Chapter 5

Net Present Value and Other Investment Rules

McGraw-Hill"Irwin

Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reser e!.

Key Concepts and Skills

Be able to compute payback and discounted payback and understand their shortcomings Be able to compute the internal rate of return and profitability index, understanding the strengths and weaknesses of both approaches Be able to compute net present alue and understand why it is the best decision criterion

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Chapter "utline
5#$ %hy &se 'et (resent )alue* 5#2 +he (ayback (eriod ,ethod 5#! +he -iscounted (ayback (eriod ,ethod 5#. +he /nternal 0ate of 0eturn 5#5 (roblems with the /00 1pproach 5#2 +he (rofitability /ndex 5#3 +he (ractice of Capital Budgeting
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5#$ %hy &se 'et (resent )alue*

1ccepting positi e '() pro4ects benefits shareholders#

'()

uses cash flows '() uses all the cash flows of the pro4ect '() discounts the cash flows properly

5-.

+he 'et (resent )alue 5'()6 0ule

'et (resent )alue 5'()6 7 +otal () of future C8s 9 /nitial /n estment :stimating '();
$# :stimate future cash flows; how much* and when* 2# :stimate discount rate !# :stimate initial costs

,inimum 1cceptance Criteria; 1ccept if '() < = 0anking Criteria; Choose the highest '()

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Calculating '() with Spreadsheets

Spreadsheets are an excellent way to compute '()s, especially when you ha e to compute the cash flows as well# &sing the '() function;

+he first component is the re>uired return entered as a decimal# +he second component is the range of cash flows beginning with year 1. 1dd the initial in estment after computing the '()#

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5#2 +he (ayback (eriod ,ethod

?ow long does it take the pro4ect to pay back its initial in estment* (ayback (eriod 7 number of years to reco er initial costs ,inimum 1cceptance Criteria;

Set by management Set by management

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0anking Criteria;

+he (ayback (eriod ,ethod

-isad antages;
/gnores the time alue of money /gnores cash flows after the payback period Biased against long-term pro4ects 0e>uires an arbitrary acceptance criteria 1 pro4ect accepted based on the payback criteria may not ha e a positi e '()

1d antages;
:asy to understand Biased toward li>uidity

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5#! +he -iscounted (ayback (eriod

?ow long does it take the pro4ect to pay back its initial in estment, taking the time alue of money into account* -ecision rule; 1ccept the pro4ect if it pays back on a discounted basis within the specified time# By the time you ha e discounted the cash flows, you might as well calculate the '()#

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5#. +he /nternal 0ate of 0eturn

/00; the discount rate that sets '() ,inimum 1cceptance Criteria;

to Bero

0anking 0ein

1ccept if the /00 exceeds the re>uired return Select alternati e with the highest /00 1ll future cash flows are assumed to be rein ested at the /00

Criteria;

estment assumption;

5-$=

/nternal 0ate of 0eturn 5/006

-isad antages;

-oes not distinguish between in esting and borrowing /00 may not exist, or there may be multiple /00s (roblems with mutually exclusi e in estments :asy to understand and communicate

1d antages;

5-$$

/00; :xample
Consider the following pro4ect;
$50 $100 $150

0 -$200

+he internal rate of return for this pro4ect is $A#..C D5= D$== D$5= NPV = = = 2== + + + 2 ! 5$ + IRR6 5$ + IRR6 5$ + IRR6
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'() (ayoff (rofile

/f we graph '() ersus the discount rate, we can see the /00 as the x-axis intercept#
=C .C @C $2C $2C 2=C 2.C 2@C !2C !2C .=C ..C D$==#== D3!#@@ D5$#$$ D!$#$! D$!#52 5D2#=@6 5D$5#A36 5D2@#!@6 5D!A#5$6 5D.A#5.6 5D5@#2=6 5D22#@26

D$5=#== D$==#== '() D5=#== D=#== -$C 5D5=#==6 5D$==#==6 -iscount rate
5-$!

/00 7 $A#..C
AC $AC 2AC !AC

Calculating /00 with Spreadsheets

Eou start with the same cash flows as you did for the '()# Eou use the /00 function;

Eou first enter your range of cash flows, beginning with the initial cash flow# Eou can enter a guess, but it is not necessary# +he default format is a whole percent F you will normally want to increase the decimal places to at least two#

5-$.

5#5 (roblems with /00

,ultiple /00s 1re %e Borrowing or Gending +he Scale (roblem +he +iming (roblem

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,utually :xclusi e s# /ndependent

,utually :xclusi e (ro4ects; only "': of se eral potential pro4ects can be chosen, e#g#, ac>uiring an accounting system#

01'K all alternati es, and select the best one#

/ndependent (ro4ects; accepting or re4ecting one pro4ect does not affect the decision of the other pro4ects#

,ust exceed a ,/'/,&, acceptance criteria

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,ultiple /00s
+here are two /00s for this pro4ect;
0
NPV

$200 $800 1

%hich one should we use*

$8 00
100% = IRR2

$200 D$==#==
D5=#== D=#== -5=C 5D5=#==6 5D$==#==6 =C 5=C

$==C

$5=C 2==C Discount rate

0% = IRR1
5-$3

,odified /00

Calculate the net present alue of all cash outflows using the borrowing rate# Calculate the net future alue of all cash inflows using the in esting rate# 8ind the rate of return that e>uates these alues# Benefits; single answer and specific rates for borrowing and rein estment
5-$@

+he Scale (roblem

%ould you rather make $==C or 5=C on your in estments* %hat if the $==C return is on a D$ in estment, while the 5=C return is on a D$,=== in estment*

5-$A

+he +iming (roblem

(ro4ect 1 0 $10,000 $1,000 $1,000 1 2 3

(ro4ect B

$10,000 $1,000 $12,000 0 $10,00 0 1 2

$1,000 3

5-2=

+he +iming (roblem

$5,000.00 $4,000.00 $3,000.00 $ ,000.00

(ro4ect 1 (ro4ect B

NPV

$!,000.00 $0.00 ($!,000.00) 0" ($ ,000.00) ($3,000.00) ($4,000.00) ($5,000.00) !0"

10.55% = crossover rate

0" 30" 40"

12.94% = IRR#

16.04% = IRRA

Discount rate
5-2$

Calculating the Crosso er 0ate

Compute the /00 for either pro4ect 1-B or B-1
Eear (ro4ect 1 (ro4ect B (ro4ect 1-B (ro4ect B-1 = 5D$=,===6 5D$=,===6 D= D= $ D$=,=== D$,=== DA,=== 5DA,===6 2 D$,=== D$,=== D= D= ! D$,=== D$2,=== 5D$$,===6 D$$,===
D!,===#== D2,===#== D$,===#== D=#== 5D$,===#==6 =C 5D2,===#==6 5D!,===#==6 -iscount rate
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10.55% = IRR
5C $=C $5C 2=C 1-B B-1

'()

'() ersus /00

'() and /00 will generally gi e the same decision# :xceptions;

'on-con entional cash flows F cash flow signs change more than once ,utually exclusi e pro4ects

/nitial

in estments are substantially different +iming of cash flows is substantially different

5-2!

5#2 +he (rofitability /ndex 5(/6

+otal () of 8uture Cash 8lows (/ = /nitial /n estent
,inimum

1cceptance Criteria;

1ccept if (/ < $

0anking

Criteria;

Select alternati e with highest (/

5-2.

+he (rofitability /ndex

-isad antages;

(roblems with mutually exclusi e in estments ,ay be useful when a ailable in estment funds are limited :asy to understand and communicate Correct decision when e aluating independent pro4ects
5-25

1d antages;

5#3 +he (ractice of Capital Budgeting

)aries by industry;

Some firms use payback, others use accounting rate of return#

+he most fre>uently used techni>ue for large corporations is either /00 or '()#

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:xample of /n estment 0ules

Compute the /00, '(), (/, and payback period for the following two pro4ects# 1ssume the re>uired return is $=C# Eear (ro4ect 1 (ro4ect B = -D2== -D$5= $ D2== D5= 2 D@== D$== ! -D@== D$5=
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:xample of /n estment 0ules

C8= ()= of C8$-! '() 7 /00 7 (/ 7 (ro4ect 1 -D2==#== D2.$#A2 D.$#A2 =C, $==C $#2=A2 (ro4ect B -D$5=#== D2.=#@= DA=#@= !2#$AC $#2=5!
5-2@

:xample of /n estment 0ules

(ayback (eriod; +ime = $ 2 ! C8 -2== 2== @== -@== $ro%ect A Cum# C8 -2== = @== = $ro%ect # C8 Cum# C8 -$5= -$5= 5= -$== $== = $5= $5=

(ayback period for pro4ect B 7 2 years# (ayback period for pro4ect 1 7 $ or ! years*
5-2A

'() and /00 0elationship

-iscount rate -$=C =C 2=C .=C 2=C @=C $==C $2=C '() for 1 -@3#52 =#== 5A#22 5A#.@ .2#$A 2=#@5 =#== -$@#A! '() for B 2!.#33 $5=#== .3#A2 -@#2= -.!#=3 -25#2. -@$#25 -A2#52

5-!=

'() (rofiles
NPV
!400 !#00 !200 !100 !0
$15% 0% 15% #0% 45% %0% 100% 1#0% 160% 190%

IRR 1 A"

IRR B"

IRR 2 A"

!100" !200"

&ross$over Rate

Discount rates

Project A Project B
5-!$

Summary F -iscounted Cash 8low

'et present alue

-ifference between market alue and cost 1ccept the pro4ect if the '() is positi e ?as no serious problems (referred decision criterion -iscount rate that makes '() 7 = +ake the pro4ect if the /00 is greater than the re>uired return Same decision as '() with con entional cash flows /00 is unreliable with non-con entional cash flows or mutually exclusi e pro4ects Benefit-cost ratio +ake in estment if (/ < $ Cannot be used to rank mutually exclusi e pro4ects ,ay be used to rank pro4ects in the presence of capital rationing
5-!2

/nternal rate of return

(rofitability /ndex

Summary F (ayback Criteria

(ayback period

Gength of time until initial in estment is reco ered +ake the pro4ect if it pays back in some specified period -oes not account for time alue of money, and there is an arbitrary cutoff period Gength of time until initial in estment is reco ered on a discounted basis +ake the pro4ect if it pays back in some specified period +here is an arbitrary cutoff period
5-!!

-iscounted payback period

Huick HuiB

Consider an in estment that costs D$==,=== and has a cash inflow of D25,=== e ery year for 5 years# +he re>uired return is AC, and payback cutoff is . years#
%hat is the payback period* %hat is the discounted payback period* %hat is the '()* %hat is the /00* Should we accept the pro4ect*

%hat method should be the primary decision rule* %hen is the /00 rule unreliable*
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