Net Present Value and Other

Investment Criteria
NPV and Cash transfers
CFO Investment Decision Tools
Payback Period
• Payback Period
• Number of years before cumulative cash flow equals initial outlay

• Payback Rule
• Only accept projects that pay back within desired time frame
• Ignores later year cash flows and present value of future cash flows
The Net Present Value (NPV) Rule

• Net Present Value (NPV) =

Total PV of future CF’s - Initial Investment

• Estimating NPV:
1. Estimate future cash flows: how much? and when?
2. Estimate discount rate
3. Estimate initial costs
• Minimum Acceptance Criteria: Accept if NPV > 0
• Ranking Criteria: Choose the highest NPV
Internal Rate of Return
• IRR: the discount rate that sets NPV to zero

• Example
• Tool A costs $4,000. Investment will generate $2,000 and $4,000 in cash flows
for two years. What is IRR?
2,000 4,000
NPV  4,000   0
(1  IRR ) 1
(1  IRR ) 2

IRR  28.08%
IRR Formula
𝑃𝑟𝑜𝑓𝑖𝑡
• Rate of Return =
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝐶1
• NPV = Intial cashflow + =0
1+𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑟𝑎𝑡𝑒
𝐶1
• Discount rate = -1
𝐶0
Internal Rate of Return
Internal Rate of Return
• Pitfall 1: Lending or Borrowing?
• NPV of project increases as discount rate increases for
some cash flows

When we lend money we need high rate of return and we borrow money at lower rate of return
Internal Rate of Return
• Pitfall 2: Multiple Rates of Return
• Certain cash flows generate NPV = 0 at two different discount rates
• Following cash flow generates NPV = $A253 million at IRR% of
3.5% and 19.54%
 Multiple Rates of Return

There are many internal rates of return for a project as there are change in the signs of the cash flows.
Internal Rate of Return
• Pitfall 3: Mutually Exclusive Projects
• IRR sometimes ignores magnitude of project
The Profitability Index (PI)

Total PV of Future Cash Flows

PI 
Initial Investent
• Minimum Acceptance Criteria:
• Accept if PI > 1


• Ranking Criteria:
• Select alternative with highest PI
The notion of a discount rate
• Thus there is a hurdle that projects have to cross before being
deemed acceptable.
• This hurdle rate should be higher for riskier projects than safe
projects

• Hurdle rate = Risk free rate + risk premium

• How do you measure risk?

• How to you translate risk measure to risk premium?