CHAPTER 9
NET PRESENT VALUE AND
OTHER INVESTMENT
CRITERIA
Net Present Value
 The difference between the market value of a project and its
cost
 Estimating NPV: (DCF)

The first step is to estimate the expected future cash
flows.

The second step is to estimate the required return for
projects of this risk level.

The third step is to find the present value of the cash
flows and subtract the initial investment.
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.
Payback Period
 The amount of time required for an investment to generate
cash flows sufficient to recover its initial cost.
 An investment is accepted if its calculated period
is less than some prespecified number of years
Example
Year
A
B
C
D
E
0
-100 $
-200$
-200$
-200$
-50$
1
30
40
40
100
100
2
40
20
20
100
-50,000,000
3
50
10
10
-200
4
60
130
200
Analyzing the rule
 Does the payback rule account for the time value of money?
 Does the payback rule account for the risk of the cash
flows?
 Does the payback rule provide an indication about the
increase in value?
 Should we consider the payback rule for our primary
decision rule?
Example
Year
Long
short
0
-250$
-250$
1
100
100
2
100
200
3
100
0
4
100
0
Advantages and Disadvantages of Payback
 Advantages
 Easy to understand
 Adjusts for uncertainty of later
cash flows
 Biased toward liquidity
 Disadvantages
 Ignores the time value
of money
 Requires an arbitrary
cutoff point
 Ignores cash flows
beyond the cutoff date
 Biased against longterm projects, such as
research and
development, and new
projects
Discounted Payback Period
 The length of time required for an investment’s discounted
cash flows to equal its initial cost.
 An investment is acceptable if its discounted
payback is less than some prespecified number of
years
Example
Cash flow
Accumulated cash flow
year
undiscounted
discounted
undiscounted
discounted
1
100$
89$
100
89
2
100
79
200
168
3
100
70
300
238
4
100
62
400
300
5
100
55
500
355
Decision Criteria Test – Discounted Payback
 Does the discounted payback rule account for the time
value of money?
 Does the discounted payback rule account for the risk of the
cash flows?
 Does the discounted payback rule provide an indication
about the increase in value?
 Should we consider the discounted payback rule for our
primary decision rule?
Advantages and Disadvantages of Discounted Payback
 Advantages
 Disadvantages
 Includes time value of money
 May reject positive
 Easy to understand
NPV investments
 Does not accept negative
 Requires an arbitrary
cutoff point
estimated NPV investments
when all future cash flows are positive  Ignores cash flows
beyond the cutoff
 Biased towards liquidity
point
 Biased against longterm projects, such as
R&D and new
products
Ex 8 Page 293
year
Cash flow
0
-34,000$
1
16,000
2
18,000
3
15,000
Suppose the firm uses the NPV decision rule. At a required
return of 11 percent, should the firm accept the project?
What of the required return was 30 percent?
Ex 11 Page 294
year
Cash flow
0
-19,500$
1
9,800
2
10,300
3
8,600
What is the NPV at a discount rate of zero percent?
Ex 1 Page 292
 What is the payback period for the following set of cash
flows?
year
Cash flow
0
-6,400$
1
1,600
2
1,900
3
2,300
4
1,400
Ex 2 Page 293
 An investment project provides cash inflows of 765$ per
year for eight years. What is the project payback period if
the initial cost is 2,400$?
Ex 4 Page 293
 An investment project has annual cash inflows of 4,200$ ,
5,300$ , 6,100$ and 7,400$, and a discount rate of 14
percent. What is the discounted payback period for these
cash flows if the initial cost is 13,000?
Average Accounting Return
 An investment’s average net income divided by its average
book value
 A project is acceptable if its average accounting
return exceeds a target average accounting return
Example
 Suppose we are deciding whether to open a store in anew
shopping mall. The required investment in improvements
is 500,000$. The store would have a five-year life. The
required investment would be 100 percent depreciated. The
tax rate is 25 percent. Net income for the five years as
follow:
year
NI
1
100,000
2
150,000
3
50,000
4
0
5
-50,000
Decision Criteria Test - AAR
 Does the AAR rule account for the time value of money?
 Does the AAR rule account for the risk of the cash flows?
 Does the AAR rule provide an indication about the increase
in value?
 Should we consider the AAR rule for our primary decision
rule?
Advantages and Disadvantages of AAR
 Advantages

Easy to calculate

Needed information
 Disadvantages

Not a true rate of
return; time value of
money is ignored
will usually be available

Based on accounting
net income and book
values, not cash flows
and market values
Internal Rate of Return
 The discounted rate that makes the NPV of an investment
zero
 This is the most important alternative to NPV
 An investment is acceptable if the IRR exceeds the
required return
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?
Advantages and Disadvantages of IRR
 Advantageous
o Closely related to NPV leading to identical decisions
o Easy to understand and communicate
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
Ex 7 Page 293
 A firm evaluates all of its projects by applying the IRR. If
the required return is 16 percent, should the firm accept the
following project?
year
CF
0
$-34,000
1
16,000
2
18,000
3
15,000
Ex 9 Page 293
 A project that provides annual cash flows of 28,500$ for
nine years costs 138,000$ today. Is this a good project if
the required rate of return is 20 percent? At what discount
rate would you be indifferent between accepting the project
and rejecting it?
Profitability Index
 The present value of an investment’s future value cash
flows divided by its initial cost.
 This measure can be very useful in situations in which we
have limited capital
Advantages of Profitability Index
 Advantages



Closely related to NPV, generally leading to identical decisions
Easy to understand and communicate
May be useful when available investment funds are limited
Ex 15 Page 294
 What is the profitability index for the following set of cash
flows if the relevant discount rate is 22 percent?
year
CF
0
-14,000$
1
7,300
2
6,900
3
5,700
Capital Budgeting In Practice
 We should consider several investment criteria when
making decisions
 NPV and IRR are the most commonly used primary
investment criteria
 Payback is a commonly used secondary investment criteria
Comprehensive Problem
 An investment project has the following cash flows: CF0 = -
1,000,000; C01 – C08 = 200,000 each
 If the required rate of return is 12%, what decision should
be made using NPV?
 How would the IRR decision rule be used for this project,
and what decision would be reached?