October 24, 2024

Chapter 5
Net Present Value and Other Investment Rules
Why Use NPV?
 That a dollar received in the future is worth less than a dollar received today. The
reason is that today’s dollar can be reinvested, yielding a greater amount in the future.
And we showed in Chapter 4 that the exact worth of a dollar to be received in the future
is its present value.
 Net Present Value (NPV): The difference between the sum of the present values of the
project’s future cash flows and the initial cost of the project.

 The basic investment/NPV rule can be generalized to:

- Accept a project if the NPV is greater than zero.
- Reject a project if the NPV is less than zero.
 Why does the NPV rule lead to good decisions? Consider the following two strategies
available to the managers of Alpha Corporation:
1. Use $100 of corporate cash to invest in the project. The $107 will be paid as a
dividend in one year.
2. Forgo the project and pay the $100 of corporate cash to stockholders as a dividend
today
 If Strategy 2 is employed, the stockholder might deposit the cash dividend in a bank for
one year. With an interest rate of 2%, Strategy 2 would produce cash of $102 (= $100 ×
1.02) at the end of the year. The stockholder would prefer Strategy 1 because Strategy 2
produces less than $107 at the end of the year. Our basic point is:
Accepting positive NPV projects benefits the stockholders
  How do we interpret the exact NPV of $4.90? This is the increase in the value of the firm
from the project. Imagine that the firm today has productive assets worth $V and has
$100 of cash. If the firm forgoes the project, the value of the firm today would be:
$V + $100
 If the firm accepts the project, the firm will receive $107 in one year but will have no
cash today. The firm’s value today would be:

 The difference between these equations is $4.90, the net present value of Equation 5.1.
Thus: The value of the firm rises by the NPV of the project.
 Value Additivity: The contribution of any project to a firm’s value is the NPV of the
project. As we will see later, alternative methods discussed in this chapter do not
generally have this property.
 The NPV rule uses the correct discount rate.
 We assumed that the project was riskless, a rather implausible assumption. Suppose the
project is about as risky as the stock market as a whole, where the expected return this
year is perhaps 10%. Then 10% becomes the discount rate, implying that the NPV of the
project would be:

 Because the NPV is negative, the project should be rejected.

 Conceptually, the discount rate on a risky project is the return that one can expect to earn
on a financial asset of comparable risk
 This discount rate is often referred to as an opportunity cost because corporate investment
in the project takes away the stockholders’ option to invest the dividend in other
opportunities
 Conceptually, we should look for the expected return of investments with similar risks
available in the capital markets
 Having shown that NPV is a sensible approach, how can we tell whether alternative
methods are as good as NPV? The key to NPV is its three attributes:
1. NPV uses cash flows. Cash flows from a project can be used for other corporate
purposes (such as dividend payments, other capital budgeting projects, or payments
of corporate interest). By contrast, earnings are an artificial construct. Although
earnings are useful to accountants, they should not be used in capital budgeting
because they do not represent cash.
2. NPV uses all the cash flows of the project. Other approaches ignore cash flows
beyond a particular date; beware of these approaches.
3. NPV discounts the cash flows properly. Other approaches may ignore the time value
of money when handling cash flows. Beware of these approaches, as well.

The Payback Period Method

Defining the Rule
 One alternative to NPV is the payback period.
 Here is how payback works: Consider a project with an initial investment of −$50,000.
Cash flows are $30,000, $20,000, and $10,000 in the first three years, respectively. These
flows are illustrated in Figure 5.1. A useful way of writing investments like the preceding
is with the notation: (-$50,000, $30,000, $20,000, $10,000)
 The minus sign in front of the $50,000 reminds us that this is a cash outflow for the
investor, and the commas between the different numbers indicate that they are received—
or if they are cash outflows, that they are paid out—at different times

 The firm receives cash flows of $30,000 and $20,000 in the first two years, which add up
to the $50,000 original investment. This means that the firm has recovered its investment
within two years. In this case, two years is the payback period of the investment.
 Payback Period Rule: A project is acceptable if its calculated payback is less than a
prespecified number of years, say two years. All projects that have payback periods of
two years or less are accepted, and those that pay back in more than two years—if at all
—are rejected
Problems with the Payback Method

 Problem 1: Timing of Cash Flows within the Payback Period

- Let us compare Project A with Project B. In Years 1 through 3, the cash flows of
Project A rise from $20 to $50, while the cash flows of Project B fall from $50 to $20.
Because the large cash flow of $50 comes earlier with Project B, its net present value
must be higher. Nevertheless, we saw that the payback periods of the two projects are
identical.
 Problem 2: Payments after the Payback Period
 - Now consider Projects B and C, which have identical cash flows within the payback
period. However, Project C is clearly preferred because it has a cash flow of $100 in
the fourth year. Another problem with the payback method is that it ignores all cash
flows occurring after the payback period. Because of the short-term orientation of the
payback method, some valuable long-term projects are likely to be rejected.
 Problem 3: Arbitrary Standard for Payback Period
- Capital markets help us estimate the discount rate used in the NPV method. The
riskless rate, perhaps proxied by the yield on a U.S. Treasury instrument, would be
the appropriate rate for a riskless investment; a higher rate should be used for risky
projects.
The Internal Rate of Return
 Now we come to the most important alternative to the NPV method: the internal rate of
return (IRR)
 The basic rationale behind the IRR method is that it provides a single number that
summarizes the quality of a project
 This number does not depend on the interest rate prevailing in the capital market. That’s
why it’s called the internal rate of return: The number is internal or intrinsic to the project
and does not depend on anything except the cash flows of the project
 For example, consider the simple project (−$100, $110) in Figure 5.2. For a given rate,
the net present value of this project can be described as:

 Where r is the discount rate. What discount rate will make the NPV of the project equal
to zero? We begin by using an arbitrary discount rate of 8 percent, which yields:

 Because the NPV in this equation is positive, we now try a higher discount rate, such as
12 percent. This yields:

 Because the NPV in this equation is negative, we try lowering the discount rate to 10
percent. This yields:
  This trial-and-error procedure tells us that the NPV of the project is zero when r equals 10
percent. Thus, we say that 10% is the project’s internal rate of return (IRR).
 IRR: The interest rate that causes the NPV of the project to be zero
 The firm should be indifferent to the project if the discount rate is 10 percent.
 The firm should accept the project if the discount rate is below 10 percent.
 The firm should reject the project if the discount rate is above 10 percent.
 The general rule for using the IRR is: Accept the project if the IRR is greater than the
discount rate. Reject the project if the IRR is less than the discount rate.

 We refer to this as the basic IRR rule. Now we can try the more complicated example (−
$200, $100, $100, $100) in Figure 5.3. As we did previously, let’s use trial and error to
calculate the internal rate of return. We try 20% and 30%, yielding the following:

 After much more trial and error, we find that the NPV of the project is zero when the
discount rate is 23.38%, which is the IRR. With a 20% discount rate, the NPV is positive
and we would accept it. However, if the discount rate were 30%, we would reject it.
Algebraically, IRR is the unknown in the following equation:

Problems with the IRR Approach

Definition of Independent and Mutually Exclusive Projects
  Independent Project: One whose acceptance or rejection is independent of the
acceptance or rejection of other projects
 Mutually Exclusive Investments: You can accept A or you can accept B or you can
reject both, but you cannot accept both. For example, A might be a decision to build an
apartment house on a corner lot that you own, and B might be a decision to build a movie
theater on the same lot
Two General Problems Affecting both Independent and Mutually Exclusive Projects
 We begin our discussion with Project A, which has the following cash flows: (−
$100, $130)
 The IRR for Project A is 30%. Table 5.2 provides other relevant information about the
project. The NPV profile for this project is shown in Figure 5.5. As you can see, the NPV
declines as the discount rate rises.
 Project A is considered an investing type project because the firms pays out money (-
$100)
Problem 1: Investing or Financing?
 Now consider Project B, with cash flows of: ($100, -$130)
 These cash flows are exactly the reverse of the flows for Project A. In Project B, the firm
receives funds first and then pays out funds later.
 Project B is a financing type project because it initially receives money ($100)
  Graph B makes intuitive sense. Suppose the firm wants to obtain $100 immediately. It
can either (1) accept Project B or (2) borrow $100 from a bank. This project is actually a
substitute for borrowing. Because the IRR is 30%, taking on Project B is equivalent to
borrowing at 30%.
 If the firm can borrow from a bank at 25 percent, it should reject the project. However, if
a firm can borrow from a bank at 35 percent, it should accept the project. Project B will
be accepted if and only if the discount rate is above the IRR because that’s when the NPV
of the project is positive according to the graph in Figure 5.5
 This should be contrasted with Project A. If the firm has $100 cash to invest, it can either
(1) accept Project A or (2) lend $100 to the bank. The project is actually a substitute for
lending. Because the IRR is 30 percent, taking on Project A is equivalent to lending at 30
percent.
 The firm should accept Project A if the lending rate is below 30%. Conversely, the firm
should reject Project A if the lending rate is above 30% because that’s when the NPV of
the project is positive according to the graph in Figure 5.5
 Because the firm initially pays out money with Project A but initially receives money
with Project B, we refer to Project A as an investing type project and Project B as a
financing type project
Problem 2: Multiple Rates of Return
 Suppose the cash flows from a project are: (-$100, $230, -$132)
 Because this project has a negative cash flow, a positive cash flow, and another negative
cash flow, we say that the project’s cash flows exhibit two changes of sign, or “flip-
flops.”
 Although this pattern of cash flows might look a bit strange at first, many projects require
outflows of cash after some inflows
- An example would be a strip-mining project. The first stage in such a project is the
initial investment in excavating the mine. Profits from operating the mine are
 received in the second stage. The third stage involves a further investment to reclaim
the land and satisfy the requirements of environmental protection legislation. Cash
flows are negative at this stage.
 It is easy to verify that this project has not one but two IRRs, 10 percent and 20 percent.4
In a case like this, the IRR does not make sense. Which IRR are we to use — 10% or
20%? Because there is no good reason to use one over the other, IRR cannot be used
here.
 Why does this project have multiple rates of return? Project C generates multiple internal
rates of return because both an inflow and an outflow occur after the initial investment. In
general, these changes in sign produce multiple IRR
 In theory, a cash flow stream with X changes in sign can have up to X sensible
internal rates of return. Therefore, because Project C has two changes in sign, it can
have as many as two IRRs.
 In review, we can handle this example (or any mutually exclusive example) in one of
three ways:
 1. Compare the NPVs of the two choices. The NPV of the large-budget picture is greater
than the NPV of the small-budget picture. That is, $27 million is greater than $22
million.
2. Calculate the incremental NPV from making the large-budget picture instead of the
small-budget picture. Because the incremental NPV equals $5 million, we choose the
large-budget picture.
3. Compare the incremental IRR to the discount rate. Because the incremental IRR is
66.67 percent and the discount rate is 25 percent, we choose the large-budget picture.
The Timing Problem

 The NPV profiles for both projects appear in Figure 5.6. Project A has an NPV of $2,000
at a zero-discount rate. This is calculated by adding up the cash flows without discounting
them. Project B has an NPV of $4,000 at the zero-discount rate. However, the NPV of
Project B declines more rapidly as the discount rate increases than does the NPV of
Project A. As we mentioned, this occurs because the cash flows of B occur later. Both
projects have the same NPV at a discount rate of 10.55 percent. The IRR for a project is
the rate at which the NPV equals zero. Because the NPV of B declines more rapidly, B
actually has a lower IRR.
 As with the movie example, we can select the better project with one of three different
methods:
1. Compare NPVs of the two projects. Figure 5.6 aids our decision. If the discount rate is
below 10.55 percent, we should choose Project B because B has a higher NPV. If the
rate is above 10.55 percent, we should choose Project A because A has a higher NPV.
2. Compare incremental IRR to discount rate. Another way of determining whether A or
B is a better project is to subtract the cash flows of A from the cash flows of B and
then calculate the IRR. This is the incremental IRR approach. The incremental cash
flows are
  This chart shows that the incremental IRR is 10.55%. In other words, the NPV on the
incremental investment is zero when the discount rate is 10.55%. Thus, if the relevant
discount rate is below 10.55%, Project B is preferred to Project A. If the relevant discount
rate is above 10.55%, Project A is preferred to Project B.

 Figure 5.6 shows that the NPVs of the two projects are equal when the discount rate is
10.55%. In other words, the crossover rate in the figure is 10.55%. The incremental cash
flows chart shows that the incremental IRR is also 10.55%. It is not a coincidence that the
crossover rate and the incremental IRR are the same. The incremental IRR is the rate that
causes the incremental cash flows to have zero NPV. The incremental cash flows have
zero NPV when the two projects have the same NPV
3. Calculate NPV on incremental cash flows. Finally, we could calculate the NPV on the
incremental cash flows. The chart that appears with the previous method displays
these NPVs. We find that the incremental NPV is positive when the discount rate is
either 0 percent or 10 percent. The incremental NPV is negative if the discount rate is
15 percent. If the NPV is positive on the incremental flows, we should choose B. If
the NPV is negative, we should choose A.
 In summary, the same decision is reached whether we (1) compare the NPVs of the two
projects, (2) compare the incremental IRR to the relevant discount rate, or (3) examine
the NPV of the incremental cash flows. However, as mentioned earlier, we should not
compare the IRR of Project A with the IRR of Project B.
Concept Questions
 Suppose a project has conventional cash flows and a positive NPV. What do you know
about its IRR? Explain.
- If NPV is positive for a certain discount rate R, then it will be zero for some larger
discount rate R*; thus, the IRR must be greater than the required return.
 Define each of the following investment rules and discuss any potential shortcomings of
each. In your definition, state the criterion for accepting or rejecting independent projects
under each rule:
a) NPV
- NPV is the present value of a project’s cash flows, including the initial outlay. NPV
specifically measures, after considering the time value of money, the net increase or
decrease in firm wealth due to the project. The decision rule is to accept projects that
have a positive NPV, and reject projects with a negative NPV. NPV is superior to the
other methods of analysis presented in the text because it has no serious flaws. The
method unambiguously ranks mutually exclusive projects, and it can differentiate
between projects of different scale and with different time horizons. The only
drawback to NPV is that it relies on cash flow and discount rate values that are often
estimates and thus not certain, but this is a problem shared by the other performance
criteria as well. A project with NPV = $2,500 implies that the total shareholder wealth
of the firm will increase by $2,500 if the project is accepted
b) IRR
- The IRR is the discount rate that causes the NPV of a series of cash flows to be
identically zero. IRR can thus be interpreted as a financial break-even rate of return;
at the IRR discount rate, the net value of the project is zero. The acceptance and
rejection criteria are:
o If (initial investment or cash flow at time 0) C0 < 0 and all future cash flows
are positive, accept the project if the internal rate of return is greater than or
equal to the discount rate.
o If C0 < 0 and all future cash flows are positive, reject the project if the internal
rate of return is less than the discount rate.
o If C0 > 0 and all future cash flows are negative, accept the project if the
internal rate of return is less than or equal to the discount rate.
o If C0 > 0 and all future cash flows are negative, reject the project if the
internal rate of return is greater than the discount rate.
