Chapter 5

Why Net Present

Value Leads to
Better Investment
Decisions Than
Other Criteria
Slides by
Matthew Will
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
 Topics Covered

• A Review of The Basics

– NPV and its Competitors
• The Payback Period
• The Book Rate of Return
• Internal Rate of Return
 NPV and Cash Transfers
• Every possible method for evaluating projects
impacts the flow of cash about the company
as follows.
Cash

Investment Investment
opportunity (real Firm Shareholder opportunities
asset) (financial assets)

Invest Alternative: Shareholders invest

pay dividend for themselves
to shareholders
 NPV and Value Creation
Consider a firm with cash of $1 million and other assets valued at $9 million.
It is considering a Project X which requires an investment of $1 million and
the present value of cash inflows from Project X is PV.
Should the firm accept Project X?

Assets Reject Project X Accept Project X

Cash 1 0
Other assets 9 9
Project X 0 PV
Total assets 10 9 + PV

Decision: Accept Project X if PV > 1, i.e., if NPV > 0.

 CFO Decision Tools
Survey Data on CFO Use of Investment Evaluation Techniques in USA

NPV, 75%

IRR, 76%

Payback, 57%

Book rate of
return, 20%

Profitability
Index, 12%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

SOURCE: Graham and Harvey, “The Theory and Practice of Finance: Evidence from the Field,”
Journal of Financial Economics 61 (2001), pp. 187-243.
 CFO Decision Tools
Survey Data on CFO Use of Investment Evaluation Techniques in India

NPV, 65%

IRR, 85%

Payback, 68%

Break-even, 58%

ARR, 35%

Profitability
Index, 35%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Source: Anand, M., 2002, “Corrporate Finance {ractoce in India: A Survey,” Vikalpa.
 Book Rate of Return
Book Rate of Return - Average book or accounting income
divided by average book value over project life. Also
called accounting rate of return.

book income
Book rate of return =
book assets

Managers rarely use this measurement to make decisions.

The components reflect tax and accounting figures, not
market values or cash flows. Book income is affected by
how accountants label some cash outlflows as capital
investments and others as operating expenses.
 Payback
• The payback period of a project is the number of
years it takes before the cumulative forecasted cash
flow equals the initial outlay.

• The payback rule says only accept projects that

“payback” in the desired time frame.

• This method is flawed, primarily because it ignores

later year cash flows and the present value of cash
flows.
 Payback
Example
Examine the three projects and note the mistake we
would make if we insisted on only taking projects
with a payback period of 2 years or less.

Payback
Project C0 C1 C2 C3 NPV@ 10%
Period
A - 2000 500 500 5000
B - 2000 500 1800 0
C - 2000 1800 500 0
 Payback
Example
Examine the three projects and note the mistake we
would make if we insisted on only taking projects
with a payback period of 2 years or less.

Payback
Project C0 C1 C2 C3 NPV@ 10%
Period
A - 2000 500 500 5000 3 + 2,624
B - 2000 500 1800 0 2 - 58
C - 2000 1800 500 0 2 + 50
 Problems with the Payback Period
• Cash flows after the cut-off date is ignored
• Gives equal weight to all cash flows before the
cut-off date (does not take time value of
money into consideration).
• One way to get over the time value is to use
the discounted payback rule. But then it
begins to look more like NPV but instead of
value creation, the point of interest is time to
get to positive NPV.
 Discounted Payback
Payback
Project C0 C1 C2 C3 NPV@ 10%
Period
A - 2000 500/1.1 500/(1.1) 2 5000/(1.1)3 3 + 2,624
455 413 3,757
B - 2000 500/(1.1) 1800/(1.1) 2 0 - - 58
455 1,488

Discounted payback does not take into account the cash flows
beyond the payback period.
Also projects that are positive NPV like Project A would still be rejected if the cut
off for payback is 2 years.

Despite these drawbacks, Payback Period is still popular.

Why? It is simple and can be implemented by non-finance managers. Also, it is
Easy to evaluate managerial decisions since the management can check if the
expected cash flows came within the payback period.

Usually decisions relying on payback is used for short term projects and so the
time value of money is less important.
 Internal Rate of Return (IRR)
IRR is the discount rate that sets the NPV =0

Example
You can purchase a turbo powered machine tool
gadget for $4,000. The investment will generate
$2,000 and $4,000 in cash flows for two years,
respectively. What is the IRR on this investment?
 Internal Rate of Return
Example
You can purchase a turbo powered machine tool gadget for $4,000. The
investment will generate $2,000 and $4,000 in cash flows for two years,
respectively. What is the IRR on this investment?

2 , 000 4 ,000
N P V = − 4 , 000 + + =0
(1 + IRR ) (1 + IRR )
1 2

IR R = 2 8 .0 8 %
 Internal Rate of Return
2500
2000
1500
IRR=28%
1000
NPV (,000s)

500
0
-500
10

20

30

40

50

60

70

80

90

0
10
-1000
-1500
-2000
Discount rate (%)
 IRR Decision Rule
• Accept project if IRR > opportunity cost.

• For projects with IRR > opportunity cost, the

NPV > 0.

• Thus, for most investment decisions, the IRR

rule and the NPV rule will give us the same
decision.
 Internal Rate of Return
Pitfall 1 - Lending or Borrowing?
• With some cash flows (as noted below) the NPV of the
project increases as the discount rate increases.
• This is contrary to the normal relationship between NPV and
discount rates.

Project C0 C1 IRR NPV @ 10 %

A − 1,000 + 1,500 + 50 % + 364
B + 1,000 − 1,500 + 50 % − 364
 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%
Figure 5.4 Multiple rates of return
 Internal Rate of Return

Pitfall 2 - Multiple Rates of Return

• It is possible to have a zero IRR and a positive NPV

Project C0 C1 C2 IRR NPV @10%

C + 1,000 + 3,000 + 2,500 None + 339
 Internal Rate of Return
Pitfall 3 - Mutually Exclusive Projects
• IRR sometimes ignores the magnitude of the project.
• The following two projects illustrate that problem.
Cash flows

Project C0 C1 IRR(%) NPV at 10%

D -10,000 +20,000 100% +8,182

E -20,000 +35,000 75% +11,818

In such situations, calculate the IRR on the incremental investment. If the

IRR on the incremental investment is greater than the opportunity cost,
Then it makes sense to proceed with the bigger project.
 Internal Rate of Return
Pitfall 3 - Mutually Exclusive Projects
• IRR sometimes ignores the magnitude of the project.
Cash flows
Project C0 C1 IRR(%) NPV at 10%
D -10,000 +20,000 100% +8,182
E -20,000 +35,000 75% +11,818
In such situations, calculate the IRR on the incremental investment. If
the IRR on the incremental investment is greater than the opportunity
cost, Then it makes sense to proceed with the bigger project.
Incremental cash flows
Project C0 C1 IRR(%) NPV at 10%
E-D -10,000 +15,000 50% +3,636
 IRR and different pattern of
cashflows over time…
Cash Flows
Project C0 C1 C2 C3 C4 C5 Etc IRR(%) NPV@10%
F -9000 +6,000 +5,000 +4,000 0 0 ….. 33% 3,592
G -9000 +1,800 +1,800 +1,800 +1,800 +1,800 …… 20% 9,000
 Internal Rate of Return
Pitfall 3 - Mutually Exclusive Projects
 Internal Rate of Return
Pitfall 4 - Term Structure Assumption
• We assume that discount rates are stable during
the term of the project.
• This assumption implies that all funds are
reinvested at the IRR.
• This is a false assumption.
 NPV and IRR

Project Cash flows (Rs. '000)

NPV
C0 C1 C2 C3 at 8% IRR (%)

A -9 2.9 4 5.4 1.4 15.58%

B -9000 2560 3540 4530 1.4 8.01%

 CFO Decision Tools
Survey Data on CFO Use of Investment Evaluation Techniques in USA

NPV, 75%

IRR, 76%

Payback, 57%

Book rate of
return, 20%

Profitability
Index, 12%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

SOURCE: Graham and Harvey, “The Theory and Practice of Finance: Evidence from the Field,”
Journal of Financial Economics 61 (2001), pp. 187-243.
 Practice Questions
• Questions 8, 12, 13