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Chapter 9
Net Present Value andOther Investment
Criteria
Copyright 2012 by McGraw-Hill Education. All rights
reserved.
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Key Concepts and Skills
Be able to compute payback and discountedpayback and understand
their shortcomings
Understand accounting rates of return andtheir shortcomings
Be able to compute internal rates of return(standard and
modified) and understand theirstrengths and weaknesses
Be able to compute the net present value andunderstand why it is
the best decision criterion
Be able to compute the profitability inde andunderstand its
relation to net present value
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Chapter $utline
%et &resent 'alue
he &ayback ule
he *iscounted &ayback he +verage +ccounting eturn
he ,nternal ate of eturn
he &rofitability ,nde he &ractice of Capital
Budgeting
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.ood *ecision Criteria
/e need to ask ourselves thefollowing 0uestions when
evaluatingcapital budgeting decision rules1
2 *oes the decision rule ad3ust for thetime value of money4
2 *oes the decision rule ad3ust for risk4
2 *oes the decision rule provideinformation on whether we are
creatingvalue for the firm4
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%et &resent 'alue
he difference between the market valueof a pro3ect and its
cost
6ow much value is created from
undertaking an investment42 he first step is to estimate the
epected
future cash flows7
2 he second step is to estimate the re0uiredreturn for pro3ects
of this risk level7
2 he third step is to find the present value ofthe cash flows
and subtract the initialinvestment7
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&ro3ect 9ample ,nformation
:ou are reviewing a new pro3ect and haveestimated the following
cash flows12 :ear ;1 C< = ">?8@;;;
2 :ear >1 C< = ?-@>#;A %, = >-@?#;2 :ear #1 C< =
;@;;A %, = -@-;;
2 :ear -1 C< = !>@;;A %, = #!@>;;
2+verage Book 'alue = #@;;;
:our re0uired return for assets of this risklevel is >#D7
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%&' 2 *ecision ule
If the NPV is positive, accept theproject
+ positive %&' means that the pro3ect is
epected to add value to the firm and willtherefore increase the
wealth of theowners7
Since our goal is to increase ownerwealth@ %&' is a direct
measure of howwell this pro3ect will meet our goal7
!"
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Computing %&' for the&ro3ect
Using the formulas12 %&' = ">?8@;;; E
?-@>#;F(>7>#) E ;@;;F
(>7>#)#E !>@;;F(>7>#)-= >#@?#75>
Using the calculator12 C
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*ecision Criteria est " %&'
*oes the %&' rule account for the timevalue of money4
*oes the %&' rule account for the risk of
the cash flows4 *oes the %&' rule provide an indication
about the increase in value4
Should we consider the %&' rule for ourprimary decision
rule4
!"!
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Calculating %&'s with aSpreadsheet
Spreadsheets are an ecellent way tocompute %&'s@ especially
when you have tocompute the cash flows as well7
Using the %&' function2 he first component is the re0uired
return
entered as a decimal
2 he second component is the range of cash
flows beginning with year 12 Subtract the initial investment
after computing the
%&'
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&ayback &eriod
6ow long does it take to get the initial costback in a nominal
sense4
Computation
2 9stimate the cash flows2 Subtract the future cash flows from
the initial
cost until the initial investment has beenrecovered
*ecision ule 2Accept if the paybackperiod is less than some
preset limit
!">>
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Computing &ayback for the&ro3ect
+ssume we will accept the pro3ect if itpays back within two
years72 :ear >1 >?8@;;; 2 ?-@>#; = >;>@; still
to
recover2 :ear #1 >;>@; 2 ;@;; = ->@;; still to
recover
2 :ear -1 ->@;; 2 !>@;; = "?;@;;;project
pays back in year 3 Do we accept or reject the project?
!">#
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*ecision Criteria est "&ayback
*oes the payback rule account for thetime value of money4
*oes the payback rule account for the risk
of the cash flows4 *oes the payback rule provide an
indication about the increase in value4
Should we consider the payback rule forour primary decision
rule4
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+dvantages and*isadvantages of &ayback
+dvantages2 9asy to understand
2+d3usts for
uncertainty of latercash flows
2 Biased towardli0uidity
*isadvantages2 ,gnores the time value
of money
2 e0uires an arbitrary
cutoff point2 ,gnores cash flows
beyond the cutoff date
2 Biased against long"
term pro3ects@ such asresearch anddevelopment@ and
newpro3ects
!">5
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*iscounted &ayback &eriod
Compute the present value of each cashflow and then determine
how long it takesto pay back on a discounted basis
Compare to a specified re0uired period *ecision ule "Accept the
project if it
pays back on a discounted basis within
the specified time
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Computing *iscounted &aybackfor the &ro3ect
+ssume we will accept the pro3ect if it pays backon a discounted
basis in # years7
Compute the &' for each cash flow anddetermine the payback
period using discounted
cash flows2 :ear >1 >?8@;;; 2 ?-@>#;F>7>#>=
>;@?5-
2 :ear #1 >;@?5- 2 ;@;;F>7>##= 8#@#;#
2 :ear -1 8#@#;# 2 !>@;;F>7>#-= ">#@?# pro3ect
paysback in year -
Do we accept or reject the project?
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*ecision Criteria est 2*iscounted &ayback
*oes the discounted payback rule account for thetime value of
money4
*oes the discounted payback rule account for the
risk of the cash flows4 *oes the discounted payback rule provide
an
indication about the increase in value4
Should we consider the discounted payback rule
for our primary decision rule4
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+dvantages and *isadvantagesof *iscounted &ayback
+dvantages2 ,ncludes time value
of money
2 9asy to understand2 *oes not accept
negative estimated%&' investmentswhen all future cashflows
are positive
2 Biased towardsli0uidity
*isadvantages2 Gay re3ect positive
%&' investments
2 e0uires an arbitrarycutoff point
2 ,gnores cash flowsbeyond the cutoffpoint
2 Biased against long"term pro3ects@ suchas H* and
newproducts
!">
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+verage +ccounting eturn
here are many different definitions foraverage accounting
return
he one used in the book is1
2+verage net income F average book value2 %ote that the average
book value depends on
how the asset is depreciated7
%eed to have a target cutoff rate
*ecision ule1Accept the project if theAA is !reater than a
preset rate
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Computing ++ for the&ro3ect
+ssume we re0uire an averageaccounting return of #8D
+verage %et ,ncome1
2 (>-@?#; E -@-;; E #!@>;;) F - = >8@-5;
++ = >8@-5; F #@;;; = 7#>- =#>7-D
Do we accept or reject theproject?
!"#;
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*ecision Criteria est " ++
*oes the ++ rule account for the timevalue of money4
*oes the ++ rule account for the risk of
the cash flows4 *oes the ++ rule provide an indication
about the increase in value4
Should we consider the ++ rule for ourprimary decision rule4
!"#>
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+dvantages and*isadvantages of ++
+dvantages2 9asy to calculate
2 %eededinformation will
usually beavailable
*isadvantages2 %ot a true rate of
returnA time value ofmoney is ignored
2Uses an arbitrarybenchmark cutoff rate
2 Based on accountingnet income and bookvalues@ not cash
flows
and market values
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,nternal ate of eturn
his is the most important alternativeto %&'
,t is often used in practice and isintuitively appealing
,t is based entirely on the estimatedcash flows and is
independent ofinterest rates found elsewhere
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, 2 *efinition and*ecision ule
*efinition1 , is the return that makes the%&' = ;
*ecision ule1Accept the project if theI is !reater than the
re"uired return
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Computing , for the&ro3ect
,f you do not have a financial calculator@then this becomes a
trial and errorprocess
Calculator2 9nter the cash flows as you did with %&'
2 &ress , and then C&
2 , = >?7>-D I >#D re0uired return
Do we accept or reject the project?
!"#8
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%&' &rofile for the &ro3ect
IRR = 16.13%
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*ecision Criteria est " ,
*oes the , rule account for the timevalue of money4
*oes the , rule account for the risk of
the cash flows4 *oes the , rule provide an indication
about the increase in value4
Should we consider the , rule for ourprimary decision
criteria4
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Calculating ,s /ith +Spreadsheet
:ou start with the cash flows the same asyou did for the
%&'
:ou use the , function2 :ou first enter your range of cash
flows@
beginning with the initial cash flow
2 :ou can enter a guess@ but it is not necessary
2 he default format is a whole percent 2 you willnormally want
to increase the decimal places toat least two
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Summary of *ecisions forthe &ro3ect
Summary
%et &resent 'alue Accept
&ayback &eriod eject
*iscounted &ayback &eriod eject
+verage +ccounting eturn eject
,nternal ate of eturn Accept
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%&' vs7 ,
%&' and , will generally give usthe same decision
9ceptions2 %onconventional cash flows 2 cash flow
signs change more than once
2 Gutually eclusive pro3ects
,nitial investments are substantially different(issue of
scale)
iming of cash flows is substantially different
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, and %onconventionalCash
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+nother 9ample 2%onconventional Cash 1 >-#@;;;2 :ear #1
>;;@;;;
2 :ear -1 ">8;@;;;
he re0uired return is >8D7 Should we accept or re3ect the
pro3ect4
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%&' &rofile
IRR = 10.11% and 42.66%
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Summary of *ecision ules
he %&' is positive at a re0uiredreturn of >8D@ so you
shouldAccept
,f you use the financial calculator@you would get an , of
>;7>>Dwhich would tell you to eject
:ou need to recogniLe that there arenon"conventional cash flows
andlook at the %&' profile
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, and Gutually 9clusive&ro3ects
Gutually eclusive pro3ects
2 ,f you choose one@ you canJt choose the other
2 9ample1 :ou can choose to attend graduate
school at either 6arvard or Stanford@ but notboth
,ntuitively@ you would use the followingdecision rules1
2 %&' 2 choose the pro3ect with the higher %&'
2 , 2 choose the pro3ect with the higher ,
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9 l /ith G t ll
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9ample /ith Gutually9clusive &ro3ects
&eriod &ro3ect+
&ro3ectB
; "8;; "5;;
> -#8 -#8
# -#8 #;;
, >!75-D
##7>D
%&' ?57;8 ?;75
The required return
for both projects is
10%.
Which project
shoud !ou accept
and "h!#
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%&' &rofiles
IRR for $ = 1.43%
IRR for & = 22.1'%
(rosso)er *oint = 11.+%
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Conflicts Between %&' and,
%&' directly measures the increase invalue to the firm
/henever there is a conflict between %&'
and another decision rule@ you shouldalwaysuse %&'
, is unreliable in the following situations2 %onconventional
cash flows
2 Gutually eclusive pro3ects
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Godified ,
Calculate the net present value of allcash outflows using the
borrowingrate7
Calculate the net future value of allcash inflows using the
investing rate7
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&rofitability ,nde
Geasures the benefit per unit cost@based on the time value of
money
+ profitability inde of >7> implies thatfor every > of
investment@ we createan additional ;7>; in value
his measure can be very useful in
situations in which we have limitedcapital
!"5>
+dvantages and *isadvantages
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+dvantages and *isadvantagesof &rofitability ,nde
+dvantages
2 Closely related to%&'@ generally
leading to identicaldecisions
2 9asy to understandand communicate
2 Gay be useful whenavailable investmentfunds are limited
*isadvantages
2 Gay lead toincorrect decisions
in comparisons ofmutually eclusiveinvestments
!"5#
C it l B d ti ,
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Capital Budgeting ,n&ractice
/e should consider severalinvestment criteria when
makingdecisions
%&' and , are the mostcommonly used primary
investmentcriteria
&ayback is a commonly usedsecondary investment criteria
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Summary 2 *C< Criteria
%et present value2 *ifference between market value and cost2 ake
the pro3ect if the %&' is positive2 6as no serious problems2
&referred decision criterion
,nternal rate of return2 *iscount rate that makes %&' = ;2
ake the pro3ect if the , is greater than the re0uired return2 Same
decision as %&' with conventional cash flows2 , is unreliable
with nonconventional cash flows or mutually
eclusive pro3ects
&rofitability ,nde2 Benefit"cost ratio2 ake investment if
&, I >2 Cannot be used to rank mutually eclusive pro3ects2
Gay be used to rank pro3ects in the presence of capital
rationing
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S + ti
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Summary 2 +ccountingCriterion
+verage +ccounting eturn
2 Geasure of accounting profit relative tobook value
2 Similar to return on assets measure
2 ake the investment if the ++ eceedssome specified return
level
2 Serious problems and should not beused
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Nuick NuiL
Consider an investment that costs >;;@;;;and has a cash
inflow of #8@;;; every yearfor 8 years7 he re0uired return is !D@
andre0uired payback is 5 years72 /hat is the payback period42 /hat
is the discounted payback period42 /hat is the %&'42 /hat is
the ,42 Should we accept the pro3ect4
/hat decision rule should be the primarydecision method4
/hen is the , rule unreliable4
!"5
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9thics ,ssues
+n +BC poll in the spring of #;;5 found that one"thirdof
students age ># 2 > admitted to cheating and thepercentage
increased as the students got older andfelt more grade pressure7 ,f
a book entitled O6ow toCheat1 + UserJs .uideP would generate a
positive%&'@ would it be proper for a publishing company to
offer the new book4
Should a firm eceed the minimum legal limits ofgovernment
imposed environmental regulations andbe responsible for the
environment@ even if thisresponsibility leads to a wealth reduction
for the firm4,s environmental damage merely a cost of
doingbusiness4
Should municipalities offer monetary incentives to
induce firms to relocate to their areas4!"5
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Comprehensive &roblem
+n investment pro3ect has the followingcash flows1 C
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9nd of Chapter
