INVESTMENT
DECISION RULES
By Le Dang Thuy Trang, MSc.
TOPICS COVERED
Net Present Value (NPV) method
NPV & Mutually Exclusive Projects
Internal Rate of Return (IRR) method
NPV vs. IRR
Payback Period (PP)
Profitability Index (PI)
The Practice of Capital Budgeting
FUNDAMENTAL OF INVESTMENT
DECISION RULES
A goal of financial management is to create value
for the stockholders.
Capital budgeting decision (Investment decision):
which investments should the firm take?
Value creation: when a project’s present value of
future cash flows exceeds its initial costs.
NET PRESENT VALUE (NPV)
The present value of a project’s expected cash flows
(including its initial cost) discounted at the
appropriate risk-adjusted rate.
In other words, Net Present Value (NPV) measures
how much value is created or added today by
undertaking the investment.
The NPV measures the increase in firm value, which
is also the increase in the value of what the
shareholders own.
NET PRESENT VALUE (NPV) (CONT’D)
The first step is to estimate the expected cash flows.
The second step is to estimate the required return
for projects of this risk level.
The third step is to calculate the present value of
each cash flow discounted at the project’s risk-
adjusted cost of capital.
NPV DECISION RULE
CF1 CF2 CFn
NPV CF0 ...
1 r 1 r 2
1 r n
CF0: Initial investment
If the NPV is positive, accept the project
A positive NPV means that the project is expected
to add value to the firm and will therefore
increase the wealth of the owners.
Since our goal is to increase owner wealth, NPV is
a direct measure of how well this project will meet
our goal.
USING NPV DECISION RULE
You are reviewing a new project and have estimated the
following cash flows:
Year 0: CF = -165,000
Year 1: CF = 63,120
Year 2: CF = 70,800
Year 3: CF = 91,080
Your required return for assets of this risk level is 12%.
Computing NPV for the Project: NPV = -165,000 +
63,120/(1.12) + 70,800/(1.12)2 + 91,080/(1.12)3 =
12,627.41
INTERNAL RATE OF RETURN (IRR)
Internal Rate of Return:
This is the most important alternative to NPV
It is often used in practice and is intuitively appealing
It is based entirely on the estimated cash flows and is
independent of interest rates found elsewhere
Definition: IRR is the discount rate that makes
the NPV = 0
Decision Rule: Accept the project if the IRR is
greater than the required return
COMPUTING IRR FOR THE PROJECT
If you do not have a financial calculator, then this
becomes a trial and error process
Example: Researchers at Vinamilk are considering
a new line of low-fat frozen yogurt, the FroYo. In
order to make this yogurt, Vinamilk will need to
invest in a new machine at a cost of $81.6 million.
Estimated return on the new yogurt will be $28
million per year, starting at the end of the first
year, and lasting for four years.
USING IRR DECISION RULE
The following timeline shows the estimated return
USING IRR DECISION RULE (CONT’D)
NPV = 0, IRR = 14%
NPV VS. IRR
In most cases IRR rule agrees with NPV for stand-
alone projects if all negative cash flows precede
positive cash flows.
In other cases the IRR may disagree with NPV:
Financing project (positive cash flows followed by
negative cash flows)
Non-conventional cash flows (sign changes more than
once)
Mutually exclusive projects (if one project is accepted,
the other must be rejected)
NPV VS. IRR – FINANCING VS.
INVESTING PROJECTS
Financing project:
Example: Consider the 2 projects
Cash Flows NPV at
Project IRR
C0 C1 10%
A -100 150 50% 36.36
B 100 -150 50% -36.36
Both 2 projects has equal IRR (50%), project A has
higher NPV → choose A
NPV VS. IRR – NON-CONVENTIONAL
CASH FLOWS
Non-conventional cash flows (sign changes more
than once)
When the cash flows change sign more than once, there
is more than one IRR.
Nonconventional cash flows and multiple IRRs occur
when there is a net cost to shutting down a project (e.g.
Collecting natural resources. After the resource has
been harvested, there is generally a cost associated
with restoring the environment.)
If you have more than one IRR, which one do you use to
make your decision?
NPV VS. IRR – NON-CONVENTIONAL
CASH FLOWS (CONT’D)
Example: Suppose an investment will cost
$90,000 initially and will generate the
following cash flows.
Year Cash Flow
1 $132,000
2 $100,000
3 -$150,000
The required return is 15%.
Should we accept or reject the project?
NPV VS. IRR – NON-CONVENTIONAL
CASH FLOWS (CONT’D)
Using trial and error, you would get an IRR of
10.11% which would tell you to Reject
The NPV is positive at a required return of 15%, so
you should Accept
You need to recognize that there are
nonconventional cash flows and look at the NPV
profile
NPV PROFILE
IRR = 10.11% and 42.66%
$4,000.00
$2,000.00
$0.00
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55
($2,000.00)
NPV
($4,000.00)
($6,000.00)
($8,000.00)
($10,000.00)
Discount Rate
NPV VS. IRR – MUTUALLY EXCLUSIVE
PROJECTS
Mutually exclusive projects
Ifyou choose one, you can’t choose the other.
E.g.: You can choose to attend undergraduate class at
either IU or FTU, but not both.
You should accept the one that adds most to the
shareholder wealth
→ IRR is not reliable
NPV VS. IRR – MUTUALLY EXCLUSIVE
PROJECTS (CONT’D)
Example:
Year Project A Project B
0 -500 -400
1 325 325
2 325 200
IRR 19.43% 22.17%
NPV 64.05 60.74
The required return for both projects is 10%.
Which project should you accept and why?
NPV PROFILES
$160.00
$140.00
$120.00
$100.00
$80.00 Crossover Point = 11.8%
NPV
A
$60.00
B
$40.00
IRR for B = 22.17%
$20.00
$0.00
($20.00) 0 0.05 0.1 0.15 0.2 0.25 0.3
($40.00) IRR for A = 19.43%
Discount Rate
NPV VS. IRR - CONCLUSION
NPV directly measures the increase in value to the
firm
NPV and IRR will generally give us the same
decision
IRR is unreliable in the following situations
Financing projects
Nonconventional cash flows
Mutually exclusive projects
Whenever there is a conflict between NPV and
another decision rule, you should always use NPV
CHOOSING BETWEEN PROJECTS
Mutually Exclusive Projects
When you must choose only one project among
several possible projects, the choice is mutually
exclusive.
Can’t just pick the project with a positive NPV.
The projects must be ranked and the best one
chosen.
Select the project with the highest NPV.
NPV & MUTUALLY EXCLUSIVE
PROJECTS
Example: You own a small piece of commercial land near a
university. You are considering what to do with it. You have been
approached recently with an offer to buy it for $220,000. You are
also considering three alternative uses yourself: a bar, a coffee
shop, and an apparel store. You assume that you would operate
your choice indefinitely, eventually leaving the business to your
children. You have collected the following information about the uses.
What should you do?
Alternatives Initial Cash Flow Growth Cost of
Investment in 1st Year Rate Capital
Bar $400,000 $60,000 3.5% 12%
Coffee Shop $200,000 $40,000 3% 10%
Apparel store $500,000 $85,000 3% 13%
NPV & MUTUALLY EXCLUSIVE
PROJECTS (CONT’D)
Since you can only do one project (you only have
one piece of land), these are mutually exclusive
projects.
In order to decide which project is most valuable,
you need to rank them by NPV.
Each of these projects (except for selling the land)
has cash flows that can be valued as a growing
perpetuity.
CF1
NPV CF0 ( Initial Investment)
rg
NPV & MUTUALLY EXCLUSIVE
PROJECTS (CONT’D)
The NPVs for each alternative are:
$60,000
Bar: − $400,000 = $305,882
0.12 − 0.035
$40,000
Coffee Shop: − $200,000 = $371,429
0.1 − 0.03
$85,000
Apparel Store: − $500,000 = $350,000
0.13 − 0.03
Alternative NPV
Based on ranking,
Coffee shop $371,429
the coffee shop
Apparel store $350,000
should be chosen
Bar $305,000
Selling the land $220,000
NPV & MUTUALLY EXCLUSIVE
PROJECTS (CONT’D)
All of the alternatives have positive NPVs, but
you can only take one of them, so you should
choose the one that creates the most value.
Even though the coffee shop has the lowest
cash flows, its lower start-up cost coupled with
its lower cost of capital (it is less risky), make it
the best choice.
PAYBACK PERIOD
The payback period is amount of time it takes to recover
or pay back the initial investment
Computation
Estimate the cash flows
Subtract the future cash flows from the initial cost until the initial
investment has been recovered
Remaining cost to recover
PB Years before cost recovery
Cash flow during the year
Decision Rule – Accept if the payback period is less than a
pre-specified length of time
COMPUTING PAYBACK PERIOD FOR
THE PROJECT – EXAMPLES
Example 1: Projects A, B, and C each have an
expected life of 5 years.
Given the initial cost and annual cash flow
information below, what is the payback period
for each project?
A B C
Cost $80 $120 $150
Annual Cash Flow
$25 $30 $35
COMPUTING PAYBACK PERIOD FOR
THE PROJECT – EXAMPLES (CONT’D)
Solution
Payback A
$80 ÷ $25 = 3.2 years
Project B
$120 ÷ $30 = 4.0 years
Project C
$150 ÷ $35 = 4.29 years
COMPUTING PAYBACK FOR THE
PROJECT – EXAMPLES (CONT’D)
Example 2:Company C is planning to undertake
another project requiring initial investment of
$50 million and is expected to generate $10
million net cash flow in Year 1, $13 million in
Year 2, $16 million in year 3, $19 million in
Year 4 and $22 million in Year 5. Calculate the
payback period of the project.
COMPUTING PAYBACK FOR THE
PROJECT – EXAMPLES (CONT’D)
(cash flows in millions)
Year Annual Cumulative
Cash Flow Cash Flow
0 (50) (50)
1 10 (40)
2 13 (27)
3 16 (11)
4 19 8
5 22 30
Payback Period = 3 + 11/19 = 3 + 0.58 ≈ 3.6 years
ADVANTAGES AND DISADVANTAGES
OF PAYBACK
Advantages Disadvantages
Easy to understand Ignores the time value
of money
Favors short-term
Requires an arbitrary
projects cutoff point
Ignores cash flows
beyond the cutoff date
Biased against long-
term projects, such as
research and
development, and new
projects
PAYBACK PERIOD (CONT’D)
Example 1: Assume a company requires all projects
to have a payback period of three years or less.
For the project below, would the firm undertake the
project under this rule?
Year Expected Net Cash Flows
0 -$10,000
1 $1,000
2 $1,000
3 $1,000
4 $1,000,000
PAYBACK PERIOD (CONT’D)
The sum of the cash flows from years 1 through
3 is $3,000.
This will not cover the initial investment of
$10,000.
Because the payback is more than 3 years the
project will not be accepted, even though the 4th
cash flow is very high!
PAYBACK PERIOD (CONT’D)
Example 2: Assume Vinamilk requires all projects to
have a payback period of 2 years or less. In this
case, would the company undertake the project
under this rule?
PAYBACK PERIOD (CONT’D)
In order to implement the payback rule, we
need to know whether the sum of the inflows
from the project will exceed the initial investment
before the end of 2 years. The project has
inflows of $28 million per year and an initial
investment of $81.6 million.
PAYBACK PERIOD (CONT’D)
Year Net Cash Flow Cumulative Net Cash Flow
1 28 28
2 28 56
3 28 84
Payback period is > 2 years, the project
will be rejected.
In this case, Vinamilk would have rejected
a project that could have increased the value
of the firm.
SUMMARY OF INVESTMENT DECISIONS
FOR VINAMILK’S NEW PROJECT
NPV at 10% $7.2 million Accept ($7.2 million > 0)
Payback Period 3 years Reject (3 years > 2 year
required payback)
IRR 14% Accept (14% > 10% cost
of capital)
PROFITABILITY INDEX
Sometimes different investment opportunities
demand different amounts of a particular
resource.
If there is a fixed supply of the resource so
that you cannot undertake all possible
opportunities, simply picking the highest-NPV
opportunity might not lead to the best decision.
PROFITABILITY INDEX (CONT’D)
Profitability Index (PI):
Measures value created per dollar invested
NPV
PI
Initial Investment
A profitability index of 0.1 implies that for every $1 of
investment, we create an additional $0.10 in value
Normally results in same accept-reject decisions as NPV
When capital is scarce, accept projects with highest PIs.
Cannot be used to rank mutually exclusive projects
PROJECT SELECTION
WITH RESOURCE CONSTRAINTS – PI
Consider three possible projects with a $100
million budget constraint
PV of Future Initial
Project CFs Investment NPV PI
($ millions) ($ millions)
1 110 100 10 0.1
2 70 50 20 0.4
3 60 50 10 0.2
From Table above, we can see it is better to take
projects II & III together and forego project I.
ADVANTAGES AND DISADVANTAGES
OF PROFITABILITY INDEX
Advantages Disadvantages
Closely related to May lead to incorrect
NPV, generally decisions in
leading to identical comparisons of
decisions mutually exclusive
Easy to understand investments
and communicate
May be useful when
available investment
funds are limited
ALTERNATIVE DECISION RULES VS. 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.
CAPITAL BUDGETING IN PRACTICE
We should consider several investment criteria when
making decisions
NPV and IRR are the most commonly used
investment criterion
Payback is a second commonly used investment
criterion
VALUATION TECHNIQUE USAGE
SUMMARY – DISCOUNTED CASH
FLOW CRITERIA
Net present value
Difference between market value and cost
Take the project if the NPV is positive
Has no serious problems
Preferred decision criterion
Internal rate of return
Discount rate that makes NPV = 0
Take the project if the IRR is greater than the
required return
Same decision as NPV with conventional cash flows
IRR is unreliable with nonconventional cash flows or
mutually exclusive projects
SUMMARY – PAYBACK CRITERIA
Payback period
Length of time until initial investment is recovered
Take the project if it pays back within some specified
period
Doesn’t account for time value of money, and there is an
arbitrary cutoff period
Profitability Index
Benefit-cost ratio
Take investment with highest PI
Cannot be used to rank mutually exclusive projects
May be used to rank projects in the presence of capital
rationing
REVISION EXERCISES
1. Premium Manufacturing Company is evaluating two
forklift systems to use in its plant that produces the
towers for a windmill power farm. The costs and the
cash flows from these systems are shown below. If
the company uses a 12% discount rate for all
projects, determine which forklift system should be
purchased using the net present value (NPV)
approach.
REVISION EXERCISES (CONT’D)
2. A firm has two capital projects, A and B, which are
under review for funding. Both projects cost $500,
and the projects have the following cash flows:
What is the payback period for each project? Which
project should management accept if the firm’s
payback cutoff point is two years?
REVISION EXERCISES (CONT’D)
3. A firm has a capital budget of $30,000 and is
considering three possible independent projects.
Project A has a present outlay of $12,000 and
yields $4, 281 per annum for 5 years. Project B has
a present outlay of $10,000 and yields $4,184 per
annum for 5 years. Project C has a present outlay
of $17,000 and yields $5,802 per annum for 10
years. Calculate the NPV of each project using a
discount rate of 15%. Which project(s) would you
accept?
THE END
