrn"r=*={*
investment $10,000,000
NPV = g;1,359,664
IRR = 29.667
6The issue ofcapicai

rationing was firsfraised in Lorie and Savage (1g55). weingartner (1g77)
issues.raised by eapirrl rarioning. conlronts the
i."
&._
COMPARING INYESTMENT DECISION RULES 309
investrnents, the dii:
:ad to very different flows.7 As pointed out earlier, the net present value rule assumes that intermediate
cash flows are reinvested at the discount rate, whereas the IRR rule assumes that inter-
mediate cash flows are reinvested at the IRR. fu a consequence, the two rules can
yield different conclusions, even for projects with the same scale. For instance, assume
that The Home Depot were choosing bewv'een rwo sophisticated computed systems,
fleremt $cales
with the same initial investment, but di{ferent expbcted cash flows as illustrated in Fig-
ru are comparing twq ure 10.11. In this case, the net present value rule ranks System B higher, while the
rf a simple computer=
IRR rule ranks System A as the better investment. The differences arise because the
nd produces the cash
;tment of $10 million
NPV rule assumes that intermediate cash flows get invested at the huidle rate, which
Juce the much higher is 15%. The IRR rule assumes that intermediate cash flows get reinvested at the IRR
)th investments. of that project. Aithough both projects are affected by this assumption, it has a-much
tcts. The net present greater efilbct for System A, which has higher cash flows earlier on. The reinvestment
rject, while the inter. assumption is made clearer if the expected end balance is esrimated under each rule.
e results are not sur-
End Balance for System A with IRR of 21.41% = ($10,000,000) (1.214D4 = $21,730,887
I constraints faced by
End Balance for System B with IRR of 20.88% = ($10,000,000) (1.2088)4 = $21,353,6i3
r has the capacity to
he net present value To arrive at these end balances, however, the cash flows in years 1, Z,'and 3 will have
r picked over the less
to be reinvested at the IRR. If they are reinvested.at a-lower rate, the end balance on
e firm can raise and
these projects will be lower than the values stated above, and the actual return earned
he rejection of other
may provide the bet- will be lower than the IRR, even though the cash flows on the project came in as
ail in Chapter 12. anticipated.
Tire longer the term of the project and the higher the IRR, the more serious are
gh the dift-erences the consequences of the reinvestment rate assumption made by the IRR rule. This is
us, there is a subtler so because the IRR rule implicitly assumes that the 6rm has'and will continue to have
f intermediate cash a fountairi of projects yielding returns similar to the returns earned by the project
under consideration.
+ $750,000 Figure
and IRR
10.11
-
Reinvestment
Assum.ption
NPV
Cash FIow
Compuler System A
$5,000,000 $4,000,000 $3,200,000 $3,000,000
lnvestment $10,000,000
NPV = $1,191,712
IRR = 21.4'lelo
$s,500,000 Computer System B
=+ Cash Flow $3,000,000 $3,500,000 $4,500,000

'l
$s,s00,000
@ry4":* | )
lnvestment $10,000,000
NPV = $1,3s8,664
IRR = 20.88o/o
er i1977\ conironrs the
7
See Meyer (1979).
310 CHAPTERTEN ,, INVESTMENT DECISION RULES
Figure 10.12 tRR

Flow
versus Modified
Cash $3OO $400 $500 $600
lnternal Rate of
lnvestment 91,000 l
Return
$600
$575
$529
$456
Terminal Value g2,1GO
=
Internal Rate of Return
= 24.gg/"
Modified lnternal Rate of Return 21.2i,/o
=
/ cc to.n: why is it more reasonable to assume, as the Npv rure does,

that the inter-
mediate cash frows are reinvested at the cost
of equity or capitar rather than the
internal rate of return?
one solution that has been suggested for the reinvestmenr

rate assumption is to
assume that internlediate cash flows get reinvested
at the hurdle rate the cost of
equity if the cash flou,s are ro equiq, invesrors and
rhe cost of capitai-ii,rhey are to
the firm .- and to calcuiate the internal rate of rerurn from
the initial investment
and the terminal value. This approach yields
r,vhat is called rhe modified internal
rate of return (MIRR), as iiiusrrated in Fig,re 10.12.
on this invesrnlenr, rhe con_
ventional internal rate of return is 24.89026. If rve
assune that the intermediate cash
t'lo'vs are reinvested at the cost or capitar of
15%, rve obtain a terminar vaiue of
$2,160. This rerminar varue arlorvs us ro compure
the modified inrerral rare of
return for this investrlenc.
Nlodiiied Internal Rate oiRerr-rr,, = 1r't6' ' \'t - I = z1 .23%

\ /t.oorl
The nlodified internal rate of rerurn is lower rh.rn
rhe inrernal rate of recurn
because the intermediare cash Ilorvs are investecl
at the hurdle rare of 15% instead of
the IRR of 24.89%.
Many believe rhar the T'IIRR is neither fish nor fow.l.
since it is a mix of the Npv
rule and the IRR rule.. From practical standpoinc. the MIRR on a project
weighted average of the internal-arate of return
is a
o,., thrtprqect and rhe hr.dre rate the
firm uses' The rveights depend on the magnitude and
riming of the 625h fl6w-5 6hs
the grearer the r,veight attached -to the
larger and eariier the cash flows o' th. p.o.j."r,
hurdle rate. Furrhermore, the MIRR ,pp.or.h
rvi1l yield the same choices as the Npv
approach for projeos of the same scale and
iives.
cr 10'3: what types of firms are good candidates for the

firms are suited for the NpV rule?
rRR rure? what types of
==:r, ;
'w'hat Approaches
Do Firms use in xnvestrrrent Anaivsis?
Tr'vo points must be made about investmenr
analvsrs ir.r p.r.ri.l. The flrst is rhat firms
r ::# J,LH ::,, JJ T, :;:l ?':::, lx ffi :r,::i**,;i: i** ; ;; ; ;;;
1
WHAT APPR.OACHES DO FIRMS USE IN INVESTMENT ANALYSIS? 311
Periodic surveys of financial managers have been conducted to find out which
inveslment techniques lhev use. These surveys serve two useful purposes. First, they
provide a sense of what practltioners are using at anv point in titre. Second, compar-
isons of surveys across time provide a measure of changes in the process of investment
analysis. The survev reported in Table 10.10 was done in 1976 nd focused on the
)0
,5 financial managers of some of the largest companies in the United States.
'o
This survey provided several interesting insights into the state ofthe art ofinvest-
;6
ment analysis in 1976. First, it demonstrated the enduring populariry of accounting
t return measures, such as return on equiry and assets, in spite of the emphasis placed
60
on cash florvs over earntngs in textbooks on investment analvsis. Second, even u'hen
discounted cash flor.v measures were used, the internal rate of return was much more
1ikely to be used as a primary decision technique than was net present va1ue. Notwith-
standing the problems r,vith multiple internal rates of return and faulty reiil'estment
rate assumptions, managers preferred a scaled measure of investment performance to
oes, that the inter- an unscaled one as a prrmarv decision ru1e. Third, a surprisingly large number of
ial rather than the respondents claimed that they used the pa1'back period as the primarv investment
decision rule, despite all of its limitations and problems. Finall1'. most respondents used
:e :lssunlption is to more than one investment analysis measure in deciding on projects
ra[e The survey was expanded and updated in 1986. The results are summarized in
-if they are of
the cost
pital Table 10.11. Fronr this survey, it is clear that the net present value rule gained a sig-
ro
inttial investment nificant proportion of adherents in the intervening decade, mostly at the expense of
rodified internal the accounting measures. Although this shift to discounted cash flow models over time
uestment, the con- can be explained as a logical shift to more sophisticated investment analysis techniques
and maV be attributed to a recognition of the importance of value maximization, a
intermediate cash
puzzling anomaly emerges frorr these findings in the doubling of lhose respondents
terminal value of
r-rsing the pavback period as their primar,v investment rule. This finding is confirmed
d internal rate of
b1, Ross (1986), r,vho examined the capital budgeting practices of 12 large manufac-
turing firms and found that the pal.back method .^-as widely used, especialiy among
srnaller firms. Some have suggested that this situation may have arisen beceuse of the
1 1 1L).
increased leverage taken on by some Iirms in the 1980s, which, in turn, increased the
nal rate of return need for curreilt or near-term cash flows to meet debt obligations.
oi 15o,'o instead of Wfrile this survev has not been updated recentl.v, anecdotal evidence and the pop-
ularitv of value cnhancement measures like EVA suggest a shift to the net present
a mix of the NPV value approach in recent years.
on a project is r
he hurdle rate the
Table 10.10 A Survey of Investment Decision Techniques in 1976
635h fl61y5 ghs
;ht attached ro rhe

- Capitai Budgeting Technique in Use
-roices as the NPV Primarv Secondarv
Technique Number Percent Number Percent

e? What types of
Internal Rate oiR eturn 6t) 53.6 13 14.0
Accounting Rate of Return 28 25.0 13 1.{.0
at
Net Present Vaiue 11 9.8 ;+ 25.8
Pavback Period 10 8.9 11 .14.0
: first is that firms Profitabiliw Ratio 3 2.7 2 2.2
cond is that there Totai Responses 112 100.0 93 100.0
;ion rules. sori,re: GiIman rnd Forrester ltll)
312 CHAPTER TEN / INyESTMENT DECISION RULES
Table 10.11 updafed survey of Investrnent DecisionTechniques

in 19g6
Capital Budgering Technique in Use
Primary Secondarv
Technique Number Percent Number Percent
Internal Rate of Return 288 49.0 70 15.0
Accounting Rate of Return 47 8.0 89 19.0
Net Present Value 123 21.0 113 24.0
Payback Period 112 19.0 164 35.0
Benefit/Cost Ratio t7 3.0 JJ 7.0
Total Responses 587 100.0 169 100.0
Source: Kim, Crick, and Kim (1986).
None of the surveys mentioned here will ever end the debate
on the right invest-
ment analysis technique, but collectively they provide some
useful lessoru. First, it is
dangerous to insist dogmatically that one and only
one technique is right and that all
others are flawed. All investment analysis techniques have
limitaiioor,.rid no one tech- Question
nique works equally well for all firms. Second, the techniques
managers use in invest-
ment analysis may go beyond t"lle mere theoretical pros ,od 1. You are a
.orr i"rr"lop.d in this initial inv
chapter and may depend on a number of real-worlJ
concerns, including it . t irrory have an al
of the business and the compensarion mechanism employed of
by the firm.ihird, while assets
fitqo may use more than one technique in analyzing projects, one value of I
technique still has
to be the primary technique in making decisions. has a cost
accepting
Et at 10.4: ln the t980s and 1990s, the attractiveness of net present value as an 2. You orvn
g investment decision rule increased, relative to other decision.rutes.
what might sion possi
account for this shift? million t<
this anrot
The expa
*:::: tax opera
r","aw;;;;i;*;;;;;;;;;;;;;;;;;;;;;;;;;,"_* Assuming
rnent, est
An invesrment decision rule is a rule that allows us to differentiate
sis' n-rent. (Tl
between good
and bad investments. A good investment decision rule
maintains a good balance 3. \6u have
berween flexibiliry and consistency, leads to firm value project.,r
maximization, Jrd works on
all kinds of projects. investmer
Investment decision rules are categorized on the basis ofaccounting ating inc<
earnings, cash
flows, or discounted cash flows. The accounting rate depreciat:
ofreturn mersr..i s,r.h as return
on equiry or return on capitd, generally work befter for projects Estimate
that have large ini- has no c
tial investments, earnings that are roughly equal to the cash
ho*s, ,.rd level earnings How lvo
over time. For most projects, accounting returns will increase
over hime, as the book nance exi
value ofthe assets is depreciated.
4. You are a
There are two cash flow-based rures: the cash return on capitar
and payback. The of $100 r
cash return on capital is an improvement on the
accounring ..r.rrn on capital, but it $25 milli,
does not fully adjust for all cash flows. The payback, ect has a
whichlooks at how iurckly the
cash flows-on a prcject cover its initial investment, 10%, esti
is a useful seiond..y *".r# of
assuming
QUESTTONS 313
project performance or a measure of risk. It is not a very effective primary technique

iques in 1986
because it does not consider cash flows after the initial investment is recouped.
1ue in Use Discounted cash flow methods provide the best measures of true returns on proj-
ects because thev are based on cash flows and consider the time value of money. They
Secondarv
are also most likely to meet our criteria for a good investrnent decision rule. Among
ber Percent discounted cash I1ow methods, net present value provides a dollar rleasure r,vhiie inter-
na1 rate of return provides a percentage measure of project returfls. Both methods
) 15.0
require the same intormation, and, for the most part, the,v agree when used to analyze
)
19.0
independentprojects.The internal rate ofreturn does tend to overstate the return on
I 24.0
good projects because it assumes that intermediate cash flolvs get reinvested at the
35.0
internal rate of return. When analyzing mutually exclusive projects, the internal rate
7.0
of return is biased toward smaller projects and maY be the more appropriate decision
100.0
rule for firnrs that have capital constraints. Firms seem much tnore inclined to use
internal rate of return than net present value as a investment analysis tool. This can be
attributed partly to the fact that IRR is a scaled nleasure of return and partly to the
capital rationing constraints firms may face.
on the right invest-
rl lessons. First, it is
is right and that all
rs, and no one tech-
Questions
lagers use in invest- 1. You are analyzing a one-vear project that requires an 5. Estimate the internal rate of return of the project
s developed in this initial investment of $10 million and rs expected to described in the last exampie. Conrpare the internal
cluding the history have an after-tax operating income of $2 million. The rate of return to the modified internal rate of retLlrn
: firm. Third, while assets oF the project are expected to have a salvage lor rhis project.
val:e of $6 million at the end of the year. if the firm 6. Wil1 the net present valui of a project always drop
: technique still has
has a cost of capitai of 159/u, would you recommend rir'hen the discount rate is increased? Ii nct, r'vhen
accepting the prqect? rnight the NPV go up as the discount rate is
2. You or'vn a bookstore and are considering the expan- increased?

esent value as an
sion possibilities. You estinrate that it will cost you $1
rules. What might 7. Megatech Corporation, a large software firm rvith a
nrillion to expand and that you can borrow 4A% of market value for its equiry of $100 mi11ion,
this amount fiom the bank at an ilrterest rate of 89/0.
announces that it r,vill be acquiring FastMail Corpo-
The expansion is expected to generate additional pre-
rati.on, a smaller software firm, tbr $15 million. On
tax operating incone of $200,000 for the bookstore.
the announcement, lvlegatech's stock price drops by
Assuming that there is no depreciation in the invest-
370. Based on these facts, estimate the arnount which
lte financial analy- rnent, estimate the return on equiry on the invest-
the market thinks Megatech should have paid for
iate betlveen good ment. (The tax rate is 40%.)
FastMail Corporation.
rs a good balance 3. You have been asked to conlpute the payback for a
8. You are the CEO of a small sofrware firrn that has
ion, and works on project with an initial investment o[ $5 miilion. The
limired access to debt and equity markets. Your firm
investment is expected to genetate an a{ter-tax oper-
earned an average return of 28% on its projects last
ating income of $1 million a year, and the straight-line 'Woulcl
iting earnings, cash
depreciation each year is expected to be $250,000.
years, while its cost of capital was 12%. you
'lres, such as return expect NPV or IRR to be the better investment deci-
Estimate the payback period, assunring that the firm
hat have large ini- sion rule for your firrn? Explain.
has no capital maintenance expenditures each year.
and level earnings How lvould your answer change if capitai mainte- 9. We need less information to use the internal race of
time, as the book nance expenditures equaled depreciation? return than the net present value, since lve need a cost
4, You are analyzing a project with an initial investrnent ofcapital to compute the net present value, but rve do
and payback. The ofg100 rnillion and expected after-tax cash flows of not need one to compute the internal rate of return.
$25 miUion a ,vear, prior to debt payments. If the prq- is this statement true? If not, rvhy not?
r on capital, but it
t how quickly the N ect has a cost oiequiry of 12%o rnd a cost ofcapital of 10. Under what conditions mighc a firm rhat accepts
1070, estirnate rhe net present value of the project, projects based on the internal rate of return not be
,ndary measure of
assuming no salvage value. maximizing firm value? Why?
3.11 CHAPTER TEN / IN\ESTMENT DECISION RULES
P:oblems
In the problems belorv' you can use a market risk Piot the n
premium of 5.590 and f, tax rate of 4Lt%
where none is speci.ed. is the inte
1' You have been given the following
information on - capital of
proJect: a 4. under what conditions rvill the return on
.nrrr.- accept thi
project be equal to the internal
:*^ rate of rerurn, esti-
' It has a five-year lifetrme' mated from cash Ilows to equiry- investors, 8. You have
on the same project:
' The initial investmenr in the projed will project?
be g25
million' and the investment u'ilL be depreciared 5. You are provided with the projected
Year
straight line, down to a salvage value income srare-
of $t0 miliion me.rts foia project: 0
ar the end ofthe fi{ih year.
year 1
1
' The revenues are expected to be g20 million next 2 J I 2

Revenues $10,000 $11.00i) g12,000 g13.(100
year and to grow 70%o a year 3
after that for the - Sold 4,000 1,100 4,800 5,200
Cost ofGoods
remaining four years. Plot the n
- Depreciation 1,000 3,000 2,000 1,000
' The cost of goods sold. excluding depreciation, ., = EBIT 2,000 3,600 5,2t)0 6,800 is the intr
expected to be 50% ofrevenues. 16%, wou
The tax rate is 40%.
' The ta-x rate is 40%' 9. Estimate r
' The project required an initial investment of project de

a' Estimate the pre.-tax return on $15,000 and an additional investment
capital, bv vear of $2,000 at decision c
and on average, for the project. the end ofyear 2.
10. You are
' *:T:':*:-.:::;'il;iln on capiul' bv vear ' *:x5':ril',tilJ:fi:i:*l::i:f:::iT with the f
Year
c lfthe firm faced a cost ofcapital of 12%, should made at the beginning ofeach period.
it take on this project? e. Estimare the free cash flow to the 0
firm for each
2. Assume that thq facts in Problem
1 remain unchanged
of the tbur -vears.
1
2
except lbr the depreciadon method, b. Estimate the payback period lor investors
rvhich ,, ,*it.f;.J in the 3
to an accelerared method with the firm.
ibllorting depreci- +
ation schedule: c. Estimate the net present value to invesrors
in the a. Estimar
o/o
of DeprcciableAsset firm if rhe cost of capital is 12%. would
Yo'
1 vou assumir
+0 accepr the project?
ter pro-
z 14
6' Estimate the internal rate of return
3 u.q to investors
in the firm. would you accepr the project?
b. Estimai
4 fi3 ect. Wl
5 6. Consider the project described rn problem
13.J 5. Assume c. What r
each
Depreciabre Asset = initiar investmenr - Sarvage varue :*:T,j;:JjT:[i":ffi,iXUI*'J:'j::t;i future
or
r
a Estimate the pre-tax return on a. Estimate the free
capital, by year and cash llow to equiry for each of the d. What
on average, for the project. four years. each ot
b. Estimate the o
after_tar on capital' bv vear and the pavback period for equirv investors 11, You have
on average, *, ,n. o:.T.T,:n it:'ffi rn
investmen
c' If the firm faced a cost of capital of c. Estimate the net present value to equirv the projec
12o,o,shou.ld it
^- investors if
take this project? the cosr of equiw is 16%. would ect? Why
accepr the
1.ou
3. Consider again the project described
in problem 1: Project? 12. Businesses
(Assume that the deprecianon
reverts ro tr.ri;;i;".i d. Fstimate the internal rate of return shouid us
Assume that 40% of the initial to equity
inrestment"fo, the invesrorsinrhefirm..wouldyouaccepttheproject? Explain.
project will be financed with debt,
,,,ith an a.rnual .7. You are provided with X3. You have
interest rate of 10% and a^ balloon the following cash rlows on a
pry_*, prqecr: ProJecrs w
principal at the end ofrhe fifth year. "i,i"
a. Esrimate the return on equiry by year Year Cash Flops to Firm Year
and on aver- 0 _ $10,000,000
age, for this project. 0
b. If the 1 4,ooo,ooo 1
cost of equiry- is 15%, shouid rhe 6rm take
thisproject? 2 5,000,000 2
" 3 6onnnno
PROBLEMS 315
Plot the net present value profile for this project.'What The cost of capital is 12%.
is the internal rate ofreturn? Ifthis firm had a cost of a. Which project would you pick using the net pres-
capiral of 10% and a cost of equiry of 15%, would you ent value rule?
turn on equiry on accept this project?
a b. Which project rvould you pick using rhe internal
rate of return, esti_ 8. You have estimated the following cash flows on a rate ofreturn rule?
vestors, on the same proj ec r:
c. Hor.v would you explain the diilerences benveen
Year Cash Flows to Equity the rwo rules? Which one rvould you rely on to
cted income state- 0 - $4,750,000 make ,vour choice?
1 4,000,000 14. You are analyzing an jnvestment decision in which
34 2 4,000,000 you r,r,ill have to make an initial investment of $10
)00 $12,000 $13,000 3 -3,000,00{,) million and you rvi11 be getrerating annual cash flows
100 4,800 5,200 Plot the net present value profile for this project. W'hat to the lirm of $2 million every year, grou'ing at 5ok a
)00 2,000 1,000 is the internal rate of return? If the cost of equiry rs year, forever.
)00 5,200 6,800 16%, rvould you accept this project? a. Estimate the NPV of this project if the cost of cap-
9. Esrimate the modified internal rate of return for the ital is 107;.
ial investment of project described in Ploblem 8. Does it change your b. Estimate the IRR of this project.
:ment of $2,000 at decision on accepting this prqect?
15. You are anailrzing a project with a 30-year lifetime,
10. You are analyzing nvo mutuaJ1.v exclusive projects u ith the [ollowing rharacteristics:
I to be 10% ofrev- w'ith the following cash florvs: . The project will require an initial iru-estment of 920
vestment has to be Year A B million and addrtional investments of $5 mrilion in
eriod. 0 -$.+,000,000 -$.1,000,000 year 10 and $5 million in year 20.
the firm for each 1 ) OOO n00 1,000,000 . The project will generate earnings before interest and
) 1 i{l0 n(l(l 1.s00,000 taxes of $3 million each year. (The tax rate is 40%.)
br investors in the I I 250 000 1,700,000
, The depreciation will amount to $500,000 each yeiq
I 1,000,000 2,400,000
and the salvage value of the equipment rvi1l be equal
to investors in rhe a. Estimate the net present value ol each project, to rhe remaining book value ar the end ofyear 30.
12%. Would you assuming a cost of capital of 10%. Which is the bet- . The cost of capital is L2.5%.
ter project?
a. Estimate the net present value of this project.
'eturn to investors b. Estimate the internal rate of return tbr each prol-
ect. Which is the better project? b. Estirnate rhe inrernal rate ofrerurn on rhis proj-
the project?
ect. W-hat might be some of the problems in esti-
roblem 5. Assume c. What reinvestment rate assumpti.olls are made by
mating the IRR for this project?
of its net capital each of these rules? Can you shorv the etTect on
future cash flows of these assumptions? 15. You are trying to esdmate the NPV of three-vear
eds rvith debt.
project, r.vhere the discount rate is expected to change
ity for each ofthe d. What is the modified internal rate of return orr
over time.
each of these prqects?
Year Cash Flowsto. Firn Discount Rate
:quiry investors in 11. You have a project that does not require an initial
invesament but has its expenses spread o',.er rhe 1i{b of r, $15,000 Q.5oo
the project. Can the IRR be estimated tor this proj- 1 5,000 10.5
equiry investors if ect? Why or why not? 2 5.000 1 1.5
d ,vou accept the 10,000 t2.5
12" Businesses with severe capital rationing constraints
a. Estimate the NPV of this project. 'Wou1d vou take
should use IRR more than NPV Do .vou agree?
:eturn to equity this project?
Expiain.
ccept the project? b. Estimate the IRR of this project. Hou' would you
13. You have to pick benveen three mutually exclusir.-e
3 cash flows on a use the IRR to decrde whether or not to take this
projects rvith the following cash flows to the firm:
proj ect?
Year Project A Projea B Project C
17, Barring the case of multiple internal rates of return, is
0 -$10,000 $s,000 -$1s,000 it possible for the net present value ofa project to be
1 8,000 5,000 10,000 positir,-e, w'hiie the internal rate of return is less than
7,000 -8,000 10.000 rhe di\iounr rare? Explain.
18. You are helping a manufacturing firm decide whether over the 1O-year lifetime ofthe project. Although the References
it should invest in a new plant. The initial invesrment cost of capital is only 12%, you have concerns about
is expected to be $50 million, and the plant is using the return on capital as an investment decision Arcicles and Books
expected to generate after-tax cash flo'ws of $5 million rule. Would it make a difference if you knew that the Gimun. L.J., andJ. I
a year lor the next 20 years. An addirional invesrment project was employing an accelerated depreciation geting Techniques
of $20 million will be needed to upgrade the plant in method to compute depreciation? Why? mefi 6,66-71.
10 years. If the discount rate is 10%, HirshleifelJ., 1958,
20" Accounting rates of return are based on accounting
Decisionl'Joumal ,
a. Esrimate the net present value of the project. income and book value of investment, whereas inter- H., T. Cric-k
Kirr, S'
b. Prepare a net present value profile for this proje*. nal rates of return are based on cash flolvs and take dce What Acadt
into account the time value of money. lJnder what 49-52.
c. Estimate the rnternal rate ofreturn for thrs project.
conditions will the rwo approaches give you similar Lorie,J. H., and L.J.
Is there any aspect ofthe cash flows that may prove
estimates? Cagitali'Joumal oJ
to be a probiem for caiculating IRR?
Meyer,R. L., 1979,"
19. You have been asked to analyze a projec in u,hich the the Reinvestment
analyst has estlmated the return on capital to be 3796
ANALYZING I}IVESTMEhIT DECISION RULES

CNLY IF EEI\SIBLE
Objective
To decide r,vhich decision ruie your firm should be using in investmenr analysis.
ffiffiffi Key Questions

. 'What investment decision ruie does your firm use in analyzing prqects?
. What investment decisiol rule should it be using to anaiyze investments?
Framework for Analysis

7" Inuestment Decision Rales Used
. What invesrment decision rule does your firm use to decide on investments?
' If your firm has a stated objective, is the investment decision rule consistent with
that objective?
2. Coryect Inuestunent Decision Rwle
o Are the earnings and cash flows on your firmt invesrments likely to be very differ-
ent? (Are there significant noncash charges and working capital needs?)
. Does )our firm face any capital rationing constraints?
Getting Inforrnation on trnvestment Decision trLules

Firms sometirncs speci$'their objectives (double revenues rvithin five years...
increase our return on equiry bv 2%...) in rheir annual reports. They almost never
specifr investment decision ru1es, though managers may sometimcs mentlon them in
the context of explaining whv chey made a specific investmenr.
RXFER-ENCES 317
proJecr. Alrhough
the fi.eferences
lhave concerns about
n tnvestment decision
; y;;icles and Books Referenced in the Chapter Ross, M., 1986,'Capial Budgeting pracrices of Twelve Large
: if you knei.v ,hr,-;;" Giwan.L.J.,:;ndJ. R. Forrester, 1977,"A Survey of Capital Bud- Manufacturing Firmsl' Finawiat Managewent 15, 15-22.
.1-:j..d depreciation geting Technrques used by Major US firmsi' Financial Manage- Weingarmer, H. M., 1977,,,Capital Rationing: n Authon in
n? !7hy? 6, 66-71 '
nefi Search of a Plotj' Jounal of Finante 32, 1403-1432.
based on accountins Hirshleifer,J., 1958,"On the Theory of the Optimal Invesrment
tment, whereas intei Decistoo)' Journal of Politkal Economy 66:329-352. Geoeral References
'K;,o, S. H., T. Crick, and S. H. Kim, 1986, "Do Executives prac-
r cash flows and take The following book akes an in-depth look at alternative invest_
money. Under rv[2g rce What Academics Preach?" Management Auotnting 69, ment decision rules:
49-52. Bierman, H., and S. Smidt, 1992, The Capital Builgeting Decision,
'nes grve you
similar Loie,J.H.,and L.J. Savage, 1955,"Three Problems in Rationing New York: Macrnillan Company.
Capital)' J o u t n a I of Bu s ine ss 28, 229 -239.
Meyer,R. L., 1979,"A Note on Capital Budgeting Technique and Related Veb Sites
the Reinvestment Ratel' Joumal of Finance 34, 12Si-1254. http:,//wwwr /iley. com/college/damodaran
lent analysis.
ojects?
:menls?
r'estments?
consistent with
, be very differ-
ds?)
five years ...

y almost never
rntion them in

Investment Decision Rules

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Investment Decision Rules

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Investment Decision R.

rc Analysts and tjse oJ What Is an {nvestrrrent Decision Rule?

Categori zing Investment Decision Rules

Accounting Incorne-Based Decision Rules

L to further our Average Book Value of Capital =

Figure 10.2 A FBIT $300

Table 10.1 EBIT on Four-year

EBIT $300 $400 $500 $600

Average EBIT = $450 million

Cost of Capital = 14.49o/o (0.9338) + 7

Lring income and

Return on Equity The return on equity measures the return to equiry

If Return on Equiry < Cost of Equiry -+ Rejecr the project

Figure 10.3 Return Real Estate lnvestment

Return on Equity 18.67% 26.157o 38.18%

/erage sook value

17,070,481 1,'743,436 10.21

will be no consistency in the wav returns are measured on difi^erent prq-

a retail firm chat leases store space for a

Cash Flow-Based Decision Rules

cash Flow Returns on Equity and capitar one simpre

Assessing cash Returns cash returns take a partial

y' cc to't: The goeing super iu.mbo

The payback on this project

cash return meas- .I}rttres $?*x,s

are value destroy-

Figure 10.4 Using

real esrare because it has a shorrer payback period. Most

Discounted Castr Flow Measures

Net Presenr value The net

3 The net prernt value.rule wds 6rst discussed in llinhieiiir (195g).

-V = Life oithe project

quite enough to Effi rrn .o,*".*

rlace accounting Figure '!0.5 NPV of a Cash Flow

@@e@ry ?ffi,ffi; fipU fi,sm the tirne,s $[aldpsiffit: Irl$c$af[

HIAsa ps,m*g$ffim gm.?: Hp!tr from

Table 10.7 NpV of suier Jumbo Jet project

Table 10.8 Equity NPV of New Store

when a firm makes an acquisition at a price that exceeds the present..alue of

expecred ro change in a predictable way over dme, resulting in changes in the

associated with the net present value rule, one cosnletic

Cash Flows $s00 $400 $5oo $600

al, can operate as a Figure 10'6

lFrhc IRR > Co>r of C.rpital -) Accept rhe project

,roject's viabilifi,.. Gffil ,r,."..r"., IRR is conputerl on ushJTows to eEtiy

Figure 10.7 NpV

14.88o/o, which is higher than.the.cost

S $re Prmmg$*e €ffi"€B; Estimatin$ |ftfi Basad 0n Ga$ft flsws xo tquity:

I In a 1986 suruey offinancial managers, abour

nternal rate of return

willhave to make additional invesrrnenrs in retooring and updating

frm Psus*E$se $ffi.€P: lt{rltiBle |fifi pnsiects

Figure 10.9 NPV

IRR problems. gq. Compafing fnvestrnent Decision Rules

Table 10.9 E{ow Investment Decision ltules Measure Up

choosing between mutually exclusive projects

ffiffiJ:i[:x,::*::?'",^T:liT:: ?:,t.j :,:r" and that vou are comparins 6,o:

Differences in Reinvestment Rate Assumption Arthough

Figure 10.10 NpV

Sophisticated Connputerized lnformation

6The issue ofcapicai

$s,500,000 Computer System B

=+ Cash Flow $3,000,000 $3,500,000 $4,500,000

er i1977\ conironrs the

quite enough to Effi rrn .o,".