Investment Decision

Rules

Chapter 7
Learning objectives
• Define the logic behind investment decisions

• Define various decision rules: net present value, payback period,

internal rate of return, profitability index

• Describe decision rules for each of the tools in objective 2, for

both stand-alone and mutually exclusive projects

• Given cash flows, compute the NPV, payback period, internal

rate of return, and profitability index for a given project, and the
incremental IRR for a pair of projects

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Learning objectives

• Compare each of the capital budgeting tools

above, and tell why NPV always gives the
correct decision

• Discuss various flaws of the other decision

rules: IRR and PI

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The logic behind the
investment decisions
• In order to invest, a firm needs to raise capital on the financial
markets

• To do so, the firm needs to offer the investors an expected return

comparable to the return they would earn elsewhere

• On an alternative investment with the same risk and time horizon!

• Such an expected return offered on the market is the cost of

capital of the firm

• We will see later how to compute it appropriately

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An alternative explanation for
the opportunity cost of capital
• The firm may have (internal) funds to invest. It can choose then
the best alternative between:

• Investing on the financial markets

• Investing in a operating project

• If the firm expects to earn a given return on the market

• on investments with the same risk/horizon…

• … then the firm should invest in the project only if its expected return
is higher (or at least no lower)!

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The logic behind the
investment decisions
• Investment decision rule: Invest in the project
if this earns at least the (correct) cost of capital

• Find a method that allows the firm to compare

the cash flows of a project with its cost of
capital

• Lecture 8: find the «correct» cost of capital

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NPV: definition / reminder

• The net present value (NPV) of a project or

investment is the difference between

• the present value of its benefits and

• the present value of its costs.

• Take care to “sign” the cash flows

NPV = PV (All project cash flows)

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The NPV Decision Rule

• When facing a stand-alone project, invest if

NPV > 0

• When making an investment decision, take the

alternative with the highest NPV

• Choosing this alternative is equivalent to

receiving its NPV in cash today

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NPV is like cash in the pocket

• Consider the following example: you have a

brilliant idea that requires €10 and yields
certain €12 in a year

• If the competitive market interest rate is 10%,

should we make this investment?

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NPV of investing in bitcoins
• NPV = −10 + 12/1.1 = 0.91 > 0, hence invest

• But what if you have no money?

• Since the payoff is certain, then there is no risk

involved. This implies two things:

• 10% is the risk-free rate of return!

• We can always (in theory!) borrow money on the competitive

market to invest

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Borrow all money
Today Cash In a year Cash
Borrow: +10.91 To repay (10% rate): −12.00
Invest: −10.00 Collect: +12.00
Net: 0.91 Net: 0.00

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Irrelevance of the funding
sources
• In the perfect world without taxes NPV does not depend on how
you finance the operation

Today Cash In a year Cash

Invest own money (E): +5.00 Retrieve the remainder: −6.50
Borrow from a bank (L): +5.00 To repay (10% rate): −5.50
Invest into project (A): −10.00 Project generates: +12.00

• NPV to the equity holder: −5 + 6.5 /1.1 = …

• This is also the reason for which the NPV of trading should be 0!

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The NPV and stock prices

• If a corporation invests in positive NPV

projects, these should add to the wealth of its
stakeholders

• Problem: what is the “correct” opportunity

cost?

• Since this is hard to obtain, we need

alternative rules to make decisions
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NPV and stand-alone projects

• Consider a take-it-or-leave-it investment

decision involving a single, stand-alone
project for Fredrick’s Feed and Farm (FFF)

• The project costs $250 million and is expected to

generate cash flows of $35 million per year,
starting at the end of the first year and lasting
forever

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Applying the NPV rule

• The NPV of the project is calculated as:

35
NPV = - 250 +
r
• The NPV is dependent on the discount rate

• The IRR is the return at which NPV = 0 (the solution of the

!" !"
equation): −250 + =0⇒𝑟= = 0.14 = 14%
# $"%

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NPV of FFF Project
• If FFF’s cost of capital is 10%, the NPV is $100 million, and they should
undertake the investment

• Whenever the cost of capital is below the IRR of 14%, the project has a
positive NPV, and you should undertake the investment

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The Internal Rate of Return
(IRR) Rule

• Take any investment where the IRR exceeds

the cost of capital

• Turn down any investment whose IRR is less

than the cost of capital

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Alternative rules versus 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, follow the NPV decision

rule

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The Internal Rate of Return
Rule
• The IRR Investment Rule will give the same answer as
the NPV rule in many, but not all, situations

• The are 6 situations in which the IRR conflicts with the

NPV:

• 3 pertain to stand alone projects

• 3 pertain to mutually exclusive projects

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The IRR/NPV Conflict
• Stand-alone • Mutually exclusive

• Delayed Investments • Scale differences

• Nonexistent IRR • Timing differences

• Multiple IRRs • Risk differences

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Example: applying the IRR
rule
• Delayed Investments

• Assume you have just retired as the CEO of a successful company.

A major publisher has offered you a book deal. The publisher will
pay you $1 million upfront if you agree to write a book about your
experiences. You estimate that it will take three years to write the
book. The time you spend writing will cause you to give up speaking
engagements amounting to $500,000 per year. You estimate your
opportunity cost to be 10%.

• Should you accept the deal?

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Example: applying the IRR
rule
• Delayed Investments

500, 000 500, 000 500, 000

NPV = 1,000,000 - - 2
- 3
= - $243,426
1.1 1.1 1.1

• Since the NPV is negative, the NPV rule

indicates you should reject the deal

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NPV of Star’s $1 million book
deal
• When the benefits of an investment occur before the
costs, the NPV is an increasing function of the
discount rate

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Example continued: multiple
IRRs
• Suppose you inform the publisher that it needs to
sweeten the deal before you will accept it. The
publisher offers you $550,000 advance and
$1,000,000 in four years when the book is
published

• Should you accept or reject the new offer?

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Example (cont’): multiple IRRs

• Multiple IRRs

• The cash flows would now look like:

• The NPV is calculated as:

500,000 500,000 500,000 1,000,000
𝑁𝑃𝑉 = 550,000 − − − +
1+𝑟 1+𝑟 ! 1+𝑟 " 1+𝑟 #

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Example continued: multiple
IRRs
• By setting the NPV equal to zero and solving for r,
we find the IRR. In this case, there are two IRRs:
7.164% and 33.673%!

• Because there is more than one IRR, the IRR rule

cannot be applied

• However…

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NPV of the book deal with
royalties

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Example continued: multiple
IRRs
• Between 7.164% and 33.673%, the book deal has
a negative NPV. Since your opportunity cost of
capital is 10%, you should reject the deal!

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Example continued: non-
existent IRR
• Finally, you can get the publisher to increase his
advance to $750,000, in addition to the $1 million
when the book is published in four years

• With these cash flows, no IRR exists; there is no

discount rate that makes NPV equal to zero

• No IRR exists because the NPV is positive for all values of

the discount rate. Thus the IRR rule cannot be used

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Example continued: non-
existent IRR

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Choosing between mutually
exclusive projects
• Mutually exclusive projects

• When you must choose only one project among several

possible projects, the choice is mutually exclusive

• NPV Rule

• Select the project with the highest NPV

• IRR Rule

• Selecting the project with the highest IRR may lead

to mistakes
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Mutually exclusive
investments: example

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Mutually exclusive
investments: example

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 Mutually exclusive
investments: example
• The projects differences:

• Scale (1 and 2)
Investment First year CF g r NPV IRR

Book store 300,000.00 63,000.00 3.00% 8.00% 960,000.00 24.00%

Coffee shop 400,000.00 80,000.00 3.00% 8.00% 1,200,000.00 23.00%

Music store 400,000.00 104,000.00 0.00% 8.00% 900,000.00

Electronic store 400,000.00 100,000.00 3.00% 11.00% 850,000.00

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Differences in scale

• If a project’s size is doubled, its NPV will

double. This is not the case with IRR

• Thus, the IRR rule cannot be used to compare

projects of different scales

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 Mutually exclusive
investments: example
• The projects differences:

• Timing of cash flows (2 and 3)

Investment First year CF g r NPV IRR

Book store 300,000.00 63,000.00 3.00% 8.00% 960,000.00

Coffee shop 400,000.00 80,000.00 3.00% 8.00% 1,200,000.00 23.00%

Music store 400,000.00 104,000.00 0.00% 8.00% 900,000.00 26.00%

Electronic store 400,000.00 100,000.00 3.00% 11.00% 850,000.00

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Timing of cash flows
• Another problem with the IRR is that it can be affected by
changing the timing of the cash flows, even when the scale is the
same

• IRR is a return, but the dollar value of earning a given return depends on
when the return is earned

• Consider again the coffee shop and the music store investment.
Both have the same initial scale and the same horizon

• The coffee shop has a lower IRR, but a higher NPV because its cash
flows are higher later in time

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Timing of cash flows
• Example:

• Project 1: invest 100 and collect 150 in a year, IRR = 50%

• Project 2: invest 100 and collect 759.38 in 5 years, IRR = 50%

• However, at 10% interest rate

• NPV(1) = 36.36

• NPV(2) = 371.51

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 Mutually exclusive
investments: example
• The projects differences:

• Riskiness (2 and 4)

Investment First year CF g r NPV IRR

Book store 300,000.00 63,000.00 3.00% 8.00% 960,000.00

Coffee shop 400,000.00 80,000.00 3.00% 8.00% 1,200,000.00 23.00%

Music store 400,000.00 104,000.00 0.00% 8.00% 900,000.00

Electronic store 400,000.00 100,000.00 3.00% 11.00% 850,000.00 28.00%

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A pitfall of the IRR rule
• An IRR that is attractive for a safe project need not to be
attractive for a riskier project: the IRR rule discard the
riskiness of the project!

• The higher cost of capital means a higher IRR is necessary

to make the project attractive

• Consider again the investment in the electronics store from

the example before. The IRR is higher than those of the
other investment opportunities, yet the NPV is the lowest

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 Mutually exclusive
investments: example
• The projects differences:

• Scale (1 and 2)

• Timing of cash flows (2 and 3)

• Riskiness
Investment First year CF
(2 and 4) g r NPV IRR

Book store 300,000.00 63,000.00 3.00% 8.00% 960,000.00 24.00%

Coffee shop 400,000.00 80,000.00 3.00% 8.00% 1,200,000.00 23.00%

Music store 400,000.00 104,000.00 0.00% 8.00% 900,000.00 26.00%

Electronic store 400,000.00 100,000.00 3.00% 11.00% 850,000.00 28.00%

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IRR Versus the NPV Rule

• While the IRR rule has shortcomings for making

investment decisions, the IRR itself remains useful

• IRR measures the average return of the investment

and the sensitivity of the NPV to any estimation error in
the cost of capital

• The difference between the cost of capital and the IRR

is the max estimation error in the cost of capital that
can exist without the original decision being altered

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The Payback Rule

• The payback period is the amount of time it takes to

recover or pay back the initial investment

• Rule: if the payback period is less than a pre-specified

length of time, you accept the project. Otherwise, you
reject the project

• The payback rule is used by many companies because of its

simplicity

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The Payback Rule: a simple
example
• 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
Cash Flow $25 $30 $35

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The Payback Rule: a simple
example
• Solution

• Payback A

• $80 ÷ $25 = 3.2 years

• Project B

• $120 ÷ $30 = 4.0 years

• Project C

• $150 ÷ $35 = 4.29 years

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The Payback Rule: pitfalls

• You may guess them by yourself already…

• Ignores the project’s cost of capital (i.e. risk) and

time value of money

• But to solve this, you can use the Discounted Payback

Rule

• Ignores cash flows after the payback period

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Project selection with resource
constraints
• Consider three possible projects with a $100
million budget constraint

• Possible Projects for a $100 Million Budget

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Profitability Index

• The profitability index can be used to identify

the optimal combination of projects to
undertake

• From previous slide, we can see it is better to take

projects II & III together and forego project I

Value Created NPV

Profitability Index = =
Resource Consumed Resource Consumed

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Profitability Index: an example

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Profitability Index: an example

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Shortcomings of the
Profitability Index
• In some situations the profitability Index does not give
an accurate answer

• Suppose that NetIT has an additional small project with a

NPV of only $120,000 that requires 3 engineers

• The profitability index in this case is 0.12/ 3 = 0.04, so this

project would appear at the bottom of the ranking. However,
3 of the 190 employees are not being used after the first four
projects are selected. As a result, it would make sense to
take on this project even though it would be ranked last

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Takeaways

• No investment decision making rule is perfect

• The mistake-proof rule is NPV

• But it is also the hardest to apply!

• Alternative rules include IRR, Payback,

Profitability index

• But they have their additional shortcomings

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