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Chapter 7
NPV and Other Investment Criteria
Chapter Outline
Net Present Value (NPV)
Other Investment Criteria
IRR (Internal Rate of Return)
Payback and Discounted Payback
Book Rate of Return
Investment Criteria When Projects Interact
Pitfalls with IRR
Capital Rationing
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PV today:
0 1 2
$373,282
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IRR BY GRAPH
NPV Profile for this Project
$60,000
$50,000
$40,000 IRR = 14.3%
(occurs where NPV = 0)
NPV ($)
$30,000
$20,000
$10,000
$0
($10,000) 5% 10% 15% 20%
($20,000)
Discount Rate
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out of a project.
Project Interactions
Investment Criteria When Projects Interact
NPV has proven to be the only reliable measure of a
projects acceptability.
But, what happens when we must choose among
projects which interact?
The NPV rule can be adapted to deal with the
following situations:
Mutually Exclusive Projects
The Investment Timing Decision
Long- vs Short-Lived Equipment (Unequal Lives)
Replacing an Old Machine
Project Interactions
Mutually Exclusive Projects
Most projects you deal with will be either-or
propositions.
For example, you own a vacant piece of land.
You have many either-or choices:
You could construct a townhouse or a condo.
Project Interactions
Mutually Exclusive Projects
In Example 7.4, you are going to replace your office network.
You can choose between a cheaper, slower package or a more
expensive, faster option.
Calculate the NPV for the two projects if the discount rate is 7%: a
Project Interactions
The Investment Timing Decision
Sometimes your choice is start a project now
or wait and do it at a later date.
In Example 7.1, you looked at purchasing a
new computer system.
Itscost today was $50,000 and its NPV was
$19,740.
However, you know that these systems are
dropping in price every year.
From the numbers on the next slide, when should
you purchase the computer?
Project Interactions
NPV at
Year of PV of Year of NPV
Purchase Cost Savings Purchase Today
t=0 $50 $70 $20 $20.0
t=1 $45 $70 $25 $22.7
t=2 $40 $70 $30 $24.8
t=3 $36 $70 $34 $25.5
t=4 $33 $70 $37 $25.3
t=5 $31 $70 $39 $24.2
Project Interactions
Long- vs Short-Lived Equipment
Suppose you must choose between buying
Machine D and E.
The two machines are designed differently, but
have identical capacity and do the same job.
The difference?
Machine D costs $15,000 and lasts 3 years. It
costs $4,000 per year to operate.
Machine E costs $10,000 and lasts 2 years. It costs
Project Interactions
Long- vs Short-Lived Equipment
So far, this looks like a mutually exclusive
choice like problem 7.4
Calculate PV of the costs for the projects if the
a
Project Interactions
Long- vs Short-Lived Equipment
Choosing Machine E may not be the best decision. Why not?
All we know is that Machine E costs less to run over 2 years than
Machine D does over 3 years.
D is being penalized by having one extra year of costs charged against
a
it!
What we should be asking is: How much would it cost per year to use
Machine E as versus Machine D?
We solve this problem by calculating the Equivalent Annual Cost
(EAC) of the two machines.
The EAC is the cost per period with the same PV as the cost of
the machine.
Think of it as calculating the annual rental charge for the machine.
There will be equal annual payments (an annuity).
The PV of these payments must equal the PV of the cost of the
machine.
Project Interactions
Calculating Equivalent Annual Cost:
Cash Flows in Dollars
Project: C0 C1 C2 C3 PV @ 6%
Machine D 15000 4000 4000 4000 $25,692.5
Equivalent
Annual cost: 9,611.5
? 9,611.5
? 9,611.5
? $25,692.5
Project Interactions
Cash Flows in Dollars
Project: PV @ 6% Equivalent Annual Cost
D $25,692.5 $9,611.50
E $21,000 $11,454.37
Long- vs Short-Lived Equipment
We see from the equivalent annual costs that D is
actually the better choice because its annual cost is
lower than for Machine E.
If mutually exclusive projects have unequal lives, then
you should calculate the equivalent annual cost of the
projects.
This will allow you to select the project which will
maximize the value of the firm.
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Project Interactions
Replacing an old machine
When should existing equipment be
replaced?
For example:
You are operating an old machine which will last 2
more years.
It costs $12,000 per year to operate.
A new machine costs $25,000 to buy, but is more
efficient and can be operated for $8,000 per year.
It will last for 5 years.
Project Interactions
Replacing an old machine
Solve these problems by calculating for the new machine
the PV of the cash flows and its equivalent annual cost:
Project Interactions
Pitfalls with IRR: 1-Mutually Exclusive Projects
IRR can mislead you when choosing among mutually
exclusive projects.
Calculate the IRR and NPV for the following projects:
Cash Flows in Dollars
Project: C0 C1 C2 C3 IRR NPV @ 7%
H -350 400 - - 14.29% $24,000
12.96% $59,000
I -350 16 16 466
Project Interactions
Pitfalls with IRR
Remember: a high IRR is not an end in itself!
Higher IRR for a project does not necessarily
mean a higher NPV.
You goal should be to maximize the value of
the firm.
Remember:
NPV is the most reliable criterion for project
evaluation.
Only NPV measures the amount by which a project
would increase the value of the firm.
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Project Interactions
Pitfalls with IRR: 2 Lending vs Borrowing
Calculate the IRR and NPV for the projects below:
Project Interactions
Pitfalls with IRR Lending vs Borrowing
Project J involves lending $100 at 50% interest.
Project K involves borrowing $100 at 50% interest.
Which option should you choose?
Remember:
When you lend money, you want a high rate of return.
When you borrow money, you want a low rate of return.
The IRR calculation shows that both projects have a
50% rate of return and are equally desirable.
You should see that this is a trap!
The NPV rule correctly warns you away from a project
which involves borrowing money at 50%.
Project Interactions
Other Pitfalls with IRR
3. Some projects will generate multiple internal
rates of return.
Look at Figure 7.4 on page 218 for an example.
4. Some projects have no internal rate of return.
Look at Footnote #6 on page 219 for an example.
Capital Rationing
Capital Rationing
Occurs when a limit is set on the amount of
funds available to a firm for investment.
Soft Rationing
Occurs when these limits are imposed by
senior management.
Hard Rationing
Occurs when these limits are imposed by the
capital markets.
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Capital Rationing
Rules for Project Selection
A firm maximizes its value by accepting all
positive NPV projects.
Withcapital rationing, you need to select a group
of projects which is within the companys
resources and gives the highest NPV.
This is done with the Profitability Index (PI)
pickthe projects that give the highest NPV per
dollar of investment.
Capital Rationing
Profitability Index (PI)
For example: Suppose your firm had the following
projects and only $20 million to spend:
NPV @
Project C0 C1 C2 10%
L -3.00 2.20 2.42 1.00
M -5.00 2.20 4.84 1.00
N -7.00 6.60 4.84 3.00
O -6.00 3.30 6.05 2.00
P -4.00 1.10 4.84 1.00
Budget -25.00
Capital Rationing
Profitability Index
NPV @
Project C0 10% PI
L 3.00 1.00 1/3 = 0.33 ACCEPT
Summary of Chapter 6
NPV is the only measure which always gives
the correct decision when evaluating projects.
The other measures can mislead you into
making poor decisions if used alone.
The other measures are:
IRR
Payback
Discounted Payback
Book Rate of Return
Profitability Index (PI)
Summary of Chapter 6
Summary of Chapter 6
It should be noted that when capital rationing
is in place, NPV by itself, cannot lead you to
the correct decision.
You must combine NPV with the Profitability Index.
Ranking the projects this way will allow you to
choose the package of projects which will offer the
highest NPV per dollar of investment.
In summary:
NPV should always be used when
evaluating project acceptability!
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