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Chapter 4

Investment Decision Rules (Capital Budgeting Techniques)


The cash flow streams developed in the previous course must be analyzed to assess
whether an investment project is acceptable or to rank projects. A number of relatively simple
(unsophisticated) techniques for performing such analyses do exist, but they are less valuable
than the more sophisticated techniques currently available.
These techniques integrate time value procedures, risk and return considerations and
valuation concepts in order to select capital expenditures that are consistent with achievement
of the firms goal. The focus here is on application of the present value techniques to relevant
cash flows to evaluate capital expenditure proposals for decision-making purposes.

4.1. Unsophisticated Capital Budgeting Techniques


There are two basic unsophisticated techniques for determining the acceptability of
capital expenditure alternatives. One is to calculate the average rate of return, and the other is
to find the payback period.
AVERAGE RATE OF RETURN
Finding the average rate of return is a popular approach for evaluating proposed
capital expenditures. Its appeal stems from the fact that the average rate of return is typically
calculated from accounting data (profits after taxes). The most common definition of the
average rate of return is as follows:
average _ profits _ after _ taxes
Average rate of return =
average _ investment
Average profits after taxes - are found by adding up the after-tax profits expected for
each year of the projects life and dividing the total by the number of years. In the case of an
annuity, the average after-tax profits are equal to any years profits.
Average investment - is found by dividing the initial investment by 2. This averaging
process implies that the cost of the asset is written off at a constant (straight-line) rate over the
life of the project. This means that, on the average, the firm will have one-half of the assets
initial purchase price on the books.
PAYBACK PERIOD
The payback period is the number of years required to recover the initial investment
from cash inflows. In the case of any annuity the payback period can be found by dividing the
initial investment by the annual cash inflow. If a project generates a mixed stream of cash
inflows, the calculation of the payback period is not quite as clear-cut.
EXAMPLE
Initial investment
Year (i)
1
2
3
4
5

Project A
$42000
CFi
$14000
14000
14000
14000
14000

Project B
$45000
CFi
$28000
12000
10000
8000
-

The payback period for project A = $42000 / $14000 = 3 years


The payback period for project B: in year 1, the firm will recover $28000 of its
$45000 initial investment. At the end of year 2, $40000 ($28000 from year 1 + $12000 from
year 2) will be recovered. At the end of year 3, $50000 ($40000 from years 1 and 2 plus the
$10000 from year 3) will be recovered. Since the amount received by the end of year 3 is
more than the initial investment of $45000, the payback period is somewhere between 2 and 3
years. Only $5000 must be recovered during year 3. Actually, $10000 is recovered, but only
50% of this cash inflow is needed to complete the payback of the initial $45000. The payback
period for project B is therefore 2,5 years (2 years plus 50% of year 3).
Project B would be preferred to project A since the former has a shorter payback
period.
There are two primary disadvantages of using the payback period:
1. like the average rate of return, this method is not able to specify the appropriate
payback period in light of the wealth maximization goal.
2. the failure to recognize cash flows that occur after the payback period. If we look
beyond the payback period, we see that project B returns only an additional $14000 ($5000 in
year 3 and $8000 in year 4), while project A returns an additional $28000 ($14000 in year 4
and $14000 in year 5). Based on this information, it appears that project A is preferable.

4.2. Sophisticated Capital Budgeting Techniques


Sophisticated capital budgeting techniques give explicit consideration to the time
value of money. In one way or another, they all discount the firms cash flows at a specified
rate. The rate used to discount cash flows is also referred to as the firms cost of capital or
opportunity cost. It refers to the minimum return that must be earned on a project in order to
leave the firms market value unchanged.
NET PRESENT VALUE
Net present value (NPV) represents the value of the project in terms of cash today. We
define the NPV of an investment project as the difference between the present value of its
benefits and the present value of its costs:
NPV = PV Benefits PV Costs
Therefore, good projects are those with positive NPV they make the investor
wealthier.
Net present value (NPV) is found by subtracting the initial investment (I) from the
present value of the cash inflows (CFi) discounted at a rate equal to the firms cost of capital
(r).
NPV = present value of cash inflows initial investment
n
CFi
I
NPV =
i
i 1 1 r
The decision rule. The criterion when the net present value approach is used to make
accept-reject decisions is as follows: if NPV > 0, accept the project; otherwise, reject the
project. If the NPV is greater than zero, the firm will earn a return greater than its required
return, or cost of capital. Such action should enhance the wealth of the firms owners, which is
the objective of the financial manager.
When making an investment decision, take the alternative with the highest NPV.
Choosing this alternative is equivalent to receiving its NPV in cash today.
INTERNAL RATE OF RETURN
Like the payback rule, the internal rate of return (IRR) investment rule is based on an
intuitive notion: if the return on the investment opportunity you are considering is greater than

the return on other alternatives in the market with equivalent risk and maturity, you should
undertake the investment opportunity.
The internal rate of return (IRR), or yield criterion, is defined as the discount rate that
equals the present value of cash inflows with the initial investment associated with the project.
The IRR, in other words, is the discount rate that equals the NPV of an investment
opportunity with zero (since the present value of cash inflows equals the initial investment).
Mathematically, the IRR is found by solving the following equation for the value of IRR.
n
CFi
I
$0 =
i
i 1 1 IRR
The decision criterion. The criterion when the IRR is used in making accept-reject
decisions is as follows: if IRR > cost of capital (r), accept the project; otherwise, reject the
project. For a project to be acceptable, the IRR must exceed the firms cost of capital or
opportunity cost. This guarantees that the firm is earning at least its required return and
assures that the market value of the firm will increase.
The figure below illustrates what it means to find the IRR for a project. The figure
plots the NPV as a function of the discount rate. The curve crosses the horizontal axes at the
IRR, because this is where NPV equals zero.
NPV ($)

Discount rate (%)


IRR

It should also be clear that the NPV is positive for discount rates below the IRR and
negative for discount rates above IRR. It means that if we accept projects when the discount
rate is less than the IRR, we will be accepting positive NPV projects.
The IRR investment rule will give the correct answer (that is, the same answer as the
NPV rule) in many but not all situations. In general, the IRR rule works for a stand-alone
project if all of the projects negative cash flows precede its positive cash flows. But in other
cases, the IRR rule may disagree with the NPV rule and thus be incorrect. Lets examine
several situations in which the IRR fails.
Delayed Investments. John Star, the founder of SuperTech, the most successful
company in the last 20 years, has just retired as CEO. A major publisher has offered him a $1
million how I did it book deal. That is, the publisher will pay him $1 million upfront if Star
agrees to write a book about his experiences. He estimates that it will take him three years to
write the book. The time that he spends writing will cause him to forgo alternative sources of
income amounting to $500 000 per year. Considering the risk of his alternative income

sources and available investment opportunities, Star estimates his opportunity cost of capital
to be 10%. The timeline of Starrs investment opportunity is:
0

$1 000 000

-$500 000

-$500 000

3
-$500 000

The NPV of Stars investment opportunity is


NPV = 1 000 000 -

500000 500000 500000

1 r
1 r 2 1 r 3

By setting the NPV equal to zero and solving for r, we find the IRR .
IRR = 23,38%
IRR is larger than the 10% opportunity cost of capital. According to the IRR rule, Star
should sign the deal. But what does the NPV rule say?
NPV = 1 000 000 -

500000 500000
500000

= - $243 426
1 0,1 1 0,1 2 1 0,1 3

At a 10% discount rate, the NPV is negative, so signing the deal would reduce Stars
wealth. He should not sign the book deal.
The figure below plots the NPV of the investment opportunity. It shows that, no matter
what the cost of capital is, the IRR rule and the NPV rule will give exactly opposite
recommendations. That is, the NPV is positive only when the opportunity cost of capital is
above 23,38% (the IRR).

0,1
Discount rate (%)
0,0
5%

10%

-0,1

15%

20%

25%

30%

35%

IRR = 23,38%

-0,2
-0,3
-0,4
Nonexistent IRR.
NPV ($ millions)
The figure also illustrates the problem with using the IRR rule in this case. For most
investment opportunities, expenses occur initially and cash is received later. In this case, Star
gets cash upfront and incurs the costs of producing the book later. It is as if Star borrowed

money, and when you borrow money you prefer as low rate as possible. Stars optimal rule is
to borrow money so long as the rate at which he borrows is less than the cost of capital.
Nonexistent IRR. Luckily for John Star, he has other opportunities available to him.
An agent has approached him and guaranteed $1 million in each of the next three years if he
will agree to give four lectures per month over that period. Star estimates that preparing and
delivering the lectures would take the same amount of time as writing the book that is, the
cost would be $500 000 per year. Therefore, his net cash flow will be $500 000 per year. What
is the IRR of this opportunity? Here is the new timeline:
0

1
$500 000

$500 000

$500 000

The NPV of Stars investment opportunity is


NPV =

500000 500000 500000

1 r
1 r 2 1 r 3

By setting the NPV equal to zero and solving for r, we find the IRR. In this case,
however, there is no discount rate that will set the NPV equal to zero. As shown in the figure
below, the NPV of this opportunity is always positive, no matter what the cost of capital is.
But do not be fooled into thinking that whenever the IRR does not exist the NPV will always
be positive. It is quite possible for no IRR to exist when the NPV is always negative.
NPV ($ millions)
2
1,75
1,5
1,25
1
0,75
0,5
0.25
0
0

50%

100%
Discount rate (%)

150%

200%

In such situations, we cannot use the IRR rule because it provides no recommendation
at all. Thus, our only choice is to rely on the NPV rule.
Multiple IRRs. Unfortunately, Stars lecture deal fell through. So Star has informed
the publisher that it needs to sweeten the deal before he will accept it. In response, the

publisher has agreed to make royalty payments. Star expects these payments to amount
$20000 per year forever, starting once the book is published in three years. Should he accept
or reject the new offer?
We begin with the timeline:
0

5
......

$1 000 000

-$500 000

-$500 000

-$500 000

$20 000

$20 000

Using the annuity and perpetuity formulas, the NPV of Stars new investment
opportunity is
500000 500000 500000

1 r
1 r 2 1 r 3
500000
1
1
1

= 1 000 000 3

r
1 r 1 r 3

NPV = 1 000 000 -

20000

1 r

20000

1 r 5 + . . . . . .

20000

By setting the NPV equal to zero and solving for r, we find the IRR. In this case, there
are two IRRs that is, there are two values of r that set the NPV equal to zero.
NPV ($ millions)
0,3

0,2

0,1

0
5%

10%

15%

IRR = 4,723%

20%

25%

IRR = 19,619%

-0,1
Discount rate (%)
Because there is more than one IRR, we cannot apply the IRR rule. If the cost of
capital is either below 4,723% or above 19,619%, Star should undertake the opportunity.
Otherwise, he should turn it down. Notice that even though the IRR rule fails in this case, the
two IRRs are still useful as bounds on the cost of capital.
The incremental IRR Rule
The incremental IRR investment rule applies the IRR rule to the difference between
the cash flows of the two mutually exclusive alternatives. Two or more projects are mutually

exclusive if the firm can, at most, accept only one of them. To illustrate, assume you are
comparing two mutually exclusive opportunities, A and B, and the IRRs of both opportunities
exceed the cost of capital. If you subtract the cash flows of opportunity B from the
opportunity A, then you should take opportunity A if the incremental IRR exceeds the cost of
capital. Otherwise, you should take opportunity B.
EXAMPLE
Suppose that the X company has two alternative uses for a warehouse. It can store
toxic waste containers (investment A) or electronic equipment (investment B). The cash flows
are as follows:
year
0
1
2
3
4
IRR
Investment A -$70000
$25000
$29000
$34000
$30000 23,65%
Investment B -$110000 $40000
$47000
$50000
$43000 22,62%
If we compare the IRRs of the two projects we should choose project A because A has
a higher IRR.
If we plot the NPV of the two project as a function of the discount rate, we will find
that the NPV of project B declines more rapidly as the discount rate increases than does the
NPV of project A. Because the NPV of B declines more rapidly, B actually has a lower IRR.
In this case we can select the better project with the following method:
We will calculate the incremental IRR. For this we will subtract the cash flows of A
from the cash flows of B and then calculate the IRR for these cash flows. The incremental
cash flows are:
year
0
1
2
3
4
IRR
CF = CFB CFA

-$40000

$15000

$18000

$16000

$13000

20,7%

VAN
VANB > VANA

VANA > VANB

23,65%
IRR A

20,7%
Inc. IRR

Discount rate

22,62%
IRR B

As this chart shows that the incremental IRR is 20,7 percent. In other words, the NPV
on the incremental investment is zero when the discount rate is 20,7%. The NPV of the two
projects are equal when the discount rate is 20,7%. The incremental IRR is also 20,7%. This is
not a coincidence; this equality must always hold. The incremental IRR is the rate that causes
the incremental cash flows to have zero NPV. The incremental cash flows have zero NPV
when the two projects have the same NPV.
The decision rule:
r discount rate (cost of capital)
if r < 20,7% accept project B
if 20,7% < r < 23,65% accept project A
if r = 20,7% its indifferent
if r > 23,65% reject both projects
ECONOMIC VALUE ADDED
The distinction between simply making money and creating value is the essence of the
NPV calculation. For example, a manager could easily make $1 million per year for a
company by simply putting $20 million into a bank account paying an interest rate of 5%. He
has made money, but created no value: the NPV of putting $20 million into a bank account is
zero.
EVA when invested capital is constant
Consider a project that requires an initial investment in capital with a cost of I dollars.
Suppose that the capital lasts forever, and generates a cash flow of CFn at each future date n.
The EVA in year n is the value added of the project over and above the opportunity cost of
tying up the capital required to run the project. If the cost of capital is r, then the cost of tying

up $I in capital in the project rather than investing it elsewhere is r x I each period (this is the
expected return we could have earned). We refer to the opportunity cost associated with the
projects use of capital as the capital charge.
The EVA in period n is the difference between the projects cash flow and the capital
charge:
EVA in period n (when capital lasts forever)
EVAn = CFn rI
The EVA investment rule can be stated as follows: Accept any investment
opportunity in which the present value of all future EVAs is positive when we compute the
present value using the projects cost of capital r.
How does the EVA investment rule compare with the NPV rule? Note that if we
discount the capital charge of rI every period at rate r, the present value is simply rI / r = I.
Thus, if we discount the projects EVA at the projects cost of capital r, then PV(EVAn) =
PV(Cn) PV(rI) = PV(Cn) I = NPV. Thus, the EVA rule and the NPV rule will coincide.
EVA when invested capital changes
Typically, the capital invested in a project will change over time. Existing capital will
tend to become less valuable over time (e.g., machines wear out with use), and new
investment may need to be made. Let In-1 be the amount of capital allocated to the project at
date n-1, which is the start of period n. then the capital charge in period n should include the
opportunity cost of tying up this capital, rI n-1. It should also take into account the cost of the
wear and tear from the use of the capital, which is the amount by which the value of the
capital depreciates over the period. Thus,
EVA in period n (when capital depreciates)
EVAn = CFn rIn-1 (depreciation in period n)
With this definition of the EVA, the EVA and NPV rules again coincide.

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