CHAPTER
6
McGraw-Hill/Irwin
Net Present Value and
Other Investment Rules
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
Slide 2
Chapter Outline
6.1 Why Use Net Present Value?
6.2 The Payback Period Method
6.3 The Discounted Payback Period Method
6.4 The Average Accounting Return Method
6.5 The Internal Rate of Return
6.6 Problems with the IRR Approach
6.7 The Profitability Index
6.8 The Practice of Capital Budgeting
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6.1 Why Use Net Present Value?
• Accepting positive NPV projects benefits
shareholders.
Forgoing the project today, the value of the firm
today is $V + $100
Accepting the project today, the value of the firm
today is $V + $100.94 (107/1.06)
The difference is $0.94.
• The value of the firm rises by the NPV of the
project.
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• The discount rate on a risky project is the
return that one can expect to earn on a
financial asset of comparable risk.
• This discount rate is often referred to as an
opportunity cost.
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The Net Present Value (NPV) Rule
• Net Present Value (NPV) =
-Initial Investment +Total PV of future CF’s
• Estimating NPV:
– 1. Estimate future cash flows: how much? and when?
– 2. Estimate discount rate
– 3. Estimate initial costs
• Minimum Acceptance Criteria: Accept if NPV > 0
• Ranking Criteria: Choose the highest NPV
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Good Attributes of the NPV Rule
• 1. Uses cash flows
• 2. Uses ALL cash flows of the project
• 3. Discounts ALL cash flows properly
• Reinvestment assumption: the NPV rule
assumes that all cash flows can be reinvested at
the discount rate.
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6.2 The Payback Period Method
• How long does it take the project to “pay
back” its initial investment?
• Payback Period = number of years to
recover initial costs
• Minimum Acceptance Criteria:
– Set by management
• Ranking Criteria:
– Set by management
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The Payback Period Method
• Disadvantages:
– Ignores the time value of money
– Ignores cash flows after the payback
period
– Biased against long-term projects
– Requires an arbitrary acceptance criteria
– A project accepted based on the payback
criteria may not have a positive NPV
• Advantages:
– Easy to understand
– Biased toward liquidity
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• The payback rule is often used by: large
and sophisticated companies when
making relatively small decisions, or firms
with very good investment opportunities
but no available cash (small, privately held
firms with good growth prospects but
limited access to the capital markets).
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Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
6.3 The Discounted Payback
Period
Slide 10
• How long does it take the project to “pay
back” its initial investment, taking the time
value of money into account?
• Decision rule: Accept the project if it pays
back on a discounted basis within the
specified time.
• By the time you have discounted the cash
flows, you might as well calculate the
NPV.
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6.4 Average Accounting Return
Average Net Income
AAR 
Average Book Value of Investment
• Another attractive, but fatally flawed,
approach
• Ranking Criteria and Minimum
Acceptance Criteria set by management
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Average Accounting Return
• Disadvantages:
– Ignores the time value of money
– Uses an arbitrary benchmark cutoff rate
– Based on book values, not cash flows and
market values
• Advantages:
– The accounting information is usually
available
– Easy to calculate
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6.5 The Internal Rate of Return
• IRR: the discount rate that sets NPV to
zero
• Minimum Acceptance Criteria:
– Accept if the IRR exceeds the required
return
• Ranking Criteria:
– Select alternative with the highest IRR
• Reinvestment assumption:
– All future cash flows assumed reinvested at
the IRR
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Internal Rate of Return (IRR)
• Disadvantages:
– Does not distinguish between investing and
borrowing
– IRR may not exist, or there may be multiple
IRRs
– Problems with mutually exclusive investments
• Advantages:
– Easy to understand and communicate
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Slide 16
IRR: Example
Consider the following project:
0
-$200
$50
$100
$150
1
2
3
The internal rate of return for this project is 19.44%
$50
$100
$150
NPV  0  200 


2
3
(1  IRR) (1  IRR) (1  IRR)
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Slide 17
NPV Payoff Profile
If we graph NPV versus the discount rate, we can see the IRR as
the x-axis intercept.
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$100.00
$73.88
$51.11
$31.13
$13.52
($2.08)
($15.97)
($28.38)
($39.51)
($49.54)
($58.60)
($66.82)
NPV
0%
4%
8%
12%
16%
20%
24%
28%
32%
36%
40%
44%
$120.00
$100.00
$80.00
$60.00
$40.00
$20.00
$0.00
($20.00)-1%
($40.00)
($60.00)
($80.00)
IRR = 19.44%
9%
19%
29%
39%
Discount rate
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Slide 18
6.6 Problems with IRR

Multiple IRRs

Are We Borrowing or Lending

The Scale Problem

The Timing Problem
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Mutually Exclusive vs.
Independent
• Mutually Exclusive Projects: only ONE of several
potential projects can be chosen, e.g., acquiring
an accounting system.
– RANK all alternatives, and select the best one.
• Independent Projects: accepting or rejecting one
project does not affect the decision of the other
projects.
– Must exceed a MINIMUM acceptance criteria
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The Scale Problem (P.175)
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The Timing Problem
$10,000
$1,000
$1,000
Project A
0
1
2
3
-$10,000
$1,000
$1,000
$12,000
Project B
0
1
2
3
-$10,000
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Slide 22
The Timing Problem
$5,000.00
Project A
$4,000.00
Project B
$3,000.00
NPV
$2,000.00
$1,000.00
10.55% = crossover rate
$0.00
($1,000.00) 0%
10%
20%
30%
40%
($2,000.00)
($3,000.00)
($4,000.00)
($5,000.00)
12.94% = IRRB
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16.04% = IRRA
Discount rate
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Slide 23
NPV versus IRR
• NPV and IRR will generally give 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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6.7 The Profitability Index (PI)
Total PV of Future Cash Flows
PI 
Initial Investent
• Minimum Acceptance Criteria:
– Accept if PI > 1
• Ranking Criteria:
– Select alternative with highest PI
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The Profitability Index
• Disadvantages:
– Problems with mutually exclusive investments
• Advantages:
– May be useful when available investment
funds are limited
– Easy to understand and communicate
– Correct decision when evaluating
independent projects
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Slide 26
6.8 The Practice of Capital
Budgeting
• Varies by industry:
• The most frequently used technique for
large corporations is IRR or NPV.
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8
27
28
Slide 29
The Internal Rate of Return: Example
Consider the following project:
0
-$200
$50
$100
$150
1
2
3
The internal rate of return for this project is 19.44%
$50
$100
$150
NPV  0  $200 


2
3
(1  IRR) (1  IRR) (1  IRR)
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