Chapter 11 Net Present Value and Other Investment Criteria

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Good Decision Criteria

We need to ask ourselves the following questions when evaluating decision criteria
1. Does the decision rule adjust for the time value of money? 2. Does the decision rule adjust for risk? 3. Does the decision rule provide information on whether we are creating value for the firm?

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Net Present Value

The difference between the market value of a project and its cost How much value is created from undertaking an investment?
1. Estimate the expected future cash flows. 2. Estimate the required return for projects of this risk level. 3. The third step is to find the present value of the cash flows and subtract the initial investment.
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Net Present Value

0 1 2 3 4 5 |----------|----------|----------|----------|----------| -250 -100 -100 -100 -100 -100 +200 +200 +200 +200 +200 +100 +100 +100 +100 +100 If conventional CFs, 0 1 2 3 4 5 |----------|----------|----------|----------|----------| (-) (+) (+) (+) (+) (+)
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Net Present Value

Cn C1 C2 NPV C0 2 n 1 r 1 r 1 r

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NPV Decision Rule

If the NPV is positive, accept the project A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners. Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal.
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Project Example Information

You are looking at a new project and you have estimated the following cash flows:
Year 0: Year 1: Year 2: Year 3: CF = -165,000 CF = 63,120 CF = 70,800 CF = 91,080

Your required return for assets of this risk is 12%.

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Computing NPV for the Project

Using the formulas:
NPV = 63,120/(1.12) + 70,800/(1.12)2 + 91,080/(1.12)3 165,000 = 12,627.42

Do we accept or reject the project?

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Computing NPV for the Project

Using the calculator:
CF, 2nd [CLR WORK] CF0 = -165,000 ENTER C01 = 63,120 ENTER F01 = 1 C02 = 70,800 ENTER F02 = 1 C03 = 91,080 ENTER NPV, I = 12 ENTER CPT => 12,627.41

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Decision Criteria Test - NPV

Does the NPV rule account for the time value of money? Does the NPV rule account for the risk of the cash flows? Does the NPV rule provide an indication about the increase in value? NPV rule is our primary decision.

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IRR Definition and Decision Rule

Definition: the return that makes the NPV = 0

Cn C1 C2 NPV 0 C0 2 n 1 IRR 1 IRR 1 IRR

Decision Rule: Accept the project if the IRR is greater than the required return
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Computing IRR For The Project

This is a trial and error process Calculator
CF, 2nd [CLR WORK] CF0 = -165,000 ENTER C01 = 63,120 ENTER F01 = 1 C02 = 70,800 ENTER F02 = 1 C03 = 91,080 ENTER IRRCPT => 16.13

Do we accept or reject the project?

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NPV Profile For The Project

70,000 60,000 50,000 40,000

IRR = 16.13%

NPV

30,000 20,000 10,000 0 -10,000 0 -20,000 Discount Rate 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22

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Decision Criteria Test - IRR

Does the IRR rule account for the time value of money? Does the IRR rule account for the risk of the cash flows? Does the IRR rule provide an indication about the increase in value? Should we consider the IRR rule for our primary decision criteria?
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Advantages of IRR
Knowing a return is intuitively appealing (This is why it is often used in practice) It is a simple way to communicate the value of a project to someone who doesnt know all the estimation details It is based entirely on the estimated cash flows and is independent of interest rates found elsewhere If the IRR is high enough, you may not need to estimate a required return, which is often a difficult task
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NPV Vs. IRR

NPV and IRR will generally give us the same decision Exceptions
Non-conventional cash flows cash flow signs change more than once Mutually exclusive projects
Initial investments are substantially different Timing of cash flows is substantially different

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IRR and Non-conventional Cash Flows

When the cash flows change sign more than once, there could be more than one IRR When you solve for IRR you are solving for the root of an equation and when you cross the x-axis more than once, there will be more than one return that solves the equation If you have more than one IRR, which one California doState you use to make your decision? 2 - 17
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IRR Definition and Decision Rule

Definition: the return that makes the NPV = 0

Cn C1 C2 NPV 0 C0 2 n 1 IRR 1 IRR 1 IRR

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IRR and Non-conventional Cash Flows

If Non-conventional CFs, 0 1 2 3 4 5 |----------|----------|----------|----------|----------| (-) (+) (-) (+) (+) (-) Descartes Rule: There could be as many IRRs as there are sign changes.
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Non-conventional CFs Example

Suppose an investment will cost $90,000 initially and will generate the following cash flows:
Year 1: 132,000 Year 2: 100,000 Year 3: -150,000

The required return is 15%. Should we accept or reject the project?

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NPV Profile
$4,000.00 $2,000.00 $0.00

NPV

-$2,000.00 -$4,000.00 -$6,000.00 -$8,000.00 -$10,000.00

0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55

IRR = 10.11% and 42.66%

Discount Rate
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Summary of Decision Rules

The NPV is positive at a required return of 15%, so you should Accept If you use the financial calculator, you would get an IRR of 10.11% which would tell you to Reject You need to recognize that there are nonconventional cash flows and look at the NPV profile
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IRR and Mutually Exclusive Projects

Mutually exclusive projects
If you choose one, you cant choose the other Example: You can choose to attend graduate school next year at either Harvard or Stanford, but not both

Intuitively you would use the following decision rules:

NPV choose the project with the higher NPV IRR choose the project with the higher IRR
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Example: Mutually Exclusive Projects

Period 0 1 2 IRR NPV
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Project A Project B -500 325 325 19.43% 64.05 -400 325 200 22.17% 60.74

The required return for both projects is 10%.

Which project should you accept and why?

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Example: Mutually Exclusive Projects

A: CF, 2nd [CLR WORK] CF0 = -500 ENTER C01 = 325 ENTER F01 = 1 C02 = 325 ENTER NPV, I = 10 ENTER CPT => 64.05 IRR CPT => 19.43 B: CF, 2nd [CLR WORK] CF0 = -400 ENTER C01 = 325 ENTER F01 = 1 C02 = 200 ENTER NPV, I = 10 ENTER CPT => 60.74 IRR CPT => 22.17
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NPV Profiles
$160.00 $140.00 $120.00 $100.00 $80.00 $60.00 $40.00 $20.00 $0.00 -$20.00 0 -$40.00 Discount Rate
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IRR for A = 19.43%

IRR for B = 22.17%

Crossover Point = 11.8%

NPV

A 0.05

B 0.1 0.15 0.2 0.25 0.3

Conflicts Between NPV and IRR

NPV directly measures the increase in value to the firm Whenever there is a conflict between NPV and another decision rule, you should always use NPV IRR is unreliable in the following situations
Non-conventional cash flows Mutually exclusive projects
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