Investment Decisions

-Net Present Value and others-

Capital-Budgeting
The process of decision making with respect to investments in
fixed assets that is, should a proposed project be accepted or
rejected.
It is easier to evaluate profitable projects than to find them.

Source of Ideas for projects

Within the Firm: Typically, a firm has a research & development
(R&D) department that searches for ways of improving existing
products or finding new projects.
Other sources: Competition, Suppliers, Customers

Capital-Budgeting Decision Criteria

1.
2.
3.
4.
5.

Net Present Value

Internal Rate of Return
Payback Period
Profitability Index
Capital Rationing

Net Present Value or NPV

NPV is equal to the present value of all future free
cash flows less the investments initial outlay. It
measures the net value of a project in todays dollars.
NPV = FCF - Initial outlay
(1+k)n

Decision Rule:
If NPV > 0, accept
If NPV < 0, reject

NPV Example
Example: Project with an initial cash outlay of $60,000
with following free cash flows for 5 years.
Yr
Initial outlay
1
2
3
4
5

FCF
-60,000
25,000
24,000
13,000
12,000
11,000

The firm has a 15% required rate of return.

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 NPV = - Initial outlay +

FCF

(1+k)n
PV of FCF = $60,764
Subtracting the initial cash outlay of $60,000 leaves an NPV of
$764.
Since NPV>0, project is feasible.

NPV in Excel
Input cash flows for initial outlay and inflows in cells A1 to A6
In cell A7 type the following formula:
=A1+npv(.15,a2:a6)

Excel will give the NPV = $764

NPV Trade-offs
Benefits

Considers cash flows, not profits

Considers all cash flows
Recognizes time value of money
By accepting only positive NPV projects, increases value of the firm

Drawbacks
Requires detailed long-term forecast of cash flows

NPV is considered to be the most theoretically correct criterion

for evaluating capital-budgeting projects.

Internal Rate of Return or IRR

IRR is the discount rate that equates the present value of a

projects future net cash flows with the projects initial cash
outlay
Decision Rule:
If IRR > Required rate of return, accept
IF IRR < Required rate of return, reject

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IRR and NPV

If NPV is positive, IRR will be greater than the required rate of
return
If NPV is negative, IRR will be less than required rate of return
If NPV = 0, IRR is the required rate of return.

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IRR Example
Initial Outlay:
$3,817
Cash flows:
Yr.1=$1,000, Yr. 2=$2,000, Yr. 3=$3,000

Discount rate
NPV
15%
$4,356
20%
$3,958
22%
$3,817
IRR is 22% because the NPV equals the initial
cash outlay

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Payback Period
Number of years needed to recover the initial cash
outlay of a capital-budgeting project

Decision Rule: Project feasible or desirable if the

payback period is less than or equal to the firms
maximum desired payback period.

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Payback Period Example

Example: Project with an initial cash outlay of $20,000
with following free cash flows for 5 years.
YEAR

CASH FLOW

BALANCE

8,000

($ 12,000)

4,000

8,000)

3,000

5,000)

5,000

10,000

0
12,000

Payback is 4 years

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Trade-offs
Benefits:
Uses cash flows rather than accounting profits
Easy to compute and understand
Useful for firms that have capital constraints

Drawbacks:
Ignores the time value of money and
Does not consider cash flows beyond the payback
period.

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Profitability Index (PI)

PI is the ratio of the present value of the future free
cash flows to the initial outlay. It yields the same
accept/reject decision as NPV.
PI = PV FCF/ Initial outlay

Decision Rule:
PI > 1 = accept
PI < 1 = reject

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PI Example
A firm with a 10% required rate of return is considering
investing in a new machine with an expected life of six years.
The initial cash outlay is $50,000.

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PI Example
FCF

PVF @ 10%

PV

Initial
Outlay

-$50,000

1.000

-$50,000

Year 1

15,000

0.909

13,636

Year 2

8,000

0.826

6,612

Year 3

10,000

0.751

7,513

Year 4

12,000

0.683

8,196

Year 5

14,000

0.621

8,693

Year 6

16,000

0.564

9,032

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PI Example
PI = ($13,636

+ $6,612+$7,513 + $8,196 +
$8,693+ $9,032) / $50,000
=$53,682/$50,000
= 1.0736

Project PI > 1, accept.

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NPV and PI
When the present value of a projects free cash inflows are
greater than the initial cash outlay, the project NPV will be
positive. PI will also be greater than 1.
NPV and PI will always yield the same decision.

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Capital Rationing

Capital Rationing
Capital rationing occurs when a limit is placed on the
dollar size of the capital budget.
How to select: Select a set of projects with the highest
NPVs subject to the capital constraint. Using NPV
may preclude accepting the highest ranked project in
terms of PI or IRR.

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Ranking Problems
Size Disparity
Time Disparity

Unequal Life

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Size Disparity
This occurs when we examine mutually exclusive projects of unequal
size.
Example: Consider the following cash flows for one-year Project A
and B, with required rates of return of 10%.
Initial Outlay: A = $200
Inflow:
A = $300

B = $1,500
B = $1,900

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Size Disparity

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Size Disparity
Which technique to use to select the better project?

Use NPV whenever there is size disparity. If there is no

capital rationing, project with the largest NPV will be
selected. When capital rationing exists, select set of
projects with the largest NPV.
But, small companies uses in general IRR when capital
rationing exists.

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Time Disparity Problem

Time Disparity problems arise because of differing reinvestment
assumptions made by the NPV and IRR decision criteria.
Cash flows reinvested at:
According to NPV: Required rate of return
According to IRR: IRR

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Time Disparity Problem

Example: Consider two projects, A and B, with initial outlay of
$1,000, cost of capital of 10%, and following cash flows in years 1, 2,
and 3:

1
2
3
A: $100
$200
$2,000
B: $650
$650
$650

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Time Disparity Problem

NPV
PI
IRR

Project A
Project B
758.83
616.45
1.759
1.616
35%
43%

Ranking Conflict:
Using NPV, A is better
Using IRR, B is better

Which technique to use to select the superior project?:

Use NPV (especially in lease calculations)

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Unequal Lives Problem

This occurs when we are comparing two mutually exclusive projects
with different life spans.
To compare projects, we compute the Equivalent Annual Annuity
(EAA)

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Unequal Lives Problem

Example: If you have two projects, A and B, with equal investment
of $1,000, required rate of return of 10%, and following cash flows
in years 1-3 (for project A) and 1-6 (for project B)
Project A = $500 each in years 1-3
Project B = $300 each in years 1-6

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Computing EAA
1.

Calculate projects NPV:

A = $243.43 and B = $306.58

2.

Calculate EAA = NPV/annual annuity factor

A = $97.89

3.

B = $70.39

Project A is better

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