Corporate Finance

NPV and other investment rules

Yrj Koskinen

Outline

Net Present Value

Alternative Decision Rules

Payback

IRR

Project Selection with Resource Constraints

Profitability Index

Net Present Value

The investment project generates the following cash flows:

CF0 , CF1 , CF2 , ... , CFT

NPV of the project is just a present values of all (incremental) cash flows:

- where rWACC is the weighted average cost of capital

- we assume here that WACC remains constant
- often CF0 is a negative number (initial investment)

Example

The investment project has the following cash flows:

Period

Cash flow

-850

200

400

500

If the WACC (the discount rate) is 8%, what is the NPV?

NPV 850

200 400
500

75.04
2
3
1.08 1.08 1.08

Note: in Excel, deduct the initial investment separately

Microsoft Excel
Worksheet

NPV in Excel assumes that first cash flow occurs one period from now

Good Attributes of the NPV Rule

Benefit/loss in todays money

The dollar value of the project today

Uses all cash flows of the project

Discounts all cash flows properly
Good for accepting/rejecting proposals
Objective benchmark from the capital markets
Accept if NPV>0, reject if NPV<0

Good for ranking proposals

The higher the NPV, the better the project

Alternative Rules Versus the NPV Rule

Sometimes alternative investment rules may give the same

answer as the NPV rule, but at other times they may disagree.
When the rules conflict, the NPV decision rule should be followed.

The Payback Rule

The payback period is the amount of time it takes to recover or

pay back the initial investment.

If the period is less than a pre-specified length of time, you

accept the project. Otherwise, you reject the project.
The payback rule is used by many companies because of its simplicity.
However, the payback rule does not always give a reliable decision
since it ignores the time value of money and the cash flows after the
payback period.

Payback Rule
Year

- 100

-100

-100

50

20

50

30

30

30

20

50

20

60

60

100

What are the payback

periods?
What is the best
project?
What is the problem
with payback rule?

Pros and Cons of Payback Rule

Disadvantages:

Ignores the time value of money

Ignores cash flows after the payback period
Biased against long-term projects
Requires an arbitrary acceptance criteria
A project accepted based on the payback criteria may not have a
positive NPV

Advantages:
Easy to understand
Biased toward liquidity
Helps keep management accountable

The Internal Rate of Return

IRR: the discount that sets NPV to zero

NPV ( IRR ) C0

1 IRR
t 1

Ct

Rule:
Take any investment where the IRR exceeds the cost of
capital: IRR rWACC
Turn down any investment whose IRR is less than the
cost of capital: IRR r
WACC

Example

The investment project has the following cash flows:

What is the IRR?

0 850

200
400
500

1 r 1 r 2 1 r 3

IRR 12.20%
Microsoft Excel
Worksheet

The Internal Rate of Return

The IRR Investment Rule will give 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.

IRR Problems

There could be several issues with IRR approach:

Borrowing versus Lending

Different horizons
Multiple or no IRR
Different scales

IRR Problems: Borrowing or Lending

Consider the following example

Project A is an investment (lending)
Project B is a financing opportunity (borrowing)

The IRR for both projects is the same NPV only accepts project A
If we want to use IRR rule, we have to modify it:
If cash outflows are followed by cash inflows, accept the project if IRR exceeds the cost of
capital
If cash inflows are followed by cash outflows, accept the project if IRR is below the cost of
capital

IRR Problems: Different Horizons

Consider choosing between C and D:

Project C has higher IRR, but project D has higher NPV

The IRR rule fails to recognize that a long-lived project D provides a

superior return over longer horizon, whereas project C gives high return
only for one period

Cross-Over Rate

With low discount rates D is better (higher NPV), but with high
discount rates C is better

What is the cross-over rate?

Period

Project C

-5000

8000

Project D

-5000

9800

D-C

-8000

9800

The IRR of project D-C is 22.5%

If cost of capital is less than 22.5%, choose D
If cost of capital is greater than 22.5%, choose C

IRR Problems: Multiple IRR or no IRR

Consider projects E and F:

Project E has two IRRs. Project F has no IRR!

There can be as many IRR as there are changes in sign on cash flows.
Sometimes, there are no real IRR.

IRR Problems: Different Scale

Compare projects A and G:

The IRR rule suggests using A over G

But A has much lower NPV!

IRR rule cannot be used to compare projects with different scale

The Bottom Line for IRR

The IRR rule has shortcomings for making investment

decisions and you should know the limitations of IRR.

The IRR itself remains useful. IRR measures:

The average return of the investment
The break-even level for the cost of capital

The Profitability Index (PI)

Total PV of Future Cash Flows
PI
Initial Investment

Minimum Acceptance Criteria:

Accept if PI > 1

Ranking Criteria:
Select alternative with highest PI

Example

The project has the following cash flows.

With r=8%, the NPV is 75.04

What is the PI?

PI

850 75.04
1.09
850

The Profitability Index

Disadvantages:
Problems with mutually exclusive investments

Advantages:
May be useful when available investment funds are limited
Easy to understand and communicate
Correct decision when evaluating independent projects

Conclusion

Always calculate NPV when evaluating investments

IRR very useful, but be aware of the pitfalls
Payback problematic, but widely used and simple
Profitability index is useful if the firm is financially
constrained
Most bang for the buck