Net Present Value &

Other Investment Criteria

Investment decision
Verizon spent $23 billion rolling out
its fiber-option network, F iOS .
 Gorgon natural gas project in
Western Australia is estimated at
$46 billion.
 General Motors' research and
development costs for the C hevrolet
Volt have been about $1.2 billion.
E stimated production costs for the
latest Pirates of the C arribean
movie have been at about $300
million.
The development costs of the
Boeing 787 Dreamliner jet are
estimated at over $30 billion.
G OOD DE CISION
CR ITE R IA

 Does the decision rule

adjust for the time value of
money?
 Does the decision rule
adjust for risk?
 Does the decision rule
provide information on
whether we are creating
value for the firm?
Net Present Value (NPV)

◉ Present value of cash inflows minus present

value of cash outflows.
◉ NPV is a direct measure of how well this
project will achieve the goal of increasing the
shareholder's wealth.
Net Present Value (NPV)

◉ Investment R ule:
◉ Accept project if NPV is positive or equal to zero.
◉ R eject project if NPV is negative.
Net Present Value (NPV)

◉ S tep 1: E stimate the expected future cash

flows.
◉ S tep 2: E stimate the required return for
projects of this risk level.
◉ S tep 3: F ind the present value of the cash
flows and subtract the initial
investment to arrive at the net
present value.
Net Present Value (NPV)

◉ F ormula:
NPV = PV
- R equired Investment

S um of the PVs of all cash flows:

Net Present Value (NPV)

 E xample:

Y ou are approached by a possible tenant who is prepared to

rent your office block for 3 years at a fixed annual rental of
$25,000. Y ou would need to expand the reception area and
add some other trailor-made features. This would increase
the initial investment to $375,000, but you forecast that after
you have collected the third year's rent, the building could be
sold for $450,000. Assume that these cash inflows are certain
and that the oppoturnity cost of capital is 7% .
Net Present Value (NPV)

 Given:

C0 = -$375,000
t =3
C1 = $25,000
C2 = $25,000
C3 = $475,000 ($450,000 + $25,000)
r = 7%
 Net Present Value (NPV)
ADVANTAGE S
• C ash flow from future years is
discounted back to the present
to find their worth.
• S tockholders can see clearly
how much a project will
contribute to their value.
• Uses the minimum rate of return
that shareholders require for
their investment in the
company.
DIS ADVANTAGE S
• R equires guessing about future
cash flows and estimating a
company's cost of capital.
• Not applicable when comparing
projects that have differing
investment amounts.
• The NPV approach is difficult to
apply when comparing projects
that have different life spans.
 “A risky
dollar is
worth less
than a safe
one.”
📌
Internal R ate of R eturn
(IR R )

◉ Discount rate of which the project's NPV of all

cash flows is equal to zero.
◉ It is used to evaluate the attractiveness of a
project or investment.
Internal R ate of R eturn
(IR R )

◉ Investment R ule:
◉ Accept project if IR R is greater than the opportunity
cost of capital (required return).
◉ Otherwise, reject project.
Internal R ate of R eturn
(IR R )

◉ F ormula: Pr ofit
IRR 
Investment

Let NPV=0,
Ct
0  C0 
1  IRR
Internal R ate of R eturn
(IR R )

◉ E xample: (Trial and E rror)

$25,000 $25,000
0  $375,000  
(1  IRR ) (1  IRR ) 2
1
Internal R ate of R eturn
(IR R )

◉ If required return < IR R , NPV > 0, AC C E PT

◉ If required return = IR R , NPV = 0, INDIF F E R E NT
◉ If re quired return > IR R , NPV < 0, R E J E C T

Note:
◉ Leads to the same decision or result as the NPV for
independent projects with conventional cash flows.
 E xample of mutually
exclusive projects using NPV
& IR R

Period Project A Project B ◉ The required return for

0 -500 -400 both projects is 10%.
1 325 325
2 325 200 ◉ Which project should
IRR 19.43% 22.17% you accept and why?
NPV 64.05 60.74
NPV vs. IR R

◉ NPV directly measures the increase in value to the firm.

◉ Whenever there is a conflict between NPV and another
decision rule, you should always use NPV.

◉ IR R is unreliable in the following situations:

○ Non-conventional cash flows
○ Mutually exclusive projects
 Internal R ate of R eturn
(IR R )

ADVANTAGE S DIS ADVANTAGE S

• Mostly used by financial • If discount rate changes every
managers as it is expressed in year, then it is difficult to make a
percentage form. comparison.
• Provide an excellent guidance on • If there are two or more
a project’s value and associated mutually exclusive projects, in
risk. that case, it is not effective.
• Give the actual returns of the
money which you invested
today.
Profitability Index

◉ The ratio of net present value to initial

investment.
◉ It is also known as the “benefit-cost ratio”.
◉ Measures the benefit per unit cost, based on the
time value of money.
Profitability Index

Net present va lue

◉ F ormula: PI 
Initial Investment

◉ E xample:
CASH FLOWS (in millions)

PROJECT C0 C1 C2 NPV at 10% Profitability

Index
C -10 30 5 21 21/10=2.1

D -5 5 20 16 16/5=3.2

E -5 5 15 12 12/5=2.4
Profitability Index

◉ Investment R ule:
◉ If the Profitability Index > 1.0, Accept
◉ This measure can be very useful in situations where
we have limited capital.
 Profitability Index

ADVANTAGE S DIS ADVANTAGE S

• C losely related to NPV, generally • May lead to incorrect decisions
leading to identical decisions. in comparisons of mutually
• E asy to understand and exclusive investment projects.
communicate.
• May be useful when available
investment funds are limited.
Profitability Index

C APITAL R ATIONING
◉ Limit set on the amount of funds available for
investment.
◉ Two reasons:
○ S oft R ationing
○ Hard R ationing
Profitability Index

S OF T R ATIONING
◉ It is when the restriction is imposed by the
management.
◉ R easons:
○ PROMOTERS’ DE C IS ION
○ AN INC R E AS E IN OPPOR TUNITY C OS T OF
C APITAL
○ F UTUR E S C E NAR IOS
Profitability Index

HAR D R ATIONING
◉ It is when the capital infusion is limited by
external sources.
◉ R easons:
○ S TAR T-UP F IR MS
○ POOR MANAGE ME NT / TR AC K R E C OR D
○ LENDER’S R E S TR IC TIONS
○ INDUS TR Y S PE C IF IC F AC TOR S
Payback Period

◉ The time until cash flows recover the initial

investment in the project.
◉ C omputation:
◉ E stimate the cash flows
◉ S ubtract the future cash flows from the initial cost
until initial investment is recovered
◉ A ‘break-even’-type measure
Payback Period

◉ Investment R ule:
◉ Accept project if the payback period is less than
some preset limit (specified number of years).
Payback Period

Initial Investment
◉ F ormula: Payback Period 
Cash flow per period

◉ E xample: Uneven C ash F lows

C ompany C is planning to undertake another project requiring
initial investment of $50 million and is expected to generate $10
million in Y ear 1, $13 million in Y ear 2, $16 million in year 3, $19
million in Y ear 4 and $22 million in Y ear 5. C alculate the payback
value of the project.
 Payback Period

ADVANTAGE S DIS ADVANTAGE S

• E asy to understand. • Ignores the time value of money.
• Adjusts for uncertainty of later • R equires an arbitrary cut-off
cash flows. period.
• Biased towards liquidity. • Ignores cash flows beyond the
cut-off date.
• Biased against long-term
projects.
 The Choice
The between When to
Investment Long- and R eplace an
Timing Short- Old
Decision Lived Machine
E q uipment
 The Investment Timing
Decision

◉ When is it best to commit to a positive-NPV

investment?
◉ Choose the investment date that produces the
highest net present value “today”.
 The Investment Timing
Decision

◉ E xample:
Year of Cost of PV NPV at Year of
NPV Today Decision
Purchase Purchase Savings Purchase (r=10%)
0 $50 $70 $20 $20.0
1 45 70 25 22.7
2 40 70 30 24.8
3 36 70 34 25.5 optimal purchase date
4 33 70 37 25.3
5 31 70 39 24.2
 The Choice between Long-
and Short-Lived E q uipment

◉ S elect the machine that has the lowest

equivalent annual annuity.

◉ E quivalent annual annuity - the cash flow per period with

the same present value as the cost of buying and
operating a machine.

PV of costs
Equivalent annual annuity 
Annuity factor
 The Choice between Long-
and Short-Lived E q uipment

◉ S teps:
1. Get the P resent Value of the costs of machine
2. Get the Annuity F actor
3. C alculate the E quivalent Annual Annuity of the project
4. S elect the project that has the lowest E AA
Costs (in thousands) PV at
EAA
0 1 2 3 6%

Machine I 15 4 4 4 ? ?

Machine J 10 6 6 - ? ?
 When to R eplace an Old
Machine

◉ When to replace?
◉ E xample:
Costs (in thousands) PV at
EAA
0 1 2 3 4 5 6%

Machine I 25 8 8 8 8 8 $58.70 ?

C osts to operate old machine VS . C osts to operate new machine

◉ S elect the lowest costs
 CAPITAL BUDG E TING IN
PR ACTICE

◉ We should consider several

investment criteria when making
decisions.
◉ NPV and IR R are the most
commonly used primary
investment criteria.
◉ Payback is a commonly used
secondary investment criteria.
◉ All provide valuable information.
Thanks!