Project Evaluation Criteria
MF 807: Corporate Finance
Professor Thomas Chemmanur
Corporate Finance



1. Investment Decision
(a) Capital Budgeting
(b) Long-term Investment Strategy
2. Financing Decision
(a) How Should Investment Be Financed?
 Internal or External Financing
 What is the Menu of Securities to Use for External
Financing?
 Stocks, Bonds, Preferred Stock, Convertible Debt
(b) Interactions between financing and investment decisions
3. Dividend or Payout Decision
2
Corporate Finance
(a) Of Total Earnings, How Much (What Fraction) Should Be
Paid Out and How Much Retained (Retained Earnings)?
(b) Once the Payout Ratio is Decided, What is the Method of
Payout?
 Cash Dividends
 Stock Repurchases
 Open Market Repurchases
 Tender Offers
 Fixed Price
 Dutch Auction
3
Objective of Firm Manager

The objective of a firm manager is to maximize shareholder
wealth
 Equivalent to maximizing total value of the firm’s equity, or its
stock price
 The above can be thought of as a benchmark; there may be in
deviations in practice
 E.g. agency problems
 However, if the deviations are too much, the CEO can be fired,
by the board.
 Takeovers and leveraged buyouts can also discipline firm
management
4
Capital Budgeting

Capital Expenditures
 Expected to generate cash benefits lasting longer than a year
 Operating Expenditures
 Expected to generate benefits for less than a year
 Capital expenditures are incurred to obtain capital assets used in
the production of goods and services; summarized in capital
budget
 New machinery, real estate, construction of factories, replace
machinery, expand product line
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Capital Budgeting is a Complex Process
 1. Searching for new projects
 2. Marketing and production analysis – cash flow
estimates
 3. Preparation of cash budgets
 4. Evaluation of project proposals
 5. Control and monitoring of past projects
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Steps Involved in Evaluating Project Proposals
 1. Estimate the cash flows involved at various points in
time.
 Include not only the benefits, but the investment required
 2. Estimate the riskiness in project cash flows, and thus
the appropriate discount rate to use.
 3. Select projects, and amounts to be invested in each
using appropriate evaluation criteria.
 Keep in mind limitations in amount of investment
7
Project Evaluation Criteria
Project Evaluation Criteria:
• 1. NPV rule
• 2. Internal Rate of Return
• 3. Benefit to Cost Ratio
Ad-hoc Project Evaluation Rules
• 4. Payback Period Rule
• 5. Discounted Payback Period Rule
• 6. Average Return on Book Value
8
The Net Present Value Rule
Cn
C1
C2
NPV   I 0 

 ... 
2
n
(1  r1 ) (1  r2 )
(1  rn )

If we assume a flat term structure:
r1  r2  r3  .....  rn  r

Decision Rule:
i. Under No Capital Rationing: accept all projects with a
positive net present value
ii. Under Capital Rationing: accept that combination of
projects that gives the highest net present value
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Example




NPVA+B = NPVA + NPVB
Project
Investment
Required
NPV
I
$5000.00
$800.00
II
$5000.00
$400.00
III
$3000.00
$350.00
IV
$2000.00
$300.00
Investment Amount (Total) = $10,000.00
Optimal Combination  I, III, IV. Why? NPV = $1450.00
Combination of I & III  NPV = $1250.00 < $1450.00
10
Internal Rate of Return (IRR)

It is that rate of return at which this equation holds:
Cn
C1
C2
I0 

 ... 
2
(1  IRR) (1  IRR)
(1  IRR) n


I.e. IRR is that discounting rate at which the net present value
equals zero
Decision Rule:
i. Under No Capital Rationing: Accept all projects with an
IRR above a certain cut-off of return, which depends on
the riskiness of the project
ii. Under Capital Rationing: Accept that combination of
available projects which satisfies the investment
constraint and gives the highest IRR
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Example

I0 = $10,000; C1=$4,000; C2 = $3000 = C3 = C4 = C5
t=0
1
2
3
4
5
-10,000

4000
3000
3000
3000
3000
NPV at r = 12%
4000
1
NPV  10, 000 

3000 PVIFA 4 yrs ,12% 
1.12 1.12
1
NPV  10, 000  3571.43 
30003.0373
1.12
NPV  $1707.05  0  ACCEPT PROJECT
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Example

NPV @ 14%
4000
1
NPV  10, 000 

3000 PVIFA 4 yrs ,14% 
1.14 1.14
1
NPV  10, 000  3508.77 
3000 2.9137 
1.12
NPV  $1176.43  0  ACCEPT PROJECT

NPV @ 15%
4000
1
NPV  10, 000 

3000 PVIFA 4 yrs ,15% 
1.15 1.15
1
NPV  10, 000  3478.26 
3000 2.8550
1.15
NPV  $926.22  0  ACCEPT PROJECT
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Example

Similarly:
 NPV @ 16% = $685.12 > 0
 NPV @ 18% = $229.24 > 0
 NPV @ 20% = -$195.05 < 0
 Thus, IRR = 19% > Cutoff (Say 12%)
NPV($)
Note that, by definition, NPV falls
to zero at the IRR discount rate
2000 -
1000 
12
-1000 -
14
16
18
IRR 19%
20
Discount Rate %
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Comparison of NPV and IRR


1. IRR Cannot Distinguish Between Lending and Borrowing
In some cases (e.g. when initial cash flows are positive), this
may lead to acceptance of negative net present value projects:
Example:
Project


C0
C1
IRR
NPV@10%
A
-1000
+1500
50%
+364
B
+1000
-1500
50%
-364
When we lend, we like a high return.
When we borrow, we want to pay a low return.
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Comparison of NPV and IRR
2. Multiple IRRs when there is more than one change in the sign of
project cash flows
 Most projects have only one change in sign  from negative to
positive cash flow
 Some projects may have negative cash flows later  more than
one change in sign, generating as many IRRs as there are
changes in sign. (“Descartes Rule of Signs”)
 What is the real IRR then? We have to appeal to NPV then.
C0
C1
C2
IRR
NPV@10%
-4000
+25,000
-25,000
25% &
400%
-1934
16
Comparison of NPV and IRR
NPV($)
0
25%
400%
Rate of Return %
25, 000 25, 000
NPV  4, 000 

0
2
(1  r ) (1  r )

TWO SOLUTIONS TO THIS EQUATION: 25% and 400%
17
Comparison of NPV and IRR

3. Gives wrong rankings for mutually exclusive projects
This is the case when the timing of cash flows of the two
projects under consideration is dissimilar
Project
C0
C1
IRR
NPV@10%
F
-10,000
+20,000
100%
+8182
G
+20,000
+35,000
75%
+11,818
NPV($)
Fisher’s intersection
G
F
0
75%
100%
Rate of Return %
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Comparison of NPV and IRR

If the cost of capital is lower than the discount rate at the
Fisher’s intersection, then choosing the project with the highest
IRR means choosing the project that contributes the least to the
firm’s equity value
4. Difficult to apply IRR when the term structure of interest rates is
not flat  unlike NPV, where this can easily be done.



Advantages of IRR
No need to estimate cost of capital, at least in initial stages.
It is a measure of profitability, accounting for the timing of cash
flows
Of course, we do need a cost of capital estimate to decide on the
accept / reject threshold that we compare with the project IRR.
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Profitability Index or Benefit to Cost Ratio

P.I. = Present Value of Benefits from the Project
Present Value of Investment in the Project
 Decision Rule
i. Under No Capital Rationing: Accept All Projects with
P.I. > 1
ii. Under Capital Rationing: Accept that combination of
projects that satisfies the investment constraint and
gives the highest P.I.
 Example:
 Consider a project with initial investment of $35,000 and net
cash inflows of $9,000 per year for 6 years. The cost of
capital is 12%
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Profitability Index or Benefit to Cost Ratio

Solution:
 PV of Benefits = 9000 [PVIFA: 12%, 6yrs]
= 9000[4.1114]
= $37,002.6
 P.I. = 37,002 / 35,000 = 1.057 > 1  ACCEPT
 NPV = 37002.6 – 35,000 = 2000.6 > 0  ACCEPT
 IRR: That discount rate “r” at which
• 35,000 = 9000 [PVIFA: r, 6yrs]
• PVIFA = 35,000 / 9000 = 3.888
• IRR  14% > 12%  ACCEPT
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The Payback Period Rule



1. Payback Period  Number of periods required for project
cash flows to add up to initial investment; i.e. smallest “n” for
which: C1 + C2 + … + Cn > I0, holds.
Decision Rule: Accept projects with pay-back period less than a
cut-off value.
Problems: (i) No discounting.
(ii) Choice of cut-off period is arbitrary  rejects
positive NPV projects with cash flows after the cut-off.
E.g. with a 2 year cutoff, Project A is accepted & B is rejected!
Project
I0
C1
C2
C3
Payback NPV @ 10%
A
(400)
300
100
20
2 years
-29.6
B
(400)
100
100
500
<3 years
+149.19
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Discounted Payback Period

Number of periods it takes for the sum of the present values of
project cash flows to equal the initial investment. However, the
problem of ignoring all cash flows after the cut-off remains.
 PV of C1 = 300(PVIF) = 300/1.1 = 272.72
 PV of C2 = 100(PVIF) = 100/1.12 = 82.64
 PV of C3 = 20(PVIF) = 20/1.13 = 15.03
 Note we would correctly reject Project A but we might also
reject Project B if the payback period was only 2 years.
Project
I0
C1
C2
C3
Payback
NPV @ 10%
PV of A (400)
272.72
82.64
15.03
No Payback
-29.6
PV of B (400)
90.90
82.64
375.65
<3 years
+149.19
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Average Return on Book Value


Average return on book value:
= average forecasted net income
average annual net book value of project investment
Example:
Initial outlay = 6,000; straight-line depreciation
Projected Income Statement:
Year 1
Year 2
Year 3
2,500
2,600
3,000
Depreciation 2,000
2,000
2,000
600
1,000
Revenue
500
Average annual net income = (500+600+1000)/3 = 700
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Example: Average Return on Book Value

It is assumed that depreciation takes place at the end of the year
Gross book value of
investment
Date 0
Date 1
Date 2
Date 3
6,000
6,000
6,000
6,000
0
2,000
4,000
6,000
6000
4000
2,000
0
Accumulated
Depreciation
Net book value

Average of beginning and ending book values
Ave. Book value
Year 1
Year 2
Year 3
5,000
3,000
1,000
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Example: Average Return on Book Value



Average book value = (6,000 + 4,000 + 2,000 + 0)/4 = 3,000
Average book rate of return = 700/3,000 = 23.33%
This project would be undertaken if the target book rate of
return was less than 23.33%
 There are a number of problems with this criterion:
 It considers only average return on book investment. No
allowance is made for the fact that immediate receipts are more
valuable than distant ones.
 Average return does not depend on cash flows; it depends on
the accounting concepts of net income and net book value.
These in turn depend on arbitrary conventions adopted for
depreciation and so on by the account.
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