Mod 14 - ROI

7/7/15
Return on Investment
Michael R. Roberts
William H. Lawrence Professor of Finance
The Wharton School, University of Pennsylvania
Copyright Michael R. Roberts
Last Time
Discounted Cash Flow (DCF)
Decision making
Free cash flow
Forecast drivers
Forecasting free cash flow
Sensitivity analysis
Decision criteria
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This Time
Return on investment
IRR versus NPV
IRR
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RECALL
The internal rate of return of an asset is the

one discount rate such that the NPV of the
assets free cash flows equals zero.
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The internal rate of return of an asset is the

one discount rate such that the NPV of the
assets free cash flows equals zero.
NPV =
CF1
CF2
CF3
CFT
+
=0
2 +
3 + ... +
(1+ IRR ) (1+ IRR ) (1+ IRR )
(1+ IRR )T
The IRR Decision Rule says accept all

projects whose IRR > R, reject all projects
whose IRR < R where R is the hurdle rate
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Rates of return are popular measures used

for making decisions
Profitability index
Accounting rate of return
Discounted payback
Payback
Net present value
Internal rate of return
0%
20%
40%
60%
80%
Graham and Harvey, 2001, The theory and pracEce of corporate

nance: Evidence from the eld, Journal of Financial Economics
7/7/15
Profitability Index
Accounting Rate of Return
Discounted Payback Period
Payback Period
Net Present Value
Internal Rate of Return
0
2
4
6
8
Mean Number of Responses
10
What do Private Equity Firms Say they Do? (Paul Gompers, Steve
Kaplan, and Vladimir Mukharlyamov)
IRR V NPV
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Lesson: The IRR rule leads to the

same decisions accept or reject as
the NPV rule if all negative cash flows
precede all positive cash flows
Examples of CF sequences where IRR

and NPV rules will coincide:
-, +, +, +, +
-, -, -, +, +, +, +, +, +
-, -, -, -, - , +
7/7/15
Examples of CF sequences where IRR

and NPV rules may not coincide:
-, +, -, +, -, +
+, +, +, +, +, +, -, -, -, -, +, +, +, +, Copyright Michael R. Roberts
Can we compare projects using IRR?
7/7/15
Comparing Projects
Wharton wants to upgrade IT system

and overhaul network infrastructure
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Wharton wants to upgrade IT system

and overhaul network infrastructure
Puts out request for proposals (RFP)
Bid #1 from Cisco

Generate $60 million in cost savings
over three years for up front cost of
$100 million
10
7/7/15
Bid #1 from Cisco

$100 million
If Whartons cost of capital is 12%,
what is your assessment of this bid?
Bid #1 from Cisco

$100 million
Cash flows first:
11
7/7/15
Bid #1 from Cisco

$100 million
0 = 100 +
60
60
60
(1+ IRR ) (1+ IRR )2 (1+ IRR )3
Bid #1 from Cisco

$100 million
IRR > R and CFs signs proper

Looks good!
12
7/7/15
Bid #1 from Cisco

$100 million
NPV = 100 +
60
60
60
(1+ 0.12 ) (1+ 0.12 )2 (1+ 0.12 )3
Bid #1 from Cisco

$100 million
NVP > 0 Looks good!

13
7/7/15
Bid #1a from Cisco

Same cost savings ($60 mil over three
years) but costs spread over time: $20
mil today, $35 mil over three years
Bid #1a from Cisco

Cash flows first:
14
7/7/15
Bid #1a from Cisco

Cash flows first:
Bid #1a from Cisco

Cash flows first:
15
7/7/15
Bid #1a from Cisco

0 = 20 +
25
25
25
+
2 +
(1+ IRR ) (1+ IRR ) (1+ IRR )3
Bid #1a from Cisco

Bid #1a IRR (112%) > Bid #1 IRR (36%)

16
7/7/15
Bid #1a from Cisco

NPV = 20 +
25
25
25
+
2 +
(1+ 0.12 ) (1+ 0.12 ) (1+ 0.12 )3
Bid #1a from Cisco

Bid #1 NPV ($44.11) > Bid #1a NPV ($40.05)

17
7/7/15
What is going on?
NPV Bid #1 is better
18
7/7/15
NPV Bid #1 is better
IRR Bid #1a is better

A closer look
19
7/7/15
A closer look
Bid 1a incorporates a loan from Cisco
A closer look
Bid 1a incorporates a loan from Cisco

What is the interest rate?
20
7/7/15
A closer look
80 =
35
35
35
+
R = 15%
2 +
(1+ R ) (1+ R ) (1+ R )3
A closer look
0 = 80 +
35
35
35
(1+ IRR ) (1+ IRR )2 (1+ IRR )3
IRR = 15%
Note: This is also the IRR of the loan

21
7/7/15
A closer look
80 =
35
35
35
+
YTM = 15%
2 +
(1+YTM ) (1+YTM ) (1+YTM )3
Note: This is also the Yield-to-Maturity

of the loan
A closer look
80 =
35
35
35
(1+YTM ) (1+YTM )2 (1+YTM )3
YTM = 15%
Is this high or low?

22
7/7/15
A closer look
80 =
35
35
35
+
YTM = 15%
2 +
(1+YTM ) (1+YTM ) (1+YTM )3
Loan interest rate (15%) > Cost of Capital (12%)

Lesson: IRR increased because initial

investment fell more than future cash flows.
23
7/7/15
Lesson: IRR increased because initial

investment fell more than future cash flows.
(Intuition: Small payoffs on a smaller
investment can generate very large returns
because of division by small numbers.)
Lesson: NPV fell because Cisco is lending

you money at an interest rate that is greater
than your cost of capital.
24
7/7/15
Lesson: IRR can mislead when deciding

among projects.
Lesson: NPV will not mislead in

comparisons. The larger the NPV, the
greater the value
25
7/7/15
ADDITIONAL BIDS
26
7/7/15
How would you rank the bids according

to the IRR and the NPV criterion?
27
7/7/15
IRR: #3 > #2 > #1

NPV: #1 > #2 > #3
100
12% Cost of Capital
80
60
NPV
40
20
0
0%
-20
Huawei
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Juniper
-40
Cisco
-60
Discount Rate
28
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Intuition:
Huawei has small upfront cost IRR
Juniper has front-loaded CFs IRR
Lesson: IRR does not address differences

in scale.
29
7/7/15
Lesson: IRR does not address differences

in scale.
Would you rather earn 100% on a $1
investment or 10% on a $1,000,000
investment?
Intuition:
Junipers bid is like Ciscos with an
embedded loan
30
7/7/15
Intuition:
Junipers bid is like Ciscos with an
embedded loanwith a 23% interest rate!
Summary
31
7/7/15
Lessons
The internal rate of return of an asset is
the one discount rate such that the NPV
of the assets free cash flows equals
zero.
NPV =
CF1
CF2
CF3
CFT
+
=0
2 +
3 + ... +
(1+ IRR ) (1+ IRR ) (1+ IRR )
(1+ IRR )T
The IRR Decision Rule says accept all

projects whose IRR > R, reject all
projects whose IRR < R where R is the
hurdle rate
Lessons
IRR Rule can mislead decision making
when cash flow signs are anything other
than all negatives before all positives
IRR Rule can mislead decision making
when comparing projects even when
cash flow signs are proper.
IRR does not account for differences in
scale
32
7/7/15
Lessons
IRR should be used in conjunction
with NPV analysis
Coming up next
Fixed Income Securities
Institutional environment
Valuation
Risk analysis
33

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7/7/15

Copyright Michael R. Roberts

Copyright Michael R. Roberts

Copyright Michael R. Roberts

Copyright Michael R. Roberts

The internal rate of return of an asset is the

Copyright Michael R. Roberts

The internal rate of return of an asset is the

Copyright Michael R. Roberts

The IRR Decision Rule says accept all

Copyright Michael R. Roberts

Rates of return are popular measures used

Copyright Michael R. Roberts

Graham and Harvey, 2001, The theory and pracEce of corporate

Copyright Michael R. Roberts

Lesson: The IRR rule leads to the

Copyright Michael R. Roberts

Examples of CF sequences where IRR

Examples of CF sequences where IRR

Can we compare projects using IRR?

Copyright Michael R. Roberts

Copyright Michael R. Roberts

Wharton wants to upgrade IT system

Copyright Michael R. Roberts

Wharton wants to upgrade IT system

Copyright Michael R. Roberts

Bid #1 from Cisco

Copyright Michael R. Roberts

Bid #1 from Cisco

Copyright Michael R. Roberts

Bid #1 from Cisco

Copyright Michael R. Roberts

Bid #1 from Cisco

(1+ IRR ) (1+ IRR )2 (1+ IRR )3

Copyright Michael R. Roberts

Bid #1 from Cisco

IRR > R and CFs signs proper

Bid #1 from Cisco

(1+ 0.12 ) (1+ 0.12 )2 (1+ 0.12 )3

Copyright Michael R. Roberts

Bid #1 from Cisco

NVP > 0 Looks good!

Bid #1a from Cisco

Copyright Michael R. Roberts

Bid #1a from Cisco

Copyright Michael R. Roberts

Bid #1a from Cisco

Copyright Michael R. Roberts

Bid #1a from Cisco

Copyright Michael R. Roberts

Bid #1a from Cisco

Copyright Michael R. Roberts

Bid #1a from Cisco

Bid #1a IRR (112%) > Bid #1 IRR (36%)

Bid #1a from Cisco

Copyright Michael R. Roberts

Bid #1a from Cisco

Bid #1 NPV ($44.11) > Bid #1a NPV ($40.05)

What is going on?

Copyright Michael R. Roberts

NPV Bid #1 is better

Copyright Michael R. Roberts

NPV Bid #1 is better

IRR Bid #1a is better