MBAC 6060

Chapter 5
Net Present Value &
Other Investment Rules

1
Capital Budgeting is…
• Budgeting the firm’s capital
• Spending the big money
– Not small, short-term money
The light bill, salaries, office supplies…
• But BIG, long-term money
– These are called Capital Expenditures
• So if a firms sells stocks, sells bonds, retains
earnings…
• What does it do with the money?

2
Here’s the idea:
• The CAPITAL BUDGETING DECISION is about
ADDING VALUE to the firm
• To pay for capital investments, a firm can
sell stocks, sell bonds or retain earnings…
• But SHOULD a firm sell stocks, sell bonds or
retain earnings?
– Does it have something WORTHWILE to do with the
money?
– Does it have GOOD CAPITAL PROJECTS?
– Does the proposed project ADD VALUE?
• If the proposed project does not add value…
– Then DON’T sell stocks, DON’T sell bonds, DON’T
retain earnings
– Instead the firm should PAY DIVIDENS
3
Net Present Value
• So how do we know if a proposed project Adds Value?
• We calculate the proposed project’s Net Present Value
• Called NPV

Here’s how NPV analysis works:

• The decision rule:
– If the Net Present Value is POSITIVE
– Then the project Adds Value
– So the company should Invest the Capital
( or Budget the Capital)

4
Net Present Value is
1. The PV of all the project’s future cash flows…
– CF1, CF2, CF3,…
2. Discounted at the Proper discount rate (R)…
– A higher discount rate for riskier projects
– A lower discount rate for less risky projects
3. Plus the initial (time 0) cash flow...
– CF0 is the Initial Cost of the project
– CF0 is usually an outflow, so it is usually negative

• If the PV of the future CFs is greater than the cost:

• Then the NPV > 0 and the project Adds Value!
– If the company can Spend $100 today
– For something Worth $110 (in PV terms – so also “today”)
– The do the project!

5
How to think about NPV
• Think about paying $1,000 today for “something”
– A bond, an annuity, a truck, a machine…
• Assume that “something” will pay a net of $400 per year
for the next 3 years
• Also assume the proper discount rate is 10%
• So pay $1,000 now for $400 at time 1, 2 and 3.
– Is it a good deal?
– First we have to get all the CFs to the same time period
– we will use time zero
– So take the PV of all the CFs
– Since all CFs are the same, use the TVM function:
N = 3 R = 10% PMT = $400 PV = $995

• So pay $1,000 today to get CFs that are worth only $995
• We would be losing $5 in present value terms
• NPV = -$5  So don’t do it!
6
Review Question:
• A project costs $100,000 today (buy a truck)
• The project will have Net CFs of $18,000 per
year
for 10 years
– $18,000 is CASH IN (revenues) less CASH OUT
(expenses)
for each of the next 10 years
• The proper discount rate is 10%
• Calculate the project’s Net Present Value:
• Hint: First calculate the PV of $18k per year
for 10 years discounted at 10%
7
Review Answer:
• A project costs $100,000 today (buy a truck) and has CFs of
$18,000 per year for 10 years
• The proper discount rate is 10%.
• NPV = Initial CF + PV of Future CFs
• PV of Future CFs:
N = 10 R = 10% PMT = 18,000 PV = $110,602
• Initial CF = -100,000
• NPV = – $100,000 + $110,602 = $10,602

• So the firm can pay $100,000 for truck that will earn
(in PV terms) $110,602
• So the firm can trade $100,000 for $110,602
• This adds $10,602 of value to the firm!
• Why don’t firm’s do this all the time? They do.
8
Chapter Outline:
5.1 Net Present Value (Calculate and Interpret)
5.2 Payback Rule
5.3 Discounted Payback Rule (skip this)
5.4 Internal Rate of Return (IRR)
5.5 Problems with IRR
5.6 Profitability Index
5.7 The Practice of Capital Budgeting

Not in the Text:

Positive Cash Flows and The Burn Rate
– Used mostly for start-ups
– Similar to Debt Service Rules: Will the firm generate enough
revenue to pay interest expense?
9
5.1 Net Present Value
An NPV Example:
A new product line will cost $165k today
 Buy a machine for $165k
 This is a cash OUTFLOW (“cost”); CF0 = -$165,000
 Earn CF1 = $63,120; CF2 = $70,800; CF3 = $91,080
0 1 2 3

-$165,000 $63,120 $70,800 $91,080

 The proper discount rate is 12%

 Why 12%? Because of the project’s risk.
So should we do the project?
 Does the project add value to the firm?
 Is the PV of all the projects future CFs greater than its cost?
 Does the project have positive NPV?
10
These are synonyms!
Example Continued:
CF0 = -$165,000;
CF1 = $63,120; CF2 = $70,800; CF3 = $91,080
R = 12%

NPV = CF0 + CF1/(1 + R) + CF2/(1 + R)2 + CF3/(1 + R)3

= -$165 + $63.12/(1.12) + $70.80/(1.12)2 + $91.08 /(1.12)3
= -$165 + $177.63 = $12.63

• NPV > 0 so Do the Project (or commit the firm’s capital)

• Why?
– Because the present value of the project’s future cash flows is
greater than it’s cost ($165 < $177.63)
– Firm trades $165 today for future CFs worth $177.63 (in today’s
terms)
– So the project increases the firm’s value by $12.63
• CFs in today’s terms are called Discounted Cash Flows or DCFs
11
New Example:
• A new product line will cost $30k today
• Revenues will be $20k per year for 8 years
• Costs will be $14k per year for 8 years.
• At the end of year 8, we can sell the machines
for $2k (call this the “salvage value”)
• The proper discount rate is 15%
• Should we do the project?
– Does it have positive NPV?
– Is the PV of all the future CFs greater than the cost?
– Are the DCFs greater then the cost?
– Does it add value to the firm?
12
CF0 = -$30; CF1 to CF7 = $6; CF8 = $8; R = 15%
NPV = CF0 + PV(CF1 through CF8)
NPV = CF0 + CF1/(1+R) + CF2/(1+R)2 + CF3/(1+R)3 + … + CF8/(1+R)8
NPV = -$30 + $27.58 = -$2.42
NPV < 0 so don’t do the project
Don’t trade $30k for $27.58k

Let’s see how to do this in Excel

13
How to Calculate NPV in Excel:

THE EXCEL NPV FUNCTION

DOES NOT CALCULATE NPV!
• NPV = CF0 + PV(CF1 through CFN)
• The Excel NPV function calculates PV(CF1 through CFN)
• It assumes the first entered CF occurs at time 1
not time 0
• So you must add the CF at time zero to the values
calculated by the NPV formula

14
Example
• Recall the R = 15% and CF0 = -30, CF1 to CF7 = 6, CF8 = 8
A B C D E F G H I
1 0 1 2 3 4 5 6 7 8
2 -$30 $6 $6 $6 $6 $6 $6 $6 $8
3
4 Rate 15%
5 NPV =A2+NPV(B4,B2:I2)

A B C D E F G H I
1 0 1 2 3 4 5 6 7 8
2 -$30 $6 $6 $6 $6 $6 $6 $6 $8
3
4 Rate 15%
5 NPV -2.42
15
Example Continued:
What if the discount rate is 10% instead of 15%.
• Just change R to 10% and NPV = 2.94 > 0
• Now NPV > 0, so the project does add value

Why would R be 10% instead of 15%?

• So it costs the firm less raise capital. Why?
– For now think of this as the cost of borrowing
• So why does it cost less to borrow?
Two reasons:
1. Maybe it is a less-risky project:
– Before Office Furniture Manufacturer CFs
– Now Toilet Paper CFs
– So risk is lower
2. The general cost of capital in the economy is higher
– If interest rates go down, the firm’s cost of capital (R) goes down
– Think about supply and demand of money available to borrow
– What happens when the Fed eases? Tightens?
16
Example Continued:
• Note that since the CFs are the same for times 1
though 7
• We can calculate the NPV using the PV function
too:
• =CF0 + -PV(rate, nper, pmt, [fv], [type])
• =-30-PV(.15,8,6,2) = -2.42

• Note that the payments of $6 last 8 periods

• And the final $8 payment at time 8 is achieved
by using a $2 FV

17
Review Question:
• A project costs $3,000 today
• It will have positive CFs of $600 per year for 10 years.
• In addition, it will cost $200 to clean up the mess caused
by the project at time 10
• The proper discount rate is 10%.
• Calculate the project’s NPV:

18
Review Answer:
• Costs $3,000 so CF0 = -$3,000
• Pays $600 10 times but costs $200 at time 10
• So CF1 through CF9 = $600 and CF10 = $600 - $200 = $400

In Excel:
=–3000+NPV(.10,600,600,…,600,400) = 609.63
Be sure to type (or reference) $600 nine times

So pay $3,000 today for DCFs worth $3,609.63

So the NET Present Value (or NPV) = $609.63

Extra Question:
What if the discount rate increases to 15%
NPV at 15% = -$38.18

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Consider NPV as a Decision Rule:
1. The NPV rule accounts for the time value of money
• Further out CFs are discounted by a greater amount
• (1 + R)2 vs. (1 + R)10
2. The NPV rule accounts for the risk of the cash flows
• The greater the risk, the greater the cost of the company’s
capital
• You want to make yachts? Give me 145% on my loan.
• You want to make toilet paper? I’ll take 10% on my loan.
• The cost of the firm’s capital is the discount rate (R)
• The greater the R, the smaller the NPV
3. NPV measures the increase in value from undertaking
the project
• If we have two mutually exclusive projects
• Select the one with the higher NPV
• Since it adds more value to the firm
20
Other Rules:
• Are there other ways to determine if we
should go ahead with a project?
• NO!
• But we’ll look at some other common rules
anyway and try to see why they are
flawed.
• The Payback Period Rule
• Internal Rate of Return
• Profitability Index
21
5.2 The Payback Period Rule
• Count the number of years it takes to recoup the initial
investment
• If the number of years is fewer than the required
years, accept.

• Disadvantages:
– Ignores the time value of money
– Ignores cash flows after the payback period
– Biased against long-term projects
– Requires an arbitrary acceptance criteria
– A project accepted based on the payback criteria may not have a
positive NPV
• Advantages:
– It is Easy
– Biased toward liquidity
22
Payback Period Example:
• CF0 = -$165,000; CF1 = $63,120; CF2 = $70,800; CF3 = $91,080
• Year 1: $165,000 – $63,120 = $101,880 (cost not yet recovered)
• Year 2: $101,880 – $70,800 = $31,080 (cost not yet recovered)
• Year 3: $31,080 – $91,080 = -$60,000 (recovered during year 3)

• Payback Period = 2 yrs + Portion of next year needed to get the rest
2 + $31,080 / $91,080 = 2 + 0.34 = 2.34 years
• If required payback period is 2 years, reject the project.
• If required payback period is 3 years, accept the project.

23
One More Payback Period Example
• Assume a 2 year payback requirement
Year Long Short 1 Short 2
0 -250 -250 -250
1 100 100 200
2 100 200 100
3 100
4 100
Payback Period 2.5 1.75 1.50
NPV @ 13% $47.45 ($4.88) $5.31

• The Payback rule does not distinguish between Short 1

and Short 2 since both payback less than 2
• Also, according to the Payback Rule, Short 2 is preferred
to Long
– Even though NPVLong > NPVShort 2 24
Review Question:
Calculate the Payback Period for each project:

Year Project 1 Project 2 Project 3

0 -$500 -$500 -$500
1 $200 $100 $0
2 $200 $100 $0
3 $200 $100 $0
4 $200 $100 $2,000

25
Review Answer:
Project 1: $500 = $200 + $200 + .5($200)  2.50 Years
Project 2: $500 > 4($100)  NEVER
Project 3: $500 = $0 + $0 + $0 + .25($2,000)  3.25 Years

Bonus Question: Calculate the NPV at 10%

Year Project 1 Project 2 Project 3

0 -$500 -$500 -$500

1 $200 $100 $0
2 $200 $100 $0
3 $200 $100 $0
4 $200 $100 $2,000
NPV @ 10% $134 -$183 $866

26
Consider Payback Period as a Decision Rule:
• The Payback rule does not account for the time value of
money
• With a 2 year rule, CF1 and CF2 are the same
• The Payback rule does not account for the risk of the
cash flows
• High risk projects and low risk projects are the same
• Payback rule gives no indication of the project’s value.
• If we have two mutually exclusive projects
• Select the one with the shorter payback period
• Since it adds more value to the firm
• Consider “Long” and Short 2 from the previous page:
Long Short 2
Payback Period 2.50 1.50
NPV at 13% 47.45 5.31

• Long adds more value but has the longer Payback period

27
Consider Payback Period as a Decision Rule:

Implicitly, the payback rule uses:

• R=0
– For all CFs prior to the Payback Period
– No discounting

• R = Infinity
– For all CFs after the Payback Period
– Since they are not considered

28
5.3 The Discounted Payback Period
• How long does it take the project to “pay back”
its initial investment, taking the time value of
money into account?
• Decision rule: Accept the project if it pays back
on a discounted basis within the specified time.
• By the time you have discounted the cash flows,
you might as well calculate the NPV.
• So we’ll skip this rule

29
5.4 Internal Rate of Return (IRR)
• IRR is the discount rate that sets NPV to zero
NPV = CF0 + CF1/(1 + R) + … + CFN/(1 + R)N

• What R do I plug in to make NPV = 0?

0 = NPV = CF0 + CF1/(1 + IRR) + … + CFN/(1 + IRR) N

• Minimum Acceptance Criteria:

• Accept if the IRR exceeds the required return
• What is the required return?
• Ranking Criteria for Mutually Exclusive Projects:
• Select alternative with the highest IRR
• Why would projects be mutually exclusive?
• Resource limitations
30
Internal Rate of Return (IRR) Example

CF0 = -$100; CF1 = $60; CF2 = $60

• So this project costs $100 and pays $60 twice
• Calculate the IRR for the project:
• First we’ll estimate the IRR:
NPV = CF0 + CF1/(1 + R) + CF2/(1 + R)2
R = 12%  NPV = -$100 + $60/1.12 + $60/1.122 = $1.40
R = 14%  NPV = -$100 + $60/1.14 + $60/1.142 = -$1.20
So the IRR must be between 12% and 14%

R = 13%  NPV = -$100 + $60/1.13 + $60/1.132 = $0.09

So IRR is close to 13%
– A little larger discount rate will decrease NPV to zero
31
Calculating IRR in Excel
• CF0 = -$100; CF1 = $60; CF2 = $60
A B C D E
1 CF0 -100
2 CF1 60
3 CF2 60
4 IRR =IRR(values, [guess])

A B C D E
1 CF0 -100
2 CF1 60
3 CF2 60
4 IRR 13.07%

NPV = -$100 + $60/1.1307 + $60/1.13072 = 0

So the IRR = 13.07% 32
The IRR Decision Rule
(Or How to Interpret IRR)

If the required rate is greater than the IRR

• Then NPV < 0  Reject the project

If the required rate is less than the than the IRR

• Then NPV > 0  Accept the project

For this Example, since IRR = 13.07%:

• If R = 12%, Accept since it adds value
• If R = 14%, Reject since it does not add value

33
Graph of NPV and R:
• When NPV = 0, R = IRR. This happens at R = 13.07%
• If the Required Rate (the Hurdle Rate) < IRR, then accept since NPV > 0
• If the Required rate is 12%, accept. If it is 14%, reject.

$20.00

$15.00

$10.00 IRR = 13.07%

$5.00

$0.00
NPV

0% 5% 10% 15% 20% 25% 30% 35%

-$5.00
R (Discount Rate)
-$10.00

-$15.00

-$20.00

-$25.00 34
Review Question:
• A project costs $5,000 today
• It will have positive CFs of $800 per year
for 10 years.
• Calculate the project’s IRR

35
Review Answer:
• Note that since all the CFS are the same you
can use the Excel Rate Function
NPER = 10, PMT = 800, PV = -5000
=RATE(nper, pmt, pv, [fv], type])
=RATE(10,800,-5000) = 9.61%
• Or you can enter the values in cells and use the IRR
function

Extra Question:
• What is the NPV of these CF at 9.61%?
• The NPV is $0.00.
• The IRR is the discount rate that sets NPV = 0
36
5.5 Problems with IRR:
Irregular Cash Flows that change signs (more than once):
 A mining project costs $90
 It pays $132 in year 1 and $100 in year 2
 Clean up costs in year 3 are $150
 CF0 = -$90, CF1 = $132, CF2 = $100, CF3 = -$150
5%  NPV = -$90 + $132/1.05 + $100/1.052 - $150/1.053 = -$3.16
25%  NPV = -$90 + $132/1.25 + $100/1.252 - $150/1.253 = $2.80
50%  NPV = -$90 + $132/1.5 + $100/1.52 - $150/1.53 = -$2.00

• At very low discount rates (5%):

$132 + $100 = $232 inflows do not compensate for the $90 + $150 = $240
outflows
• At very high discount rates (50%):
$150 outflow year 3 is not as important relative to the inflows at times 1
and 2

If the CFs are not regular, the IRR rule may not work 
37
Example with Irregular CFs
CF0 = -$90, CF1 = $132, CF2 = $100, CF3 = -$150
A B C D E F G H I
1 CF0 -90 Guess 10%
2 CF1 132
3 CF2 100
4 CF3 -150
5 NPV =IRR(B1:B4,E1) = 10.11%

A B C D E F G H I
1 CF0 -90 Guess 50%
2 CF1 132
3 CF2 100
4 CF3 -150
5 NPV =IRR(B1:B4,E1) = 42.66%
38
Graph of NPV and R for this Project:
• When NPV = 0, R = IRR. This happens at R = 10.11% and 42.66%
• If Required Rate < 42.66%, accept, but less than 10.11%, reject
• The IRR rule (if the required rate is less than IRR, accept) does not
work!

4.00

IRR =10.11% IRR = 42.66%

2.00

0.00
0% 10% 20% 30% 40% 50% 60%
-2.00 R (Discount Rate)
NPV

-4.00

-6.00

-8.00

39
-10.00
Another Problem with IRR:
• Mutually Exclusive Projects:
• Both require the same factory or land or HR or…
Project A Project B
CF0 -500 -400
CF1 325 325
CF2 325 200

• Assume a 10% required return for both projects

• Calculate the IRR for both Projects
• IRRA = 19.43% > 10% so accept
• IRRB = 22.18% >10% so accept
• But we cant accept both!
So which one? 
40
Mutually Exclusive Projects (continued):
• At 10% IRRA = 19.43% and IRRB = 22.18%
• So which do we accept?
• Calculate the NPV of each project at 10%:
NPVA = $64.05
NPVB = $60.74
NPVA > NPVB so accept A
• What if the required rate is 15%? Calculate the
NPV of each project at 15%
NPVA = $28.36
NPVB = $33.84
NPVB > NPVA so accept B

What do the graphs of these two projects look like? 

41
Graph of Projects A and B:
• At 15%, Project B is better. At 10%, Project A is better.
150.00

Cross Over Point:

R = 11.80%
100.00 Project A
Project B

50.00
IRR = 22.18%
NPV

0.00
0% 5% 10% 15% 20% 25% 30%
R (Discount Rate)
IRR =19.43%
-50.00

-100.00
42
How to find Cross Over Point:
Calculate the IRR of the differences in the CFs:

Project A Project B A–B

CF0 -500 -400 -100
CF1 325 325 0
CF2 325 200 125

IRR of (A – B) = 11.80%
– This also works for B – A as well. Try it.

43
5.6 The Profitability Index (PI)
Profitability Index = PV/Cost

For Project A at 15%:

• PV = $325/1.15 + $325/1.152 = $528.36
• Cost = $500
• PI = $528.36/$500 = 1.06
Rule: If PI > 1 then accept the project
IF PI > 1, then PV > Cost so it must mean the NPV > 0

For Project A at 25%:

• PV = $325/1.25 + $325/1.252 = $468.00
• Cost = $500
• PI = $468.00/$500 = 0.94
Rule: If PI < 1 then reject the project
IF PI < 1, then PV < Cost so it must mean the NPV < 0

Almost identical decisions to NPV

The problem is with mutually exclusive projects 

44
Problem with PI:
Mutually Exclusive Projects: Consider projects A and B again:

Project A Project B
CF0 -500 -400
CF1 325 325
CF2 325 200

• Now look at the NPV & PI for each project at different discount rates:
Project A Project B
R Cost PV NPV PI Cost PV NPV PI
5% 500 604 104 1.21 400 491 91 1.23
10% 500 564 64 1.13 400 461 61 1.15
15% 500 528 28 1.06 400 434 34 1.08
20% 500 497 -3 0.99 400 410 10 1.02
25% 500 468 -32 0.94 400 388 -12 0.97
30% 500 442 -58 0.88 400 368 -32 0.92

• At 5% and 10%, A adds more value (NPVA > NPVB) so choose A

• But PIB > PIB 5% and 10%. The PI rule leads to the wrong decision.45
5.7 The Practice of Capital Budgeting
• Capital Budgeting leads to Capital Expenditures
• Called “Capex”
• Accumulated Capex across all firms is a large
component of the “Investments” part of GPD:
• GDP = C + I + G + (X - M)

46
5.7 The Practice of Capital Budgeting
What do firms use? (Table 5.3, page 157)

47
5.7 The Practice of Capital Budgeting
What do firms use? (Table 5.4, page 158)
• Firms Asked frequency of use: 0 = Never, 4 = Always

48
Another Criteria:
– Not in the text but sort of related to Payback Period:
• How long until a Positive CF?
• Consider this Project:
– Pay $200 now and again every year for 4 more years
– Then get $400 for the 5 years after that.
– 10% discount rate
• Time Subscript Notation:
– CF0 through CF4 = -$200 and CF5 through CF9 = $400

• NPV = $201.69 > 0 so do the project

• BUT maybe you need a positive CF sooner than time 5
Why? 

49
The “How long until a Positive CF” Criteria
• Project NPV > 0, but doesn’t make money for 5 years
– If this a small project proposed by a big company
– Then maybe this not a problem
– Maybe a big company can finance a “negative CF” project for a
few years
• But if this is a STARTUP
• Investors may not be willing to wait that long
• The amount of cash a company loses each year
– And therefore needs to have replenished to do business the next
year
Is called it’s Burn Rate

50
Burn Rate
Think of it this way: Start a new company:
• Time 0: Buy computers, manufacturing equipment, hire
people
• 1st year: Don’t sell anything, but pay salaries
– So a negative CF
– That money must be supplied by owners or lenders
• 2st year: Sell a little, still pay salaries
– So still a negative CF
– So need more money to get through year 2
• Keeps happening until a year’s CF is greater then zero
• Now the firm (or project?) has generated enough cash to
cover that year’s expenses
51
Burn Rate
1 2 3 4 5 6
Inflows 0 $100 $200 $300 $800 $900
Outflows -$500 -$500 -$600 -$650 -$700 -$750
CF -$500 -$400 -$400 -$350 $100 $150

• In Years 1 through 4, the company needs additional

money to continue operations
• The company produces a positive CF in year 5
• This means that it brought in enough cash to fully pay for
that year’s outflows (expenses)
• It didn’t need an infusion to get through year 5

52
So where Do We Go From Here?
• We will spend a lot of time looking a capital budgeting decisions:
CF1 CF2 CFN
NPV  CF0     
1  R 1  R 2 1  R N
To do this we need to know two things:
1. How to calculate the correct cash flows to use each period:
The Numerators (CF0, CF1, …, CFN)
– We’ll need to calculate the net cash generated by a project
– lots of accounting
2. How to calculate the correct discount rate:
The denominators (R)
– Calculate risks and returns needed to determine R in general
– And then how to R for a specific company or project
• Along the way will learn a lot of finance terminology, history,
methodology…

53