Chapter 8

Net Present Value

and Other
Investment Criteria

Prepared by
Tanya Willis
Saint Marys University 2016 McGraw-Hill Education Limited Chapter 8 - 1
After studying this chapter, you should be able to:
LO1 Calculate the net present value of an investment.
LO2 Calculate the internal rate of return of a project and know what to look
out for when using the internal rate of return rule.
LO3 Explain why the payback and discounted payback rules dont always
make shareholders better off.
LO4 Use the net present value rule to analyze three common problems that
involve competing projects: (a) when to postpone an investment
expenditure, (b) how to choose between projects with unequal lives, and (c)
when to replace equipment.
LO5 Calculate the profitability index and use it to choose between projects
when funds are limited.

2016 McGraw-Hill Education Limited Chapter 8 - 2

 Capital Budgeting is the process of determining what
investments will maximize the value of the firm.

Suppose, you are given the opportunity to buy a building today for
$350,000 and a guarantee of being able to sell it next year for $400,000.
Should you take it?

0 1
r%

-$350,000 $400,00
0

LO1
2016 McGraw-Hill Education Limited Chapter 8 - 3
 What discount rate do we use to value this stream of cash flows?
What else could we have done with the $350,000?
What other opportunity are we giving up by investing in the
building?
What if the interest rate on the risk-free T-bill is 7%?

0 1
7%

-$350,000 $400,000

$400,000/(1+0.07) = $373,832

NPV = $23,832

LO1
2016 McGraw-Hill Education Limited Chapter 8 - 4
 NPV = PV of cash flows minus initial investment.
Expected rate of return given up by investing in a project is
the opportunity cost of capital.

C1 C2 Ct
NPV C0 ...
(1 r ) (1 r )
1 2
(1 r ) t

Where:
Ct = Cash flow at time t
r = Opportunity cost of capital

LO1
2016 McGraw-Hill Education Limited Chapter 8 - 5
 Risk and Present Value
The discount rate used to discount a set of cash flows must match the
risk of the cash flows.

Instead of being risk-free, if the building investment in the previous

example was estimated to be as risky as the stock market yielding 12%,
the NPV would be:

NPV =PV C0
= [$400,000/(1+.12)] - $350,000
= $357,143 - $350,000 = $7,143

LO1
2016 McGraw-Hill Education Limited Chapter 8 - 6
 Valuing long lived projects:

The NPV rule works for projects of any duration.

The critical problems in any NPV problem are to determine:
The amount and timing of the cash flows
The appropriate discount rate

Net Present Value Rule:

Managers increase shareholders wealth by accepting all projects

that are worth more than they cost.
Therefore, they should accept all projects with a positive net
present value.

LO1
2016 McGraw-Hill Education Limited Chapter 8 - 7
 Example: A company is considering the purchase of a piece of production
equipment to increase volume. The equipment has a cost of $500,000
and will produce annual cash flows over the next 3 years of $150,000 in
year 1, $200,000 in year 2, and $250,000 in year 3. If the required return
on investment is 10%, should the company purchase the equipment?

C1 C2 Ct
NPV C0 ...
(1 r )1 (1 r ) 2 (1 r ) t

150,000 200,000 250,000

NPV 500,000 1
2

(1.10) (1.10) (1.10) 3
NPV 500,000 136,364 165,289 187,829
NPV 500,000 489481 10,519

LO1
2016 McGraw-Hill Education Limited Chapter 8 - 8
 The Cash Flow Worksheet aids in calculating the internal rate of return (IRR) and net present value
(NPV).
Step 1: Always begin by clearing the Cash Flow worksheet. To do so:
Press [CF] to turn the CF worksheet on.
Press [2nd] CLR Work Quit
Step 2: Press [CF]. The display should show: CF0= 0.00000.
Step 3: Type the numeric amount of the cash flow for time period 'zero'. Then press [+\-] to change
this amount to a cash outflow. The [+\-] key is a toggle key. Press [Enter].
Step 4: Press the down arrow key to display C01. Type in the cash amount for period 1, then press
[Enter]. Press the down arrow key to display F01. Press [Enter] to accept the default amount of
1.00000.
Step 5: Press the down arrow key to display C02. Type in the cash amount for period 2, then press
[Enter]. Press the down arrow key to display F02. Press the down arrow key again to accept F02,
and to move to the next field which will display as C03.
Step 6: Type in the cash amount for each subsequent period in the same manner. Once all cash
flows are inputted, use the up and down arrow keys to scroll through the Cash Flow worksheet to
verify your input.
Either one of the following steps, or both may be performed, depending on if you want to calculate
NPV, IRR, or both.
Step 7: To compute IRR: Press [IRR] then [Cpt]. After a few seconds, the display should show the IRR
percentage.
Step 8: To compute NPV: Press [NPV] to display I = 0.0000. Enter the required rate of return in
decimal format 'as-if' there is a percentage sign following. (e.g., 7.45) Press [Enter]. Press the down
arrow key, then press [Cpt] to display the dollar amount of the NPV.
LO1 Source: http://www.unf.edu/~dtanner/dtch/dt_ch15.htm
2016 McGraw-Hill Education Limited Chapter 8 - 8
 Using the NPV Rule to Choose Among Projects

Most companies must choose between multiple projects. If

doing one project precludes you from doing the other the
projects are said to be mutually exclusive.

If projects are mutually exclusive, determine NPV and choose the

project with the higher positive NPV.

LO1
2016 McGraw-Hill Education Limited Chapter 8 - 9
 Other criteria are sometimes used by firms when evaluating
investment opportunities.

Most commonly used alternatives are: Payback, Discounted

Payback and Internal Rate of Return (IRR)
Payback and Discounted payback are rough guides to an
investments worth and often give an incorrect decision.
Internal rate of return will usually lead to the same decision as
NPV however there are exceptions.

LO2, LO3
2016 McGraw-Hill Education Limited Chapter 8 - 10
 Payback
Payback is the time period it takes for the cash flows
generated by the project to cover the initial investment in
the project. If the payback period is less than a specified
cutoff point, the project should be accepted.

LO3
2016 McGraw-Hill Education Limited Chapter 8 - 11
 Example: A company has the following three investment opportunities.
The company accepts all projects with a 2 year or less payback period and
uses a 10% discount rate.

Project C0 C1 C2 C3
A -2,000 +1,000 +1,000 +10,000
B -2,000 +1,000 +1,000 -
C -2,000 - +2,000 -

LO3
2016 McGraw-Hill Education Limited Chapter 8 - 12
Project C0 C1 C2 C3 Payback NPV @ 10%
A -2,000 +1,000 +1,000 +10,000 2 $7,249
B -2,000 +1,000 +1,000 - 2 -$264
C -2,000 - +2,000 - 2 -$347

Although all the projects have a payback period of 2 years and are
therefore acceptable, the use of NPV shows us that only the first
project will create value for the shareholders. Therefore, only
Project A should be chosen.

LO3
2016 McGraw-Hill Education Limited Chapter 8 - 13
 Discounted Payback Period
Discounted payback is the time period it takes for the discounted
cash flows generated by the project to cover the initial
investment in the project. The acceptance rule is still the same
the discounted payback should be less than a pre-set cutoff
point.

Although better than payback, it still ignores all cash flows after
an arbitrary cutoff date.

Therefore it will reject some positive NPV projects.

LO3
2016 McGraw-Hill Education Limited Chapter 8 - 14
 Example: A company has the following cash flows. If the cut-off is
2 years, should the project be accepted?

Year CF Discounted CF Cumulative Discounted

@ 10%, $ CF @ 10%, $
0 -2,000 -2,000 -2,000
1 +1,000 909 1,091
2 +1,000 827 264
3 +10,000 7513 +7,249
NPV=7,249

LO3
2016 McGraw-Hill Education Limited Chapter 8 - 15
 Internal Rate of Return (IRR)
IRR is the discount rate at which the NPV of the project
equals zero.
A project is acceptable if the IRR is more than the cost of
capital of the project.

Recall the NPV example we used earlier, where the NPV was
$23,832 at a discount rate of 7% and $7,143 at a rate of
12%.

At what discount rate will the NPV be equal to 0?

LO2
2016 McGraw-Hill Education Limited Chapter 8 - 16
 IRR Calculation: If we solve for the r in the equation below, we
will find the IRR.

C1
NPV C0
(1 r )1

400,000
0 350,000
(1 r )1
r .142857 14.3%

Another way of finding IRR is using the NPV profile. By finding out
where the profile crosses the X axis, we can find out the IRR.

LO2
2016 McGraw-Hill Education Limited Chapter 8 - 17
LO2
2016 McGraw-Hill Education Limited Chapter 8 - 18
 For a multi-period case, we can solve the IRR either by trial and
error or by a financial calculator.
Example: You can purchase a building for $350,000. The
investment will generate $16,000 in cash flows (i.e. rent) during
the first three years. At the end of three years you will sell the
building for $450,000. What is the IRR on this investment?
We can picture the project in the following way:

3
0 1 2

-$350,000 $16,000 $16,000 $466,000

LO2
2016 McGraw-Hill Education Limited Chapter 8 - 19
 In this case, what we are trying to do is to solve the following
equation:
16,000 16,000 466,000
0 350,000
(1 IRR ) 1
(1 IRR ) 2
(1 IRR ) 3

By trial and error or by financial calculator, we find:

IRR = 12.96%

LO2
2016 McGraw-Hill Education Limited Chapter 8 - 20
 Borrowing vs. Lending:
Lets say project J involves lending $100 at 50% interest. Project K
involves borrowing $100 at 50% interest. Which one will you
choose?
According to the IRR rule, both projects have a 50% rate of return and
are thus equally desirable.
However, you lend in Project J, and earn 50%; you borrow in Project
K, and pay 50%.
Pick the project where you earn more than the opportunity cost of
capital.

LO2
2016 McGraw-Hill Education Limited Chapter 8 - 21
 Mutually Exclusive Projects Timing of Cash Flows:
Calculate the IRR and NPV for the following projects:
Cash flows in $000s

Project C0 C1 C2 C3 IRR NPV @ 7%

H -350 400 - - 14.29% $24,000
I -350 16 16 466 12.96% $59,000

Project H has a higher IRR but is not the best choice at a discount rate of 7%
as NPV is higher for Project I.

LO2
2016 McGraw-Hill Education Limited Chapter 8 - 22
 The decision depends on the discount rate used. If we plot the NPV
of each project as a function of the discount rate, the two profiles
cross at an interest rate of 12.26%.

At discount rates above 12.26%, project H with its rapid cash inflow
would provide a higher NPV.
At discount rates below 12.26%, project I, with more total cash
flow but received later, would provide a higher NPV.

LO2
2016 McGraw-Hill Education Limited Chapter 8 - 23
 Mutually Exclusive projects Size of Project
A small project may have a high IRR but a low NPV.
A large project may have a low IRR but a high NPV.

Example: Would you rather earn 50% on a $1 investment or 10%

on a $100 investment?

LO2
2016 McGraw-Hill Education Limited Chapter 8 - 24
 Multiple Rates of Return:
Projects with cash flows that change direction more than once,
will have more than one discount rate at which the NPV will be
zero. That means, there are multiple IRRs for projects with non-
conventional cash flows.
The IRR rule would not work in this case; NPV works!

LO2
2016 McGraw-Hill Education Limited Chapter 8 - 25
 Choosing between competing projects can be tricky. We will
look at three important but challenging problems:

The Investment timing project

The choice between long- and short-lived equipment
The replacement problem

LO4
2016 McGraw-Hill Education Limited Chapter 8 - 26
 Sometimes you have the ability to defer an investment and select a
time that is more ideal at which to make the investment decision.
The decision rule is to choose the investment date that results in
the highest NPV today.

Example:
You can buy a computer system today for $50,000 which will last
4 years from date of installment. Based on the PV of savings it
provides to you ($70,000), the NPV of this investment is $20,000.
However, you know that these systems are dropping in price
every year.
When should you purchase the computer?

LO4
2016 McGraw-Hill Education Limited Chapter 8 - 27
 The decision rule for investment timing is to choose the investment
date that results in the highest NPV today.

LO4
2016 McGraw-Hill Education Limited Chapter 8 - 28
 Suppose you must choose between buying two machines
with different lives.
Machines D and E are designed differently, but have identical
capacity and do the same job.
Machine D costs $15,000 and lasts 3 years. It costs $4,000 per
year to operate.
Machine E costs $10,000 and lasts 2 years. It costs $6,000 per
year to operate.

Which machine should the firm acquire?

LO4
2016 McGraw-Hill Education Limited Chapter 8 - 29
 Costs, $000s
Machine C0 C1 C2 C3 PV of costs @ 6%
Machine D 15 4 4 4 25.69
Machine E 10 6 6 - 21.00

We cannot compare the PV of costs of assets with different lives.

LO4
2016 McGraw-Hill Education Limited Chapter 8 30
 For comparing assets with different lives, we need to compare
their Equivalent Annual Costs (EAC).

The Equivalent Annual Cost is the cost per period with the
same PV as the cost of buying and operating the machine.

LO4
2016 McGraw-Hill Education Limited Chapter 8 - 31
 Calculating equivalent annual cost for Machine D

Machine Co C1 C2 C3 PV @ 6%
Machine D 15 4 4 4 $25.69
Equivalent ? ? ? $25.69
Annual Cost

The equivalent annual cost is calculated as follows:

Equivalent Annual Cost = PV of Costs / Annuity Factor
= $25.69 / 3 Year Annuity Factor
= $25.69 / 2.673
= $9.61 per year

LO4
2016 McGraw-Hill Education Limited Chapter 8 - 32
 If mutually exclusive projects have unequal lives, then you
should calculate the equivalent annual cost of the projects.
Picking the lowest EAC allows you to select the project which
will maximize the value of the firm.

Machine PV @ 6% Equivalent Annual Cost

D $25.69 $9.61
E $21.00 $11.45

LO4
2016 McGraw-Hill Education Limited Chapter 8 - 33
 Example:
You are operating an old machine that will last two more years before it
will be worthless.
It costs $12,000 per year to operate.
You can replace it now with a new machine, which costs $25,000 but is
much more efficient ($8,000 per year in operating costs) and will last
for five years.
Should you replace it now or wait a year?
The opportunity cost of capital is 6%.

LO4
2016 McGraw-Hill Education Limited Chapter 8 - 34
 Year 0 1 2 3 4 5 PV @ 6%
New Machine 25 8 8 8 8 8 58.70
Equivalent 5-year 13.93 13.93 13.93 13.93 13.93 58.70
annuity

Cash flow will be $13,930 for new machine

Cash flow will be $12,000 for old machine
Why replace an old machine with a new one that will cost $1,930
more to run?
Decision: Do not replace - wait the two years.

LO4
2016 McGraw-Hill Education Limited Chapter 8 - 35
 We refer to the limit set on the amount of funds available for
investment as capital rationing. A limit may be set for 2
reasons:

Soft Rationing: Imposed by the senior management.

Hard Rationing: Imposed by the unavailability of capital in the

market. For example, the limit set during the 2008 credit
crunch crisis.

LO5
2016 McGraw-Hill Education Limited Chapter 8 - 36
 Example: A company has an opportunity cost of capital of 10%
and total resources of $20 million. Which projects should the firm
select?
Cash Flows, $ Millions
Project C0 C1 C2 PV @ 10% NPV
L -3 +2.2 +2.42 $4 $1
M -5 +2.2 +4.84 6 1
N -7 +6.6 +4.84 10 3
O -6 +3.3 +6.05 8 2
P -4 +1.1 +4.84 5 1

LO5
2016 McGraw-Hill Education Limited Chapter 8 - 37
 The solution is to pick the projects that give the highest NPV per
dollar of investment.
We do this by calculating the Profitability Index: The ratio of NPV
to initial investment.
The company will select the projects with the highest possible
NPV within the budget.

LO5
2016 McGraw-Hill Education Limited Chapter 8 - 38
 Project PV Investment NPV PI Decision
L $3 $3 $1 1/3=.33 accept
M 5 5 1 1/5=.20 reject
N 7 7 3 3/7=.43 accept
O 6 6 2 2/6=.33 accept
P 4 4 1 1/4=.25 accept

All projects would be acceptable if sufficient funds were available.

Project N with highest PI is picked first.
Projects L and O are picked next, both with PI of .33.
Project P is last with a PI of .25
These 4 projects add up to $20 million (the budget) and will provide
the highest increases in value to shareholders.

LO5
2016 McGraw-Hill Education Limited Chapter 8 - 39
 Profitability Index will not always be reliable when choosing
between mutually exclusive projects (just like with IRR).

A small project may have a high PI but a low NPV.

A large project may have a low PI but a high NPV.

A higher NPV is always preferable to a higher PI.

LO5
2016 McGraw-Hill Education Limited Chapter 8 - 40
 NPV is the best decision criteria.
It tells you whether an investment will increase the value of
the firm and by how much.
The only exception is when the firm is facing capital
rationing.
Despite the advantages of discounted cash flow methods,
many corporations use payback.

2016 McGraw-Hill Education Limited Chapter 8 - 41

 2016 McGraw-Hill Education Limited Chapter 8 - 42
 NPV measures the difference between a projects cost and its
benefits (all in todays dollars).

It is the only measure which always gives the correct decision

when evaluating projects.

IRR is the discount rate that results in an NPV of zero. The

project should be accepted if the IRR exceeds the opportunity
cost of capital.

2016 McGraw-Hill Education Limited Chapter 8 - 43

 Be careful using IRR when: (1) early cash flows are positive,
(2) more than one change in the sign of the cash flows occurs,
or (3) projects are mutually exclusive.

Payback and discounted payback methods ignore cash flows

that occur beyond the arbitrary cutoff period.

Always compare NPVs today when deciding if you should

postpone an investment.

2016 McGraw-Hill Education Limited Chapter 8 - 44

 When choosing between projects with different lives,
compare the equivalent annual cost.

When choosing between replacing an asset with a new one,

compare the cost of operating the old asset with the
equivalent annual cost of the new.

When firms have limited funds, use profitability index to rank

projects that offer the highest NPV per dollar of investment.

2016 McGraw-Hill Education Limited Chapter 8 - 45

NPV and IRR. A project that costs $3,000 to install will provide
annual cash flows of $800 for each of the next 6 years.
Is this project worth pursuing if the discount rate is 10%?
Compute NPV
PV of cash flow 800=PMT, 6=N, 10=I/Y, 0=FV, CPT PV = 3,484.21
NPV= -3,000 + 3,484.21= 484.21
How high can the discount rate be before you would reject the
project? (LO1)
Compute IRR

2016 McGraw-Hill Education

Limited Chapter 3 - 1
The Cash Flow Worksheet aids in calculating the internal rate of return (IRR) and net present value (NPV).
Step 2: Press [CF]. The display should show: CF0= 0.00000.
Step 3: Type the numeric amount of the cash flow for time period 'zero'. Then press [+\-] to change this
amount to a cash outflow. The [+\-] key is a toggle key. Press [Enter].
Step 4: Press the down arrow key to display C01. Type in the cash amount for period 1, then press [Enter].
Press the down arrow key to display F01. Press [Enter] to accept the default amount of 1.00000.
Step 5: Press the down arrow key to display C02. Type in the cash amount for period 2, then press [Enter].
Press the down arrow key to display F02. Press the down arrow key again to accept F02, and to move to the
next field which will display as C03.
Step 6: Type in the cash amount for each subsequent period in the same manner. Once all cash flows are
inputted, use the up and down arrow keys to scroll through the Cash Flow worksheet to verify your input.
Either one of the following steps, or both may be performed, depending on if you want to calculate NPV, IRR,
or both.
Step 7: To compute IRR: Press [IRR] then [Cpt]. After a few seconds, the display should show the IRR
percentage.
Step 8: To compute NPV: Press [NPV] to display I = 0.0000. Enter the required rate of return in decimal format
'as-if' there is a percentage sign following. (e.g., 7.45) Press [Enter]. Press the down arrow key, then press
[Cpt] to display the dollar amount of the NPV.

Source: http://www.unf.edu/~dtanner/dtch/dt_ch15.htm

2016 McGraw-Hill Education

Limited Chapter 3 - 1
Payback. A project that costs $2,500 to install will provide annual
cash flows of $600 for the next 6 years. The firm accepts projects
with payback periods of less than 5 years.

Will the project be accepted? (LO3)

2500
600 1900
600 1300
600 700
600 100

4 years and 100/600 = .17 years 4.17 years or 4 years and 2 months

2016 McGraw-Hill Education

Limited Chapter 3 - 1
14. NPV. A proposed nuclear power plant will cost $2.2 billion to
build and then will produce cash flows of $300 million a year for
15 years. After that period (in year 15), it must be
decommissioned at a cost of $900 million.
What is project NPV if the discount rate is 6%?

What if it is 16%? (LO1)

2016 McGraw-Hill Education

Limited Chapter 3 - 1
 21.NPV Versus IRR. Here are the cash flows for two mutually
exclusive projects:
Project C0 C1 C2 C3
A $20,000 +$8,000 $8,000 +$8,000
B $20,000 0 0 $25,000

a.At what interest rates would you prefer project A to B? Hint:

Try drawing the NPV profile of each project. (LO1, LO2)

b.What is the IRR of each project? (LO2)

2016 McGraw-Hill Education

Limited Chapter 3 - 1
Discount Rate NPVA NPVB

0% 4000 5000
2% 3071 3558
4% 2201 2225
6% 1384 990
8% 617 154
10% 105 1217
12% 785 2205
14% 1427 3126
16% 2033 3984
18% 2606 4784
20% 3148 5532
2016 McGraw-Hill Education
Limited Chapter 3 - 1
26.NPV. A project requires an initial investment of $10,000, and
over its 5-year life it will generate annual cash revenues of
$5,000 and cash expenses of $2,000. The firm will use straight-
line depreciation, but it does not pay taxes. (LO1)

Is the project worth pursuing if the opportunity cost of capital is

8%?

2016 McGraw-Hill Education

Limited Chapter 3 - 1
 Homework:

Reach chapter 9

Questions: 2, 3, 6 and 8

2016 McGraw-Hill Education

Limited Chapter 2 - 1