Chapter 9: Net Present Value and Other Investment Criteria

I. Capital Budgeting
A. Definition: The process of analyzing fixed asset investment proposals
B. Involves the same procedures used in security valuation
1. Cash flows from a project are estimated
2. Riskiness is determined based on the probability of the cash flows
actual occurrence
3. Discount rate is determined based on:
a. The cost of money
b. The level of riskiness
4. The Present value of the project is calculated
a. The present value of the project's cash flows are compared
with its costs
b. Decision made on project (Accept if benefits exceed costs.)
C. Level of analysis of cash flows
1. Expansion and new product decisions require more detailed
analysis than replacement and maintenance decisions.
2. Larger projects require more analysis than smaller projects
(Replacing welding equipment vs Building a Boeing 777)
II. Project Identification
A. Identify potential projects, following a corporate strategic plan or
mission statement.
Mission Statement of Headstrong Group, Inc
Our mission is to become the world's leading manufacturer, marketer
and merchandiser of affordable recreational safety-related items serving
 targeted and expanding markets.
To achieve this goal, we will continue to:
1. Develop unique technologies and proprietary production
methodologies. This will allow us to remain innovative, focused
and relentless in our quest to bring advanced safety products to an
ever-expanding consumer marketplace.
2. Create a stimulating, rewarding and safe workplace. This will
allow us to attract and keep the most intelligent and productive
minds and to ensure that we can continue to develop exciting new
products which meet the needs & desires of the recreationally-
active consumer.
3. Remain at the forefront of unique and exciting promotional and
merchandising programs. It is through promotion that we will
continue to stimulate the imagination of the consumer and through
which we will continue to drive the sell-through of our products.
4. Lead by example in the communities in which we do business.
We will ensure that our production facilities respect local
standards for environmental efficiency and that we contribute to
the growth of these communities so that they, like, us continue to
thrive.
5. Finally, we believe that our commitment to these four areas will
lead to the achievement of our mission. This commitment will, in
turn, permit us to reward those who invest in our business with
returns that regularly exceed those which might be obtained
elsewhere.
B. Classify projects by size and purpose so that management resources can
be directed to the more important projects.
 C. Integrate or eliminate dependent projects.
III. Decision Making Methods
A. Payback period
1. The number of years needed to recover the original cost of the
project
2. Simply add inflows to the initial outflow until the initial outflow
is recovered.
a. Example: Suppose two projects A and B have the following
cash flows

CASH FLOWS
YEAR Project A Project B
0 ($700) ($700)
1 100 300
2 200 300
3 300 300
4 400 300
5 500 300

b. (Here's an Excel spreadsheet that contains an example I

often use in class.)
 Payback for project A is 3¼ years: $700 - $100 -
$200 - $300 = $100
Assume that cash flows occur evenly over the year.
The last $100 will be recovered in the first quarter of
year 4.
 Payback for project B is 2.3333 years
3. Disadvantages of Payback Period
a. Ignores cash flows beyond the payback period
– Penalizes long-term projects
 b. Ignores the time value of money
- Equal weight is assigned to a dollar one year from now
and a dollar three years from now.
B. Discounted Payback
1. Similar to payback method except uses discounted cash flows.
For above example. If the required rate of return was 10%:

$700 - $100(1.10)1 - $200(1.10)2 - $300(1.10)3 = $218.41$400(1.10)4 = $273.21$21
8.41$273.21 ≈ 0.8 years$700 - $100(1.10)1 - $200(1.10)2 - $300(1.10)3 = $

218.41$400(1.10)4 = $273.21$218.41$273.21 ≈ 0.8 years

The discounted payback for project A is 3.8 years.

The discounted payback for project B is 2.8 years.

2. Disadvantage: Ignores cash flows beyond the payback period

C. Net Present Value:

NPV =  ∑t=0nCFt(1 + R)tNPV =  ∑t=0nCFt(1 + R)t

Where: C0 is the initial investment

             t is the operating cash flow in year t.
             n is the life span of the project
             R is the project's required rate of return
From the previous example:

NPVA = -$700 + $100(1.10) + $200(1.10)2 + $300(1.10)3 + $400(1.10)4 + $500(1.10)5 = 
$365.26NPVB = -$700 + $300[10.10 - 10.10(1.10)5] = $437.24NPVA = -$700 + 
 $100(1.10) + $200(1.10)2 + $300(1.10)3 + $400(1.10)4 + $500(1.10)5 = $365.26

NPVB = -$700 + $300[10.10 - 10.10(1.10)5] = $437.24

Decision rule: If NPV ≥ 0 accept the project; If NPV < 0 reject the
project

D. Profitability Index:

PI = Present Value of Future Cash Flow|Initial Investment| = PV of CF1-t|CF0|PI = Present V
alue of Future Cash Flow|Initial Investment| = PV of CF1-t|CF0|

From the previous example:

PIA = $700 + $365.26700 = 1.52PIB = $700 + $437.24700 = 1.62PIA = $700 + $365.2
6700 = 1.52PIB = $700 + $437.24700 = 1.62

The decision rule is to accept the project if the PI is greater than 1.

E. Internal Rate of Return

1. Definition: The discount rate that equates the present value of
cash inflows with the investment associated with a project,
thereby causing NPV to equal zero.

NPV = ∑t=0nCFt(1+IRR)t = 0NPV = ∑t=0nCFt(1+IRR)t = 0

2. Similar to finding YTM for a bond

3. For our example IRRA = 24.42%; IRRB = 32.27%
4. Decision Rule: If IRR ≥ required rate of return (R), accept project;
If IRR < R, reject project
5. Multiple IRRs
Example: Consider the following cash flows:

Year 0 1 2
Cash - 25,00 -
Flow $4,000 0 25,000

6. There are two IRRs at 25% AND 400%. Which one is correct?

7.
8.
DesCartes's Law of Signs tells us what the maximum number of
IRRs will be:

Cash Flow
Sign # of IRRs
Changes
1 1
2 2 or 0
3 3 or 1
4 4 or 2 or 0
5 5 or 3 or 1

9. It is also possible that the IRR doesn't exist:

Year 0 1 2
Cash $1,00 - 2,50
Flow 0 3,000 0
 10.
IV. Conflicts between NPV, PI, and IRR
A. When choosing independent projects, all three methods should yield the
same decision.
B. When choosing between two mutually exclusive projects, conflicts may
occur.
1. When projects differ in scale.
Example: The president of Giant Enterprises must choose between
two possible investments (cost of capital is 9%):

Cash Flows, Thousands of Dollars

Project CF0 CF1 CF2 IRR NPV
A -400   241   293 21% $67.71
B -200 131 172 31% $64.95

2.
 3.

4. When projects differ in cash flow timings

a. One project has large early cash flows
b. The second project has large later cash flows
c. Example: Suppose you were considering the purchase of
some timberland for $1 million dollars. You could harvest
the timber next year for an expected cash flow of $1.28
million, or you could delay logging for 10 years when the
larger trees would produce cash flows of $4,046,000.
Assume your cost of capital is 10%.

NPV1 YR = $163,636 NPV10 YR = $559,908

IRR1 YR = 28% IRR10 YR = 15%

d.
 e.
C. Finding the crossover rate

At the crossover rate, NPVA=NPVBCF0A + CF1A(1+R) + CF2A(1+R)2 + CF3A(
1+R)3 + CF4A(1+R)4= CF0B + CF1B(1+R) + CF2B(1+R)2 + CF3B(1+R)3 + CF4B(1+R)4

0=CF0A - CF0B+ CF1A- CF1B(1+R) + CF2A- CF2B(1+R)2 + CF3A- CF3B(1+R)3 + CF4A
- CF4B(1+R)4At the crossover rate, NPVA=NPVBCF0A + CF1A(1+R) + CF2A(1+

R)2 + CF3A(1+R)3 + CF4A(1+R)4= CF0B + CF1B(1+R) + CF2B(1+R)2 + CF3

B(1+R)3 + CF4B(1+R)40=CF0A - CF0B+ CF1A- CF1B(1+R) + CF2A- CF2B(1

+R)2 + CF3A- CF3B(1+R)3 + CF4A- CF4B(1+R)4

The definition of internal rate of return: a discount rate that sets NPV equal
to zero.

1. Step 1: Subtract one set of cash flows from the other set of cash
flows.
2. Step 2: Find the IRR of the cash flow differences. This is the
crossover rate.
3. Step 3: Find the NPV for both projects at the crossover rate. If you
have found the correct crossover rate, the NPVs should be equal.
4. Example: Consider the following projects:

Year Project A Project B A-B

 0 -$230,000 -$100,000 -$130,000
1 $125,000 $70,000 $55,000
2 $175,000 $80,000 $95,000
3 $100,000 $90,000 $10,000
4 $100,000 $100,000 $0

5. The IRR of the differences is 13.00103698%.

6. The NPV of Project A at the crossover rate is equal to the NPV of
Project B at the crossover rate.
7. NPVA = NPVB = $148,299.34