Corporate Finance

Lecture 02: NPV and Other Investment Rules

1 Why Use Net Present Value?

Accepting positive NPV projects benefits shareholders.

NPV uses cash flows
NPV uses all the cash flows of the project
NPV discounts the cash flows properly

The Net Present Value (NPV) Rule

Net Present Value (NPV) = Total PV of future CFs + Initial Investment

Minimum Acceptance Criteria: Accept if NPV > 0

Estimating NPV:

Ranking Criteria: Choose the highest NPV

1. Estimate future cash flows: how much? and when?

2. Estimate initial costs
3. Estimate discount rate (opportunity cost)

Estimate discount rate

Cash flows can only be estimated, rather than known.

Suppose the project is about as risky as the stock market as a

whole, where the expected return this year is perhaps 10
percent.

Then 10 percent becomes the discount rate.

As a manager, you expect the cash flow of a project with

$100 initial investment to be $107 next year. That is, the cash
flow could be higher, say $117, or lower, say $97. It is risky.

The NPV Rule : Example

Assume you have the following information on

Project X:

Initial outlay -$1,100

Required return = 10%

Annual cash revenues and expenses are as

follows:
Year
Revenues
Expenses
1
$1,000
$500
2
2,000
1,300
3
2,200
2,700
4
2,600
1,400

The NPV Rule : Example (continued)

0

Initial Revenues $1,000

outlay Expenses
500
($1,100)
Cash flow
$500

Revenues
Expenses

$2,000
1,300

Revenues
Expenses

$2,200
2,700

Cash flow

$700

Cash flow

(500)

Revenues
Expenses

Cash flow $1,200

$1,100.00
1
$500 x
1.10
+454.54
$700 x

+578.51

1
1.10 2
- $500 x

-375.66

1
1.10 3

+819.62

$1,200 x

1
1.10 4

+$377.02

= NPV

$2,600
1,400

The NPV Rule : Example (continued)

NPV = -C0 + PV0(Future CFs)
= -C0 + C1/(1+r) + C2/(1+r)2 + C3/(1+r)3 + C4/(1+r)4
= -1,100 + 500/1.1 + 700/1.12 + (-500)/1.13 + 1,200/1.14
= $377.02 > 0

Calculating NPV using a Spreadsheet

2 The Payback Period Rule

How long does it take the project to pay back its initial
investment?

Payback Period = number of years to recover initial costs

Minimum Acceptance Criteria:

set by management

Ranking Criteria:

set by management

2 The Payback Period Rule

The Payback Period Rule

(continued)
Disadvantages:

Ignores the time value of money

Ignores cash flows after the payback period
Biased against long-term projects
Requires an arbitrary acceptance criteria
A project accepted based on the payback criteria may not have a
positive NPV

Advantages:

Easy to understand
Biased toward liquidity

The Payback Period Rule

(continued)

3 The Discounted Payback Period

Rule
How long does it take the project to pay back its initial
investment taking the time value of money into account?

By the time you have discounted the cash flows, you might
as well calculate the NPV.

The Discounted Payback Period Rule: Example

Assume you have the following information on
Project X:
Initial outlay -$1,000
Required return = 10%

Annual that cash flows and their PVs are as follows:

Year
1
2
3
4

Cash flow
$ 200
400
700
300

PV of Cash flow
$ 182
331
526
205

The Discounted Payback Period Rule:

Example (continued)
Year
1
2
3
4

Accumulated discounted CF
$ 182
513
1,039
1,244

Discounted payback period is just under 3 years

4 Internal Rate of Return (IRR) Rule

The most important alternative to NPV rule.

IRR: the discount that sets NPV to zero.

IRR, An Example

$110
NPV $100
1R

IRR, An Example
How to solve for the IRR? Use a trial-and-error method
(interpolation)

$110
$1.85 $100
1.08
$110
$1.79 $100
1.12
$110
0 $100
1.10

4 Internal Rate of Return (IRR) Rule

Minimum Acceptance Criteria:

Accept if the IRR exceeds the required return.

Ranking Criteria:

Select alternative with the highest IRR

Reinvestment assumption:

All future cash flows assumed reinvested at the IRR.

$
5
0
$
1
0
$
1
5
0
N
P
V
0(1IR)(IR)2(IR)3
The Internal Rate of Return: Example

Consider the following project:

$50
$100

0
-$200

$150

The internal rate of return for this project is 19.44%

The NPV Payoff Profile for This Example

If we graph NPV versus discount rate, we can see the IRR as
the x-axis intercept.
Discount Rate
0%
4%
8%
12%
16%
20%
24%
28%
32%
36%
40%

NPV
$100.00
$71.04
$47.32
$27.79
$11.65
($1.74)
($12.88)
($22.17)
($29.93)
($36.43)
($41.86)

IRR = 19.44%

Calculating IRR with a Spreadsheet

5 Problems with the IRR Approach

Are We Borrowing or Lending?
Multiple IRRs.
The Scale Problem.
The Timing Problem.

Problem 1: Are We Borrowing or

Lending?

Problem 1: Are We Borrowing or

Lending?

Problem 2: Multiple IRRs

Problem 2: Multiple IRRs

In general, these flip-flops or changes in sign produce
multiple IRRs.
In theory, a cash flow stream with K changes in sign can
have up to K sensible internal rates of return (IRRs above
100 percent).

To Handle Problem 2: Modified IRR

The modified IRR method (MIRR): combining cash flows
until only one change in sign remains.
Consider Project C again. With a discount rate of 14%, the
value of the last cash flow, $132, is as of Date 1.

- $132/1.14 - $115.79

To Handle Problem 2: Modified IRR

The modified IRR method (MIRR): combining cash flows
until only one change in sign remains.
Consider Project C again. With a discount rate of 14%, the
value of the last cash flow, $132, is as of Date 1.

- $132/1.14 - $115.79
The adjusted cash flow at Date 1 is $114.21 (=$230
115.79) .
We produced the following cash flows for this project:

($100, $114.21 )

Modified IRR (Continued)

We produced the following cash flows for this project
using MIRR:

($100, $114.21 )
Note that now we have only one change in sign.
The IRR of these two cash flows is 14.21%, which is
larger than the discount rate: 14%.

Although correct, MIRR violates the spirit of the IRR

approach. The number should be internal, or intrinsic, to
the project.

Problem 2: Multiple IRRs

Problem 3: The Scale Problem

Problem 3: The Scale Problem

For the reasons in the previous example, Sherry

is correct. But how to convince Stanley?

Problem 3: The Scale Problem

Answer: use the Modified IRR

Formula for computing the incremental IRR:

$25 million
0 $15 million
1 IRR

The equation gives us IRR=66.67% > the discount rate

25%

Problem 3: The Scale Problem

Similarly, we can use the incremental NPV

Formula for computing the incremental NPV:

$25 million
$15 million
$5 million
1.25

The incremental NPV is positive.

Problem 3: The Scale Problem

To sum up, we have 3 ways to deal with the NPV
problem:
1. Compare the NPVs of the two choices .
2. Calculate the incremental NPV
3. Compare the incremental IRR to the discount rate .

Problem 4: The Timing Problem

$10,000
$1,000
$1,000

Project A
0

Project B

$10,000
$1,000
$12,000
0

$1,000
2

$10,00
0 in this case depends on the discount
The preferred project
rate, not the IRR.

The Timing Problem

10.55% = crossover rate

12.94% = IRRB

16.04% = IRRA

Calculating the Crossover Rate

Compute the IRR for either project A-B or B-A
Year Project A Project B Project A-B Project B-A
0 ($10,000) ($10,000)
$0
$0
1 $10,000
$1,000
$9,000
($9,000)
2 $1,000
$1,000
$0
$0
3 $1,000 $12,000
($11,000)
$11,000

$3,000.00

NPV

$2,000.00

10.55% = IRR

$1,000.00
$0.00
($1,000.00) 0%

5%

10%

($2,000.00)
($3,000.00)
Discount rate

15%

20%

A-B
B-A

Mutually Exclusive vs. Independent

Project

Mutually Exclusive Projects: only ONE of several potential projects can

be chosen, e.g., acquiring an accounting system.

RANK all alternatives and select the best one.

Independent Projects: accepting or rejecting one project does not affect

the decision of the other projects.

Must exceed a MINIMUM acceptance criteria.

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6 The Profitability Index (PI) Rule

Minimum Acceptance Criteria:

Accept if PI > 1

Select alternative with highest PI

Problems with mutually exclusive investments

May be useful when available investment funds are limited

Easy to understand and communicate
Correct decision when evaluating independent projects

Ranking Criteria:
Disadvantages:
Advantages:

6 The Profitability Index (PI) Rule

6 The Profitability Index (PI) Rule

The problem of PI when evaluating mutually exclusive
projects can be solved by using the incremental PI.

6 The Profitability Index (PI) Rule

Credit Rationing

7 The Practice of Capital Budgeting

Varies by industries.
Discounted cash flow techniques (such as IRR or NPV )
are the most frequently used in US&Canada.

7 The Practice of Capital Budgeting

Payback is most commonly used by small firms and by
CEOs without an MBA.

Example of Investment Rules

Compute the IRR, NPV, PI, and payback period for the following
two projects. Assume the required return is 10%.
Year
0
1
2
3

Project A
-$200
$200
$800
-$800

Project B
-$150
$50
$100
$150

Example of Investment Rules

CF0
PV0 of CF1-3
NPV =
IRR =
PI =

Project A

Project B

-$200.00

-$150.00

$241.92

$240.80

$41.92

$90.80

0%, 100%

36.19%

1.2096

1.6053

Example of Investment Rules

Payback Period:
Time
0
1
2
3

CF
-200
200
800
-800

Project A
Cum. CF
-200
0
800
0

Payback period for Project B = 2 years.

Payback period for Project A = 1 or 3 years?

CF
-150
50
100
150

Project B
Cum. CF
-150
-100
0
150

Relationship Between NPV and

IRR
Discount rate

NPV for A

NPV for B

-10%

-87.52

234.77

0%

0.00

150.00

20%

59.26

47.92

40%

59.48

-8.60

60%

42.19

-43.07

80%

20.85

-65.64

100%

0.00

-81.25

120%

-18.93

-92.52

NPV

NPV Profiles
$400
$300

IRR 1(A)

IRR (B)

IRR 2(A)

$200
$100
$0
-15%

0%

15%

30%

45%

70%

100% 130% 160% 190%

($100)
($200)

Cross-over Rate

Discount rates

Project A
Project B

8 Summary and Conclusions

This chapter evaluates the most popular alternatives to
NPV:

Payback period
Internal rate of return
Profitability index

When it is all said and done, they are not the NPV rule; for

those of us in finance, it makes them decidedly second-rate.