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Capital Investment Decisions

EXPGP (WE)-2009-12
Sessions 1-2-3
Handout—For Classroom Discussion only

Coverage
• Capital Budgeting … building blocks
• Alternative decision criteria

Capital Investment Decisions – What are these ?

What long term investments should the firm take on ?----- capital budgeting
– Investments like :
• Plant and equipment, new projects
• A new retail outlet for Pantaloons or Walmart
• A new software for an Infosys or a Microsoft
• A fleet of new Aircrafts for an airlines company
– Issues Involved :
• What are the time, quantum and risk of the cash flows vis-a vis-
cost involved in the projects ?
• Is it Profitable for the company to go for the project?
• Whether the investment decision is going to create value for the
company?

Types of Projects
Mutually exclusive : A or B

– Example :
– A firm may own a block of land, which is large enough to establish a
shoe manufacturing business or a steel fabrication plant. The selection of
one will exclude the acceptance of the other.
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– TELCO considering to establish a new manufacturing complexes can

locate it in Gujrat, Orissa or West Bengal. If the company chooses
Orissa, the other two locations are ruled out… as the company can have
only one new manufacturing location.

Independent : A or B or A+B

– Example :
– The introduction of a new product line (soap) and at the same time the
replacement of a machine, which is currently producing a different
product (plastic bottles).

– The installation of a new air conditioning system and the commissioning

of a new advertising campaign for a product currently sold by the firm.

Contingent : Either A+B or nothing :

– Contingent projects are dependant on the acceptance of another

project. Suppose Archies develops a new character called “Pippy”
and is considering starting a new line of Pippy cards. If Pippy catches
on , the firm will start producing a line of Pippy T- shirts---- but only
if the Pippy character is popular. The T-shirt project is a contingent
project.

Problems managers face when they make investment decisions

Three major problems :

– They have to search out for new opportunities or projects in the

marketplace( unfortunately theory of finance cannot help much with this
problem)

– The expected cash flows from the project need to be estimated.

– The project’s acceptability has to be decided according to sound
decision rules.

What is a sound decision rule to make investment decisions ?

The best technique or decision rule should have the following properties:
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All cash flows should be considered

The cash flow’s time value of money should be considered at a
suitable discount rate
The technique should be able to select one from a set of mutually
exclusive projects

4)The rule should follow value additivity principle

• i.e based on this rule managers should be able to consider one project
independently from all others .
• This is particularly important because then projects can be selected
independently in isolation without looking at them in an infinite variety
of combinations.

Put naively, the value additivity principle implies that

– if A> B ( A better than B ) based on the chosen criteria then A+C
> B+C where C is a project independent of both A and B ).

Violation of the Value Additivity Principle … implication for managers

If Value additivity Principle is violated the management has to consider all

possible combinations of projects and choose the one that is most suitable
combination.
– If for example the firm has only five projects ,it would need to consider
32 different combinations. (Why?)( 5C0 +5C1 + 5C2+5C4+5C5 = 32) .
– Imagine the number of combinations if there were 50 projects.

Competing Investment Decision Criteria

Following investment decision criteria are primarily used for taking such
decisions:

– Net Present Value

– The Payback Rule
– The Discounted Payback
– The Average Accounting Return
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– The Internal Rate of Return

– Modified Internal Rate of Return
– The Profitability Index
Net Present Value ( NPV)
Defined as the difference between the value( PV of the expected cash flows )
of a project and its cost

How do we find NPV of a project or generally an investment?

– STEP 1:
– The first step is to estimate the expected future cash flows.( not earnings
or other accounting numbers… it is the incremental or net cash flows
that matter for capital budgeting decisions)

– STEP II :
– The second step is to estimate the required return for projects of this risk
level, i.e “the opportunity cost of capital”.

Opportunity Cost of Capital : This is the discount rate that is used to discount
the expected cash flows from an investment and to find the NPV.
It is the opportunity cost of taking the project, (Why?)………..

this is the return the shareholders would have earned themselves by investing
in financial assets, if the project was not taken and the cash distributed as
dividends to shareholders.

STEP III
• the third step is to find the present value of the cash flows, by discounting
them by the opportunity cost of capital, and subtract the initial investment.
• So NPV = PV of the expected cash flows from the project ( discounted at
Opportunity cost of capital) – the PV of the investment made

PV – Decision Rule
If the NPV is positive, accept the project
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A positive NPV means that the project is expected to add value to the firm and
will therefore increase the wealth of the owners (why?)

Since the goal of the financial manager is to increase owner’s wealth, NPV is
a direct measure of how well this project will meet their goal.

Example 1):
Suppose you are looking at a new project and you have estimated the
following cash flows:
– Year 0: CF = -165,000 (i.e initial investment required)
– Year 1: CF = 63,120;
– Year 2: CF = 70,800;
– Year 3: CF = 91,080;

Your required return for assets of this risk is 12%.

NPV – Decision Rule… contd..
Computing NPV for the Project
Using the formulas:

– NPV = 63,120/(1.12) + 70,800/(1.12) + 91,080/(1.12) – 165,000 =

2 3

12,627.42
Do we accept or reject the project?
--Accept, since NPV > 0

Example 2 :
Suppose we are asked to decide whether a new consumer product should be
launched. Based on projected sales and costs, we expect that the cash flows
over the five year life of the project will be $2000, in the first two years,$4000
in the next two, and $5000 in the last year. It will cost about $10,000 to begin
production. We use a 10% discount rate to evaluate such new products.
Should we go for the new product?

Soln :
PV of the cash flows expected = (2000/1.1 + 2000/1.12 +4000/1.13 +4000/1.14
+5000/1.15 ) = $12,313
NPV = $12313 – investment = $12,313-$10,000 = $2,313 >0
So accept project.
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The payback rule :

The amount of time required for an investment to generate cash flows
sufficient to recover its initial cost is called the payback period of the
investment.
For example : A project requiring an initial investment of $500 is expected to
generate the following cash flows over the next three years :
Year 1 $100
Year 2 $200
Year 3 $500
What will be the payback period for this project ?

Soln :
During the first 2 years cash generated = $300 and remaining amount of cash
to be recovered for full payback = $200 which should happen sometime
during year 2 and year 3. The exact time ( assuming uniform inflow of cash
during the year 3)= 200/500 = 0.4 years.
Thus payback period for this project = 2.4 years or roughly 2 years and 5
months.

The payback rule says :

– an investment is acceptable if its payback period is less than some pre
specified number of years.

What are the problems with Payback rule?

To find out let’s examine the following 3 projects, all having the same
payback of 3 years i.e they should be equally attractive as per payback rule.

Problem 1) Timing of cash flows within the payback period not considered:
If we compare projects A and B, at 15% discount rate, NPV of A = 7.26 while
that of B =13.62 so B is more attractive than A although as per payback rule
they are equally attractive. Why does this happen ?

Because, payback method does not take into account any time value of money
.
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Project B has larger cash inflows early in its life compared to A. Payback
method completely ignores this.

Problem 2)Payments after the payback period ignored:

Compare B and C. NPV of B =13.62 while that of C = 34284.51, but they
appear equally attractive by payback method. Why does this happen?
Because payback method completely ignores the cash flows after the payback
period.
Because of short term orientation of Payback method, some valuable long
term projects may be ignored.

Problem 3) Biggest problem is to select a proper cut off payback period. There
is no objective basis or economic rationale for selection of the same.

So is the payback method not used at all in practice?

Often used by large, sophisticated companies when making relatively small
decisions. The principal advantages of the payback rule perceived by the
practitioners are as follows :
– It is easy to understand and interpret

Because it is biased towards short term projects it tends to favour investments

that free up capital soon i.e it is biased towards liquidity. This could be
important for small businesses although less significant for large businesses.

The cash flows occurring at the later part of a project’s life are always more
uncertain. Thus arguably the payback period adjusts for the extra riskiness
of such cash flows, but it does so in a rather crude manner by totally
ignoring them.

The Discounted Payback Period Rule

How long does it take the project to “pay back” its initial investment
taking the time value of money into account?

Compute the present value of each cash flow and then determine how long it
takes to pay back on a discounted basis.

Compare to a specified required period

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Decision Rule - Accept the project if it pays back on a discounted basis

within the specified time

Discounted payback period rule– example

Assume a project that needs $165,000 as initial investment and is

expected to generate $63120,$70800, and $91080 in years 1 , 2 and 3. We
will accept the project if it pays back on a discounted basis in 2 years. Use
12% as the appropriate discount rate.
Do we accept or reject the project?

Compute the PV for each cash flow and determine the payback period using
discounted cash flows
– Year 1: 165,000 – 63,120/1.121 = 108,643
– Year 2: 108,643 – 70,800/1.122 = 52,202
– Year 3: 52,202 – 91,080/1.123 = -12,627 project pays back in year 3
– So we do not accept.
– But NPV = + 12,627 … still we reject.
But if a project pays back on a discounted basis ever, with some cash flows
still remaining, it is bound to have a positive NPV( assuming that all the cash
flows from the project are positive) and should increase the value of the
company.( Why ? ) …
This is because by definition, the NPV is zero when the sum of the discounted
cash flows equals the initial investment. So if a project pays back on a
discounted basis, then some cash flows may still remain which must add up to
give a positive NPV.
This implies that if we use a discounted payback, we won’t be accidentally
taking up any projects with a negative NPV. (But we may reject some
with positive NPV like the one we just discussed.).

Advantages and Disadvantages of Discounted Payback method:

Advantages
– Includes time value of money
– Easy to understand
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– Does not accept negative NPV investments when all future cash flows
are positive
– Biased towards liquidity

Disadvantages
– May reject positive NPV investments
– Requires an arbitrary cutoff point
– Ignores cash flows beyond the cutoff point
– Biased against long-term projects, such as R&D and new products

The Internal Rate of Return (IRR) Rule

IRR: the discount rate that sets NPV to zero

Minimum Acceptance Criteria:

– Accept if the IRR exceeds the required return.

Ranking Criteria:

– Select alternative with the highest IRR

The Internal Rate of Return: Example

Consider the following project:

The internal rate of return for this project is 19.44% (found by trial and error
just like the YTM of a bond)
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The NPV Payoff Profile for This Example

If we graph NPV versus discount rate, we can see the IRR as the x-axis
intercept… the discount rate that makes the NPV=0

Discount Rate NPV $120.00

0% $100.00
$100.00
4% $71.04
$80.00
8% $47.32
$60.00
12% $27.79
$40.00 IRR = 19.44%

NPV
16% $11.65
20% ($1.74) $20.00
24% ($12.88) $0.00
28% ($22.17) ($20.00)-1% 9% 19% 29% 39%
32% ($29.93) ($40.00)
36% ($36.43) ($60.00)
40% ($41.86) Discount rate

Example:
A project has a total up front cost of $435.44.The cash flows are $100 in the
first year,$200 in the second year and $300 in the third year. What’s the IRR
of the project? If we require an 18% return should we take this investment?

Soln : The IRR can be given by the following equation,

NPV=0= -435.44 + 100/(1+IRR) + 200/(1+IRR)2 + 300/(1+IRR)3
At discount rate = 20% NPV = -39.61
At discount rate = 10%, NPV = + 46.13---- Therefore the actual IRR should
be somewhere in between 20% and 10%.
A little trial and error shows that the IRR comes out to be 15%.( CHECK NPV
=0 for discount rate = 15%)

Now given that our required rate of return is 18 % .

As per IRR rule we should not accept the project .
Internal rate of return … contd…
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Problems with IRR rule :

The IRR Investment Rule will give the same answer as the NPV rule in many,
but not all, situations.

Problem 1 ) Non Conventional Cash Flows :

In general, the IRR rule works for a stand-alone project if all of the project’s
negative cash flows precede its positive cash flows.
In other cases, the IRR rule may disagree with the NPV rule and thus be
incorrect.
In this context, situations where the IRR rule and NPV rule may be
in conflict:
Delayed Investments
Nonexistent IRR
Multiple IRRs

i)Delayed Investments :Example :

– Assume you have just retired as the CEO of a successful company. A

major publisher has offered you a book deal. The publisher will pay you
$1 million upfront if you agree to write a book about your experiences.
You estimate that it will take three years to write the book. The time you
spend writing will cause you to give up speaking engagements
amounting to $500,000 per year. ( This is effectively an outflow to
you).You estimate your opportunity cost to be 10%.

– Should you accept the deal?

– 100,000 = -50,000/(1+IRR) +(-50,000/(1+IRR)^2)+(-50000/(1+IRR)^3)
i.e IRR = 23% (approx)

– Calculate the IRR using excel :

– The IRR(23%) is greater than the cost capital(10%). Thus, the IRR rule
indicates you should accept the deal.

Delayed Investments
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– Should you actually accept the deal?

– NPV = 1,000,000 − 500,1.1000 − 500,1.1000 − 500,1.1000 = − $243,426
2 3

– Since the NPV is negative, the NPV rule indicates you should reject the
deal.

NPV Profile of the $1 million Book Deal

When the benefits of an investment occur before the costs, the NPV is an
increasing function of the discount rate. The normal IRR rule is therefore
completely reversed.

Nonexistent IRR
Assume now that you are offered $1 million per year if you agree to go on a
speaking tour for the next three years. If you lecture, you will not be able to
write the book( so you do not receive the $1 million upfront). Thus your net
cash flows every year would look as follows (1 million -500,000 opportunity
cost = 500,000)
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Nonexistent IRR
500, 000 500, 000 500, 000
NPV = + +
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.

NPV Profile of lecture Contract

No IRR exists because the NPV is positive for all values of the discount rate.
Thus the IRR rule cannot be used.

Multiple IRRs
Now assume the lecture deal fell through. You inform the publisher that it
needs to increase its offer before you will accept it. The publisher then agrees
to make royalty payments of $20,000 per year forever, starting once the book
is published in three years.

– Should you accept or reject the new offer?

– The cash flows would now look like:
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– The NPV is calculated as:

500, 000 500, 000 20, 000 20, 000 20, 000
NPV = 1,000, 000 − − − + + + L
1 + r (1 + r ) 2 (1 + r )3 (1 + r ) 4 (1 + r )5
500, 000  1  1  20, 000 
= 1,000, 000 − 1 − 3 
+ 3  
r  (1 + r )  (1 + r )  r 
By setting the NPV equal to zero and solving for r, we find the IRR. In this case,
there are two IRRs: 4.723 % and 19.619 % . Because there is more than one IRR,
the IRR rule cannot be applied.

NPV of Book Deal with Royalties

If the opportunity cost of capital is either below 4.723 % or above 19.619 % , you
should accept the deal. Between 4.723 % and 19.619 % , the book deal has a
negative NPV. Since your opportunity cost of capital is 10 % , you should reject
the deal.

As per Descarte’s rule of signs : the number of IRRs will be the same as the
number of changes of signs in cash flows i.e from negative to positive or positive
to negative( or less than it by a multiple of 2).

Problem 2) Mutually Exclusive Projects:

Mutually exclusive projects
– If you choose one, you can’t choose the other

Intuitively you would use the following decision rules:

• NPV – choose the project with the higher NPV
• IRR – choose the project with the higher IRR– but is that always correct?

Example With Mutually Exclusive Projects

The required return for both projects is 10%.
Period Project A Project B
0 -500 -400
1 325 325
2 325 200
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IRR 19.43% 22.17%

NPV 64.05 60.74

Which project should you accept and why?

A has a higher total cash flow, but it pays back at a slower rate than B. So its NPV
is higher at low discount rates but as the discount rates increase, the effect of the
distant cash flows is reduced to a great extent and the NPV of B starts exceeding its
NPV.

Moral of the example is – when we have mutually exclusive projects we should

not rank them based on their IRRs. Instead we need to look at relative NPVs and
the required rate of return.

$160.00
$140.00 NPV Profiles
$120.00 IRR for A = 19.43%
IRR for B = 22.17%
$100.00 Crossover Point = 11.8%
$80.00
A
NPV

$60.00
B
$40.00
$20.00
$0.00
($20.00) 0 0.05 0.1 0.15 0.2 0.25 0.3
($40.00)
Discount Rate

Another example and crossover rate

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The preferred project in this case depends on the discount rate, not the IRR

The cross over rate

$5,000.00
Project A
$4,000.00
Project B
$3,000.00 the Crossover Rate
Calculating
10.55% = crossover rate
$2,000.00
$1,000.00 16.04% = IRRA
NPV

$0.00
($1,000.00) 0% 10% 20% 30% 40%

($2,000.00) 12.94% = IRRB

($3,000.00)
($4,000.00)
Discount rate
Calculating the Crossover Rate

• Compute the IRR for either project “A-B” or “B-A”

• Year Project A Project B Project A-B Project B-A
0 ($10,000) ($10,000) $0 $0
1 $10,000 $1,000 $9,000 ($9,000)
2 $1,000 $1,000 $0 $0
3 $1,000 $12,000 ($11,000) $11,000
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$3,000.00
$2,000.00
10.55% = IRR
$1,000.00
A-B
NPV
$0.00
B-A
($1,000.00) 0% 5% 10% 15% 20%
($2,000.00)
($3,000.00)
Discount rate

What is the implication of this Calculation and the result obtained?----

It says that at 10.55% discount rate, we are indifferent between the two
investments because the NPV of the difference in their cash flows is zero.

As a consequence , the two investments have the same NPV at this rate, so
this 10.55% is the cross over rate.

CHECK … NPV at 10.55% for both the projects is $604.69

Problem 3 : reinvestment rate assumption :

The NPV rule assumes that the investors can reinvest their cash flows
from the project at the required rate of return or opportunity cost of
capital (Why?)
– which seems to be a logical assumption--- there is no reason to believe that
one should not be able to re invest all the future cash flows at the market
determined rate of return.

What about IRR approach ?

This on the other hand assumes that all the future cash flows are reinvested at
the IRR of the project– which is not a market determined rate which is solely
a function of the estimated cash flows of the project. So this may not a very
logical assumption.
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Problem 4: Violation of the Value Additivity Principle by IRR

The fourth of the desirable properties of decision rules…… says that using
the rule managers should be able to consider one project independently of all
others. To demonstrate that IRR rule can violate the value additivity principle,
consider the three projects whose cash flows are given in the table below :
Projects 1 and 2 are mutually exclusive and project 3 is independent of the
other two.

Year Project1 Project 2 Project 3 1+3 2+3 PVIF@

10%
0 -100 -100 -100 -200 -200 1.00
1 0 225 450 450 675 0.909
2 550 0 0 550 0 0.826

If the value additivity principle holds we should be able to choose the better of the
two mutually exclusive projects 1 and 2 without having to consider the
independent projects i.e we should choose 1 as IRR of 1 > IRR of 2 as shown
below.

But if we consider combination of projects we should prefer 2+3 than 1+3 i.e
project 1 is better in isolation but project 2 is better in combination with project 3
i.e value additivity is violated.

What is the implication of this violation for managers ?

The management has to consider all possible combinations of projects and choose
the one that has the greatest IRR.
– If for example the firm has only five projects ,it would need to consider
32 different combinations. (Why?)( 5C0 +5C1 + 5C2+5C4+5C5 = 32) .
– Imagine the number of combinations if there were 50 projects.

Redeeming Qualities of the IRR approach :

Despite the problems discussed above, the IRR approach is very popular
among managers for capital budgeting decisions… principal reason may be
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the fact that managers and financial analysts in general are more comfortable
about rates of return rather than rupee values .

Example : A statement like “The project gives 20% IRR”, seems to be more
popular than saying , “ at 10% discount rate the present value is Rs. 40000/-
say.

Under certain circumstances the IRR may have a practical advantage over the
NPV approach. We can’t estimate the NPV until we know the appropriate
discount rate, but we can still determine the IRR.

Modified Internal rate of Return ( MIRR)

To address some of the problems with conventional IRR ( like multiple IRRs)
sometimes a modified IRR is used.

Say we have a cash flow of -$60 at time 0, +$155 at time 1 and -$100 at time
2. If we try and find the IRR for this cash flow stream there will be 2 IRRS
25% and 33.33%. BY using MIRR we can arrive at only one answer
whereby eliminating the multiple IRR problem.

Approach 1 : The discounting approach : The idea is to discount all

negative cash flows at the required rate of return and add them to the initial
cost. .. Then calculate the IRR. The discount rate used might be the required
return. In this example , if the projects required rate of return is 20%, then
the modified cash flows look as follows :

– Time 0 : -$60 + (-$100/1.2 )=-$129.44

2

– Time 1 : +$155
– Time 2 : +$0
– If you calculate the IRR now, you should get IRR = 19.71%
Approach 2 : The Reinvestment approach : Here we compound all cash
flows(positive and negative)except the first one, to the end of the projects life
at the required rate of return and then calculate the IRR. In a sense we
reinvest the cash flows and not taking them out of the project till its very end.
 P a g e | 20

and add them to the initial cost. In this example , if the projects required rate
of return is 20%, then the modified cash flows look as follows :

– Time 0 : -$60
– Time 1 : 0
– Time 2 : +$155*1.2 -$100= $86
– If you calculate the IRR now, you should get IRR = 19.72%
Approach 3.. Combination
Discount all the negative cash flows back to the present and compound all the
positive cash flows to the end.
For our example modified cash flows become :

– At time 0 : -$60+(-$100/1.2 )=-$129.44

2

– Time 1 : +$0
– Time 2 : $155x 1.2 = $186
– Calculate the MIRR = 19.87%
MIRR …problems

• MIRRs are controversial.

• Many analysts claim that MIRRs are superior to IRRs,. For example by
design they clearly do not suffer from the multiple rate of return
problem.
• One problem with MIRRs is however there are different ways to
calculate it and we get different results with each and there is no clear
reason which one is better
• .Because MIRR depends on an externally supplied discount( or
compounding ) rate, the answer that one gets is not truly ‘internal’
which by definition should depend only on the projects cash flows and
nothing else.
• If we have the discounting rate, why not calculate the NPV and be done
with it ?
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Average Accounting Return Rule

The average accounting return is interpreted as an average measure of the

accounting performance of a project over time, computed as some average profit
measure attributable to the project divided by some average balance sheet value for
the project.

The one most often used expression for AAR is:

Average net income / average book value

– Note that the average book value of assets depend on how the asset is
depreciated.—if one uses straight line depreciation to a zero salvage;
then one can take the initial asset value and divide by 2 to get the
average book value. For example if an investment is made amounting
to 500,000 to be depreciated using a straight line method over an
estimated life of 5 years then the average book value should be
500,000/2 = 250,000. Alternatively one can find the average book value
by averaging 6 figures (in ‘000s)as follows : (500 +400
+300+200+100+0)/6 = 250,000.
– For any other methods of depreciation you need to compute the BV in
each preceding period and take the average.

Need to have a target cutoff rate of return. (Which is a problem?)

Decision Rule: Accept the project if the AAR is greater than a preset rate.

Example AAR
You are looking at a three year project with a projected net income of $2000
in year 1, $4000 in year 2, and $6000 in year 3. The cost is $12000 and that
will be depreciated over the three year life of the project. What is the AAR for
the project?
Solution :
Average net income for the project is =(2000 +4000 +6000)/3 =4000
Average book value of the project = (12000 +8000 +4000 +0)/4 = 6000 ( or
=12000/2 =6000)
AAR = 4000/6000 = 66.67%
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Advantages and Disadvantages of AAR

Advantages
– Easy to calculate and understand

Disadvantages
– Not a true rate of return; time value of money is ignored completely.
– Uses an arbitrary benchmark cutoff rate
– Based on accounting net income and book values, not real cash flows
and market values

The Profitability Index (PI) Rule

Example : if a project costs Rs. 200 crores and the present value of the future
cash flows discounted at a suitable opportunity cost is Rs. 220 crores then, the
PI is 220/200 = 1.1.

If a project has a PI > 1 it implies that the PV of the future cash flows > the
initial cost i.e the project has a positive NPV.

Thus , Minimum Acceptance Criteria:

– Accept if PI > 1

Ranking Criteria:
– Select alternative with highest PI ( particularly when capital is scarce.
Because projects with highest PI would give maximum NPV per rupee
invested) ….. But does it always happen ?

Problem of scale :
Consider an investment that costs Rs. 5 crores and has a Rs. 10 crores PV of
future cash flows and an investment that costs 100 crores and a PV of future
cash flows = Rs. 150 crores.

The first project has a PI of 2 and an NPV of 5 crores while the second has a
PI of 1.5 but an NPV of 50 crores. If these are mutually exclusive projects
and we rely on PI method then we lose out by choosing the first one.
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Advantages

– Closely related to NPV, generally leading to identical decisions

– Easy to understand and communicate
Disadvantages

– May lead to incorrect decisions in comparisons of mutually exclusive

investments of different scale.

Practice problem1
a) Consider an investment that costs $100,000 and has a cash inflow of
$25,000 every year for 5 years. The required return is 9% and required
payback is 4 years.
– What is the payback period?
– What is the discounted payback period?
– What is the NPV?
– What is the IRR?
– Should we accept the project?
b)What decision rule should be the primary decision method?
c) When is the IRR rule unreliable?

Practice problem 2
An investment project has the following cash flows: CF0 = -1,000,000; C01 –
C08 = 200,000 each
If the required rate of return is 12%, what decision should be made using
NPV?
How would the IRR decision rule be used for this project, and what decision
would be reached?
How are the above two decisions related?
NPV = -$6,472; reject the project since it would lower the value of the firm.

IRR = 11.81%, so reject the project since it would tie up investable funds in a
project that will provide insufficient return.

The NPV and IRR decision rules will provide the same decision for all
independent projects with conventional/normal cash flow patterns. If a project
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adds value to the firm (i.e., has a positive NPV), then it must be expected to
provide a return above that which is required. Both of those justifications are
good for shareholders.

Practice Problem 3
If we define the NPV index as the ratio of NPV to cost, what is the
relationship between this index and the profitability index ?

Practice problem 4
A project has an initial cost of I, has a required return of R, and pays C
annually for N years.
– Find C in terms of I and N such that the project has a payback period
just equal to its life.
– Find C in terms of I, N and R such that this is a profitable project
according to the NPV decision rule.
– Find C in terms of I, N and R such that the project has a benefit cost
ratio of 2.

Practice problem 5 :
An investment under consideration has a payback of seven years and a cost of
$537,000. If the required return is 12%, what is the worst case NPV? What is
the best case NPV? Explain. Assume the cash flows are conventional.

Practice Problem 6
The Yurdone Corporation wants to set up a private cemetery business.
According to the CFO, Barry M Deep, business is “looking up”. As a result,
the cemetery project will provide net cash inflow of $60,000 for the firm
during the first year, and the cash flows are projected to grow at a rate of 6%
per year forever. The project requires an initial investment of $925,000.
– If Yurdone requires a 13% return on such undertakings, should the
cemetery business be started?

– The company is somewhat unsure about the assumption of a 6% growth

rate in its cash flows. At what constant growth rate would the company
just breakeven if it still required a 13% return on investment?

Practice Problem 7
A project has the following cash flows :
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Year Cash Flow

0 $64000
1 -30000
2 -48000

What is the IRR of this project ? If the required return is 12%, should the firm
accept the project ? What is the NPV of the project ? What is the NPV of the
project if the required return is 0%? 24% ? What is going on here ? Skecth the
NPV profile to help you answer the qs?