INVESTMENT CRITERIA

Topic #2

Outline

What is capital budgeting?

NPV rule for making investment decisions

Other alternative investment criteria

Payback period

Internal rate of return

Profitability index and capital rationing

Deciding on projects with different lives

Investment criteria in corporate practice

2

What is capital budgeting?

Capital budgeting deals with the analysis of potential

additions to firms fixed assets
These are long-term decisions that generally involve
large expenditures and are difficult to reverse
What types of project can we find?

Independent projects
Mutually exclusive projects
Expansion projects
Replacement projects
Research & development projects
Other projects (safety / environmental projects)
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Capital budgeting process

Accounting,
finance,
engineering

Idea
development

Collection of
data

Project
analysis

Decision
making

Results

Reevaluation

NPV rule illustrated

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
1
2

Revenues
$1,000
2,000

Expenses
$500
1,000

Draw a time line and compute the NPV of project X

5

NPV rule concluded

0

Initial outlay
($1,100)

Revenues $1,000
Expenses
500

Revenues $2,000
Expenses 1,000

Cash flow

Cash flow $1,000

$500

$1,100.00
$500 x
+454.55

1
1.10

$1,000 x
+826.45

1.102

+$181.00 NPV
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Foundations of the NPV rule

Why does NPV work? And what does work

mean?

A firm is created when security holders supply the

funds to acquire assets that will be used to produce and
sell goods and services
The market value of the firm is based on the free cash
flows it is expected to generate

Thus, good projects are those which increase firm

value
Good projects are those projects that have positive
NPVs
Moral:
INVEST ONLY IN PROJECTS WITH POSITIVE NPVs

Why do we like NPV that much?

NPV uses cash flows, and not other

NPV uses all the cash flows generated by the

accounting artificial constructs

project during its life

NPV discounts the cash flows properly, since

it takes into account TVM

Payback period

The payback period of a project (PB) is the

number of years it takes before the
cumulative forecasted cash flows equal the
initial outlay
Payback period rule accept projects that
payback in the desired time frame
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Pitfalls in using the payback period

Which project would you choose from the

followings, given a 2 years payback?
Project

CF0

CF1

CF2

CF3

500 5000

Payback
period

-2,000

500

-2,000

500

1800

-2,000 1800

500

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Pitfalls in using the payback period

Project

CF0

CF1

CF2

CF3

500 5000

Payback
period

NPV @
10%

+2,624

-2,000

500

-2,000

500

1800

-58

-2,000 1800

500

+50

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Pitfalls in using the payback period

Payback period may select projects that are

not acceptable under NPV rule
Timing of cash flows within the payback
period compare project B and project C
Cash flows after the payback period
compare project A and project C
Arbitrary standard for payback period
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Use of payback period

PB is often used when making relatively

small decisions
PB ensures liquidity
PB is used as a pre-selection criterion
Nevertheless, as a decision grows in
importance, the NPV becomes the order of
the day
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Internal rate of return

IRR tries to find a single number that

summarizes the merits of a project
This number does not depend on the
interest rate that prevails in the capital
market
The number is intrinsic to the project and
only depends on the cash flows of the

project and their timing

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Internal rate of return illustrated

Year

Cash flow

-200

50

100

150

Find r such that NPV = 0

50
100
150
0 200

2
1 r (1 r)
1 r 3

r 19.44% this r is IRR

IRR rule:

Accept the project if IRR > opportunity cost of

capital
Reject the project if IRR < opportunity cost of
capital
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NPV profile
100,00

IRR = 19.44%

80,00
60,00

NPV

40,00
20,00
0,00
1

13

17

21

25

29

-20,00
-40,00
-60,00

Discount rate (%)

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Trial and error for IRR

Trial and error

IRR is just under 20%

19.44%

Discount rates

NPV

0%

$100

5%

68

10%

41

15%

18

20%

-2

Approximation formula

NPV
IRR rmin (rmax rmin )
NPV NPV
18
For our project : IRR 15 (20 15)
19.5%
18 2
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Pitfalls with the IRR approach

Pitfall 1: IRR assumes funds can be invested

each year at the same rate

Pitfall 2: Investing or financing?

Pitfall 3: Multiple rates of return

Pitfall 4: The scale problem

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Investing or financing?

With some cash flow patterns, the NPV of the

project increases as the discount rate increases

Year

35,00

Net present value

25,00

Project A

IRR(A) = IRR(B)

15,00

0 -100

100

130 -130

5,00
-5,00 0

10

20

30

40

50

60

-15,00
-25,00

Project B

-35,00
Discount rate (%)

19

Investing or financing?

Project A is a substitute for investing

Project B is a substitute for financing
In the case of financing-like projects, IRR
rule is reversed:

Accept project if IRR < opportunity cost of

capital
Reject project if IRR > opportunity cost of
capital
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Multiple internal rates of return

Year
Cash flow
0,04

-252

1,431

-3,035

2,850

-1,000

IRR1 = 25.0%

IRR4 = 66.6%

IRR3 = 42.8%

0,02

NPV

0,00
-0,02
-0,04

15

25

35

45

55

65

IRR2 = 33.3%

-0,06
-0,08
Discount rate
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Multiple rates of return

When should we expect a project to have more

than one IRR?

How many IRRs can a project have?

Answer: whenever we have more than one sign

change (+/- or -/+) on the cash flows
Answer: as many as the number of sign changes
(example: 4 changes maximum 4 IRRs)

In all these cases, IRR rule cannot be applied

NPV is the only criteria we can use
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The scale problem

Suppose you have purchased the rights to produce

a motion picture and you have to decide on
allocating either a small or a large budget for it.
The two projects look as follows:
CF0

CF1

NPV @ 25%

IRR

Small budget

-$10 mil.

$40 mil.

$22 mil.

300%

Large budget

-$25 mil.

$65 mil.

$27 mil.

160%

Which one would you choose?

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The scale problem and incremental IRR

Incremental IRR of large budget versus small

budget

Incremental cash flows: large

budget - small budget

CF0

CF1

-25 (-10) =
-15

65 40 =
25

25
0 15
Incrementa l IRR 66.67% 25%
1 IRR
25
NPV of incrementa l cash flows 15
50
1.25
Large budget is better than small budget project
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Profitability index
Profitability index

PI Rule for independent projects:

PV(Cash flows subsequent to initial investment )

Initial investment

Accept project if PI > 1

Reject project if PI < 1

Look at this!
NPV > 0 PI > 1

IRR > discount rate

ACCEPT
PROJECT

NPV < 0 PI < 1

IRR < discount rate

REJECT
PROJECT
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Problems with PI

Making decisions with PI for mutually exclusive

projects
Cash flows
Project

CF0

CF1

CF2 PV @ 12%

PI

NPV @ 12%

-20

70

10

70.5

3.53

50.5

-10

15

40

45.3

4.53

35.3

Same problems as in the case of scale problem form

IRR decide using NPV
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Capital rationing
Cash flows

Project

CF0

CF1

CF2 PV @ 12%

PI

NPV @ 12%

-20

70

10

70.5

3.53

50.5

-10

15

40

45.3

4.53

35.3

-10

-5

60

43.4

4.34

33.4

Suppose the projects above are independent, but

you have only $25 mil. to invest. Which project(s)
do you choose?
USE PROFITABILITY INDEX
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Capital rationing

Profitability index does not work if funds are

also limited beyond the initial time period
Two types of capital rationing:

Soft rationing provisional limits adopted by

management as an aid to financial control

Hard rationing the firm is unable to raise the

money she desires
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Projects with different lives

You have to choose one of the following two

machines. Both have identical capacity and do
exactly the same job. The costs of buying and
operating them are displayed below.
Costs
Machine

CF0

CF1

CF2

CF3

PV @ 6%

15

28.37

10

21.00

29

Projects with different lives

Choosing on PV will not necessarily lead to

the best decision the timing of a future
investment decision depends on today s
choice
In this case, a good decision can be made
computing the equivalent annual cost

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Equivalent annual cost

Present va lue of costs
Equivalent annual cost
Annuity factor

annuity which has exactly the same life and PV as

the project
28.37
28.37
EAC (Machine A)

10.61
AF(6%, 3y) 2.673
21.00
21.00
EAC (Machine B)

11.45
AF(6%, 2y) 1.833
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Using investment criteria in practice

CFOs using a given capital budgeting technique in 1999

Capital budgeting
technique

Percentage
always or
almost always
use

Average score
Scale is 4(always) or
0(never)

Overall

Large
firms

Small
firms

Internal rate of return

76

3.09

3.41

2.87

Net present value

75

3.08

3.42

2.83

Payback period

57

2.53

2.25

2.72

Discounted payback period

29

1.56

1.55

1.58

Book rate of return

20

1.34

1.25

1.41

Profitability index

12

0.83

0.75

0.88

Source: Graham & Harvey Theory and Practice of Corporate Finance, Journal of Financial
Economics, 61 (1), 2001

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