Net Present Value and
Other Investment
Rules
Chapter # 5
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Learning Goals
1. Calculate, interpret, and evaluate various
Investment Rules.
2. Calculate, interpret, and evaluate the net
present value (NPV).
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Learning Goals (cont.)
3. Calculate, interpret, and evaluate the
internal rate of return (IRR).
4.Discuss NPV and IRR in terms of
conflicting rankings and the theoretical and
practical strengths of each approach.
5.Discuss Capital Rationing and Profitability
Index
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Investment Problem # 1
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Investment Problem # 1 (cont.)
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Investment Problem # 1
• Calculate Payback period
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Investment Problem # 1
• Calculate NPV
Decision Criteria
If NPV > 0, accept the project
If NPV < 0, reject the project
If NPV = 0, technically indifferent
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Net Present Value (NPV) (cont.)
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Net Present Value (NPV) (cont.)
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Net Present Value (NPV) (cont.)
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Investment Problem # 1
• Calculate IRR
• The IRR is the project’s intrinsic rate of return.
Decision Criteria
If IRR > k, accept the project
If IRR < k, reject the project
If IRR = k, technically indifferent
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Internal Rate of Return (IRR) (cont.)
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Internal Rate of Return (IRR) (cont.)
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Conflicting Between NPV vs IRR
• Conflicting rankings between two or more mutually
exclusive projects using NPV and IRR sometimes
occurs because of:
1. Differences in the timing and magnitude of cash flows.
2. Differences in the size of initial investment
3. Difference in the life of projects
• This underlying cause of conflicting rankings is the
implicit assumption concerning the reinvestment of
intermediate cash inflows—cash inflows received prior
to the termination of the project.
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1. Timing Problem
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1. Timing Problem
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1. Timing Problem - Solution
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2. Size Problem
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2. Size Problem - Solution
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3. Life Problem
Example:
• Two mutually exclusive projects with unequal lives, and
have 10% required rate of return
• Projects’ NPV:
Project S = $28.93 vs. Project L = $35.66
Projects’ IRR: Gi
20
Project S = 29% vs. Project L = 25%
3. Life Problem – Solution 1
• For Least common multiple approach, extend the analysis
time horizon so that the life of both projects will divide exactly
into the horizon
• Project’s New NPV:
Project S = $72.59 vs. Project L = $62.45 21
3. Life Problem - Solution 2
• For an investment project with an outlay and variable
future cash flows in future, the project NPV summarizes
the equivalent value at time zero. For this same project,
the EAA or ANPV is the annuity payment (series of
equal annual payments over the project’s life) that is
equivalent in value to the NPV.
1. Calculate the NPV of each project over its live using the
appropriate cost of capital.
2. Divide the NPV of each positive NPV project by the PVIFA at
the given cost of capital and the project’s live to get the
EAA/ANPV for each project.
3. Select the project with the highest EAA/ANPV.
22
3. Life Problem – Solution 2
• Projects’ NPV:
Project S = $28.93 vs. Project L = $35.66
• Required rate of return = 10%
NPV
EAA/ANPV =
annuity factor
• Projects’ EAA/ANPV:
23
Project S = $16.66 vs. Project L = $14.34
4. Reinvestment Rate
• NPV assumes intermediate cash flows are reinvested at
the cost of capital, while IRR assumes that they are
reinvested at the IRR.
A project requiring a $170,000 initial investment is
expected to provide cash inflows of $52,000, $78,000
and $100,000. The NPV of the project at 10% is
$16,867 and it’s IRR is 15%. Table 9.5 on the following
slide demonstrates the calculation of the project’s future
value at the end of it’s 3-year life, assuming both a 10%
(cost of capital) and 15% (IRR) interest rate.
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4. Reinvestment Rate (cont.)
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4. Reinvestment Rate (cont.)
If the future value in each case in Table 9.5 were
viewed as the return received 3 years from today from
the $170,000 investment, then the cash flows would be
those given in Table 9.6 on the following slide.
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4. Reinvestment Rate (cont.)
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Which Approach is Better?
• A project with positive NPV will always have an IRR greater than
Cost of capital
• On a purely theoretical basis, NPV is the better approach because:
– Certain mathematical properties may cause a project with non-
conventional cash flows to have zero or more than one real IRR.
– Decision rule for IRR change if a project is a financing project
• Despite its theoretical superiority, however, financial managers
prefer to use the IRR because of the preference for rates of return.
• Moreover, NPV requires an estimate of the cost of capital which
itself is a cumbersome task and requires many assumptions. IRR
can be calculated without a prior estimate of the cost of capital
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What if Capital is Scarce? Capital
Rationing
• When resources are limited, the Profitability index (PI)
provides a tool for selecting among various project
combinations and alternatives
• A set of limited resources and projects can yield various
combinations.
• The highest weighted average PI can indicate which
projects to select.
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Profitability Index
Example
We only have $300,000 to invest. Which do we
select?
Proj PV of CF Investment PI
A 230,000 200,000 1.15
B 141,250 125,000 1.13
C 194,250 175,000 1.11
D 162,000 150,000 1.08
Profitability Index
Example - continued
Proj PV (CF) Investment PI
A 230,000 200,000 1.15
B 141,250 125,000 1.13
C 194,250 175,000 1.11
D 162,000 150,000 1.08
Select projects with highest Weighted Avg PI
WAPI (BD) = 1.13(125) + 1.08(150) + 0.0 (25)
(300) (300) (300)
= 1.01
Profitability Index
Example - continued
Proj PV (CF) Investment PI
A 230,000 200,000 1.15
B 141,250 125,000 1.13
C 194,250 175,000 1.11
D 162,000 150,000 1.08
Select projects with highest Weighted Avg PI
WAPI (BD) = 1.01
WAPI (A) = 0.77
WAPI (BC) = 1.12
