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CHAPTER5:
WHYNETPRESENTVALUE
LEADSTOBETTERINVESTMENTDECISIONS
THANOTHERCRITERIA
5.1 Introduction
Theobjectiveofthefinancialmanageristomaximizethevalueofthefirm.Inorderto
attainthisobjectivemustdecidewhichassetstoinvestinandhowtofinancethem.
Thustherearethreetypesofdecisionsthefinancialmanageriscalledupontomake
Capitalbudgeting
Capitalstructure
Workingcapitalmanagement

Inthecurrentchapterweconcentrateoncapitalbudgetingdecision

5.2 CapitalBudgeting

Capital budgeting can be defined as the process of analyzing, evaluating, and

decidingwhetherresourcesshouldbeallocatedtoaprojectornot.

Processofcapitalbudgetingensurethebestpossibleallocationofresourcesandhelps
managementworktowardsthegoalofshareholderwealthmaximization.
Capitalbudgetingdecisionsareconsideredtobequiteimportanttothesuccessofany
business.Thereasonsare:
Involveenormousinvestmentofresources
Arenoteasilyreversible
Havelongtermimplicationsforthefirm
Entailuncertaintyandriskforthefirm
Due to the above factors, capital budgeting decisions become critical and must be
evaluated very carefully. Any firm that does not follow the capital budgeting process
will not be maximizing shareholder wealth and management will not be acting in the
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bestinterestsofshareholders.
Examples:
EuroDisney, Concorde Plane, Saturn of GM all faced problems due to bad capital
budgeting,whileIntelbecamegloballeaderduetosoundcapitalbudgetingdecisionsin
1990s.
Inpracticetherearefivealternativeinvestmentcriteriathatcanhelpustoidentifythe
rightinvestmentalternative.Theseare:
PaybackPeriodApproach
DiscountedPaybackPeriodApproach
NetPresentValueApproach
InternalRateofReturn
ProfitabilityIndex
Wewillusethefollowingexampletodemonstratethetechniquesofcapitalbudgeting

Example51
Assumethatyourcompanyisinvestigatinganewlaborsavingmachinethatwillcost
$10,000.Themachineisexpectedtoprovidecostsavingseachyearasshowninthe
followingtimeline:

5.3 PaybackPeriod

The payback period is simply the time taken by the project to return your
initialinvestment.Themeasureisverypopularandiswidelyused;itisalso
anunsoundandunreliablemeasure.

Paybackrepresentsthenumberofyearsrequiredfortheoriginalcashinvestmenttobe
returned, but the time value of money is ignored. Therefore, it will be misleading to
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thinkthatallcashflowsafterpaybackrepresentprofit.

5.3.1 Calculation
Thepaybackperiodmeasuresthetimethatittakestorecoupthecostoftheinvestment.
Ifthecashflowsareanannuity,thenwecansimplydividethecostbytheannualcash
flow to determine the payback period. Otherwise, as in the example, we subtract the
cash flowsfrom the cost until theremainder is zero. That is the cash flows from each
yearareaddedtofindoutthepointintimeatwhichthecumulativecashflowsequalthe
initialinvestment.

PP = years full recovery + unrecovered cost at beginning of last year

cashflowinlastyear

Forourexampleproject,wewillsubtractthecashflowsfromtheinitialoutlayuntilthe
entirecostisrecovered:

Since it will take 0.7143 years (= 2500/3500) to recover the last 2,500, the payback
periodmustbe3.7143years

5.3.2 DecisionRule
Theshorterthepaybackperiod,thebetter

Generally, firms will have some maximum allowable payback period against which all
investmentsarecompared.
If the projects payback period is less than the maximum acceptable payback
period,accepttheproject.
Iftheprojectspaybackperiodisgreaterthanthemaximumacceptablepayback
period,rejecttheproject.
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5.3.3 AdvantagesandDisadvantages

Advantages

Computationalsimplicity
Easytounderstand
Focusoncashflow
Disadvantages
Doesnotaccountproperlyfortimevalueofmoney
Doesnotaccountproperlyforrisk
Cutoffperiodisarbitrary
Doesnotleadtovaluemaximizingdecisions

Example52

Examinethethreeprojectsandnotethemistakewewouldmakeifweinsistedononly
takingprojectswithapaybackperiodof2yearsorless.

Project

C0

C1

C2

C3

A
B

2000 500 500 5000

2000 500 1800 0

2000 1800 500

Project

C0

C1

C2

Payback
NPV@10%
Period

C3

Payback

Period
500 5000
3

NPV@10%
+ 2,624

2000 500

2000 500 1800

58

2000 1800 500

+ 50

5.4 Discountedpayback
The discounted payback period is exactly the same as the regular payback period,
except that we use the present values of the cash flows in the calculation. This is an
improvementoverthetraditionalpaybackinthatthetimevalueofmoneyisrecognized.

Sinceourrequiredreturn(WACC)is12%,thetimelinewiththePVslookslikethis:
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Thediscountedpaybackperiodis4.82years

Note that the discounted payback period is always longer than the regular payback
period
The discounted payback period solves the time value problem, but it still ignores the
cash flows beyond the payback period. Therefore, you may reject projects that have
largecashflowsintheoutlyingyearsthatmakeitveryprofitable.Inotherwords,any
measure of payback can lead to a focus on shortrun profits at the expense of larger
longtermprofits

5.4.1 AdvantagesandDisadvantages
Advantages
Includestimevalueofmoney
Easytounderstand
DoesnotacceptnegativeestimatedNPVinvestmentswhenallfuturecashflows
arepositive
Biasedtowardsliquidity
Disadvantages
MayrejectpositiveNPVinvestments
Requiresanarbitrarycutoffpoint
Ignorescashflowsbeyondthecutoffpoint
Biasedagainstlongtermprojects,suchasR&Dandnewproducts

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5.5 AccountingRateofReturn
Theaccountingrateofreturn(ARR)methodmaybeknownbyothernamessuchasthe
returnoncapitalemployed(ROCE)orreturnoninvestment(ROI).ARRisaratioofthe
accountingprofittotheinvestmentintheproject,expressedasapercentage

Thisisarateofreturnmeasurebasedonaccountingearningsandisdefined
as the ratio of book income to book assets. It is also called book rate of
return.

5.5.1 Calculation

AverageBookrateof return =

Averagebookincome
Avegagebookassetvalue

5.5.2 Decisionruleandinterpretation

Acceptprojectswith returnsgreaterthan the averagereturn onthebookvalueofthe

firm,orsomeexternalyardstick.

Following our initial example, in order to calculate the Accounting rate of return we
need
To calculate the depreciation of the asset. Since the asset has initial cost of $
10,000andtheasseta5yearlifethenthedepreciationis$2,000perannum
Tocalculatetheprofitforeachyear
Takingintoaccountthecashflowandthedepreciationtheprofitforeachyearis:

Yr0

CashFlow 10,000
Depreciation
Profit

Yr1
2,000
2000
0

Yr2
2,500
2000
500

Yr3
3,000
2000
1,000

Yr4
3,500
2000
1,500

Yr5
4,000
2000
2,000

The next step is to calculate the average book income. This can be found as
follow:

AverageBookIncome =

0 + 500 + 1,000 + 1,500 + 2,000

= $1,000
5

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Thenwecalculatetheaveragebookassetvalue,whichis
InitialCost+ScrapValue 10 ,000 + 0
AverageBookAssetValue =
=
= $5,000
2
2

Thelaststepistocalculatetheaveragebookrateofreturn
1,000
AverageBookRateof Return =
= 20%
5,000

5.5.3 AdvantagesandDisadvantages
Advantages
Easytocalculate
Neededinformationwillusuallybeavailable
Disadvantages
Notatruerateofreturn;timevalueofmoneyisignored
Usesanarbitrarybenchmarkcutoffrate
Basedonaccountingnetincomeandbookvalues,notcashflowsandmarket
values
Profitfiguresareverypoorsubstitutesforcashflow

5.6 NetPresentValue
TheNPVrepresentsthevalueaddedtothebusinessbytheprojectortheinvestment.It
representstheincreaseinthemarketvalueofthestockholderswealth.Thus,accepting
aprojectwithapositiveNPVwillmakethestockholdersbetteroffbytheamountofits
NPV.

NPV:Thesumofthepresentvaluesofaprojectscashinflowsand outflows.Is
thedifferencebetweenthemarketvalueofaprojectanditscost.

Thefigurebelowrepresentsatradeoff=>thefirmcaneitherkeepandreinvestcash
orreturnittoinvestors(Arrowsrepresentpossiblecashflowsortransfers).Ifcashare
reinvested, the opportunity cost of capital is the expected rate of return that
shareholderscouldhaveobtainedbyinvestinginfinancialassets.

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Cash

Investment
opportunity
(realassets)

Firm

Shareholder

Invest
Alternative:
Paydividendto
shareholders

Investment
opportunities
(financial
assets)

Shareholdersinvest
forthemselves

NPVisthetheoreticallycorrectmethodtouseinmostsituations.Othermeasuresare
inferior because they often give decisions different from those given by following the
NPVrule.Theywillnotservethebestinterestsofthestockholders.

5.6.1 Calculation
Thefirststepistoestimatetheexpectedfuturecashflows.
Thesecondstepistoestimatetherequiredreturnforprojectsofthisrisklevel.
The third step is to find the present value of the cash flows and subtract the
initialinvestment.
NPV=PVofcashinflowsinitialinvestment.

GoingtotheinitialexampletheNPVoftheproject
2000
2500
3000
3500
4000

(1.12)1 + (1.12)2 + (1.12)3 + (1.12)4 + (1.12)5 10000 = 408.06

SincetheNPVispositive,theprojectisacceptable

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5.6.2 DecisionRuleandInterpretation

If the NPV is positive, accept the project. A positive NPV means that the project is

expectedtoaddvaluetothefirmandwillthereforeincreasethewealthoftheowners.

Since our goal is to increase owner wealth, NPV is a direct measure of how well
thisprojectwillmeetourgoal.

For mutually exclusiveprojects, accept the project withthehighestNPV, if theNPV is

positive.

Thediscountrateshouldreflecttheopportunitycostofcapitalorwhatthestockholders
canexpecttoearnonotherinvestmentsofequivalentrisk.

5.6.3 AdvantagesandDisadvantages
NPVisthegoldstandardofinvestmentdecisionrules.
Advantages
Focusesoncashflows,notaccountingearnings
Makesappropriateadjustmentfortimevalueofmoney
Canproperlyaccountforriskdifferencesbetweenprojects
Clearlymeasurestheincreaseinmarketvalueorwealthcreatedbytheproject.
Disadvantages
Doesntcapturemanagerialflexibility(optionvalue)well

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5.7 InternalRateofReturn(IRR)

IRRisdefinedasthediscountrateatwhichtheNPVequalszero.

ThisisthemostimportantalternativetoNPV.Itisoftenusedinpracticeandiisbased
entirely on the estimated cash flows and is independent of interest rates found
elsewhere.

5.7.1 Calculation
Itiscalculatedbytrialanderror.
FollowthestepsforcalculatingtheNPVandcalculatetheNPVforseveraldiscount
rates.
Start with a low discount rate and then calculate the NPV at progressively higher
ratestilltheNPVcalculatedhasanegativevalue.Thenyoucaneither

PlottheNPVs(yaxis)againstthediscountrate(xaxis).TheIRRisthat
discountrateatwhichthelinecrossestheXaxis(NPV=0),or

Calculatethefollowingformula
IRR= lowerrate +

NPVatlowerrate
NPVatlowerrate NPVathigerrate

Ingeneral,theNPVwilldecreaseasthediscountrateisincreased.
Forourexample,theIRRisfoundbysolvingthefollowing:

10,000 =

2000
2500
3000
3500
4000
+
+
+
+
1
2
3
4
(1 + IRR ) (1 + IRR ) (1 + IRR ) (1 + IRR ) (1 + IRR )5

Inthiscase,thesolutionis13.45%
Example53

Youcanpurchaseaturbopoweredmachinetoolgadgetfor$4,000.Theinvestmentwill
generate$2,000and$4,000incashflowsfortwoyears,respectively.WhatistheIRR
onthisinvestment?

2,000

4 ,000

NPV = 4 ,000 +
+
=0
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2500

IRR = 28 . 08 %

2000

1000
500

10
0

90

80

70

60

50

40

30

-500

20

10

NPV (,000s)

1500

-1000
-1500
-2000

Discount rate (%)

5.7.2 DecisionRuleandInterpretation

IfIRRisgreaterthanthecostofcapital,accepttheproject.
IfIRRislessthanthecostofcapital,rejecttheproject.
As long as the cost of capital is less than the IRR, the NPV for the project will be
positive.

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5.7.3 AdvantagesandDisadvantages
Advantages
Properlyadjustsfortimevalueofmoney
Usescashflowsratherthanearnings
Accountsforallcashflows
Itisasimplewaytocommunicatethevalueofaprojecttosomeonewhodoesnt
knowalltheestimationdetails

Disadvantages
IRRcanrankprojectsincorrectly.
Formutuallyexclusiveprojects,IRRcangiveincorrectdecisionsandshouldnot
beusedtorankprojects.IfonemustuseIRRformutuallyexclusiveprojects,it
should be done by calculating the IRR on the differences between their cash
flows.
Example54

ConsiderprojectEandF:

Project
E
F

C0

Ct

IRR NPV @10%

10,000 + 20,000 100

20,000 + 35,000 75

+ 8 ,182
+ 11,818

With the IRR rule project E should be accepted since it has the higher IRR rate.
NeverthelessifyoufollowtheIRRrule,youhavethesatisfactionofearning100%rate
ofreturn;ifyoufollowtheNPVyouare$11,818richer!
IRR can also be misleading in cases where the project cash flow patterns are
reverses of the normal project. These projects give cash inflows first, followed
byoutflows.Thus,itislike borrowingandinsuchcases,theIRRdecisionrule
shouldbereversed.TheprojectshouldbeacceptedonlyiftheIRRislessthan
theopportunitycostofcapital.
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Example55

ConsiderthefollowingprojectsAandB:
Project
A
B

C0
1,000
+1,000

C1
+1,500
1,500

IRR
+50%
+50%

NPVat10%
+364
364

Each project has an IRR of 50%. But does this means that are equally attractive?
CLEARLYNOT!!!

InthecaseofAwearelendingmoneyat50%
InthecaseofBweareborrowingmoneyat50%

When we want to lend money we want a high rate of return; when we want to
borrowmoneywewantalowrateof

return.

NPV

DiscountRate

Another problem with IRR is that for projects whose cash flows change sign
morethanoncetherewillhavemorethanoneIRR.(multipleratesofreturn).In
such cases,it may notbe obvious whether ahigh IRR is good or bad. One will
needtolookintotheNPVprofile(theNPVdiscountrategraph)toidentifythe
discountraterangeforwhichtheNPVispositive.

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Example56

ThefollowingcashflowgeneratesNPV=0atboth(50%)and15.2%.

C0
C1
C2
C3
C4
C5
C6
1,000 + 800 + 150 + 150 + 150 + 150 150

NPV
1000

IRR=15.2%

500
0
-500

Discount Rate
IRR=-50%

-1000

5.8 CapitalRationingandProfitabilityIndex:
Occasionally, companies face resource constraint or capital rationing. The amount
availableforinvestmentislimitedsothatallpositiveNPVprojectscannotbeaccepted.
Insuch cases,stockholder wealthismaximizedbytakingupprojects withthehighest
NPVperdollarofinitialinvestment.

Thisapproachisfacilitatedbytheprofitabilityindex(PI)measure.

5.8.1 Calculation

ProfitabilityIndex =

NPV
Investment

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ProfitabilityIndexmeasuresthebenefitperunitcost,basedonthetimevalueofmoney.
A profitability index of 1.1 implies that for every $1 of investment, we create an
additional$0.10invalue.

Fortheexample,thePIis:
PI =

10 ,408.06
= 1.0408
10 ,000

5.8.2 DecisionRule
ThedecisionruleforprofitabilityindexistoacceptallprojectswithaPIgreaterthan
zero.ThisruleisequivalenttotheNPVrule.
Themodifiedruleappliedinthecaseofcapitalrationingistoacceptprojectswiththe
highestprofitabilityindexfirst,followedbytheonewithnexthighest,andsoontillthe
investmentdollarsareexhausted.
ThisrulewillmaximizetheNPVandstockholderwealth.Iftheresourceconstraintison
someotherresources,theprofitabilityindexneedstobemodifiedtomeasuretheNPV
perunitoftheresourcethatis rationed. Whenmorethanoneresourceisrationed, a
morecomplicated(linearprogramming)analysisisneeded.

5.8.3 AdvantagesandDisadvantages
Advantages
CloselyrelatedtoNPV,generallyleadingtoidenticaldecisions
Easytounderstandandcommunicate
Maybeusefulwhenavailableinvestmentfundsarelimited
Disadvantages
May lead to incorrect decisions in comparisons of mutually exclusive
investments

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5.9 NPVandothercriteria:
TheNPVissuperiortoothercriteriabecause:
i)

it is the only measure which considers the time value of money, properly
adjustingfortheopportunitycostofcapital,

ii)

givesconsistentmeasuresoftheprojectsvalue(i.e.notaffectedbypackaging
withotherprojects),and

iii)

itclearlymeasuresthevalueaddedtothestockholderswealth.

However,theotherthreecriteriafortheevaluationofprojectsarefoundtobepopular
incorporatepractice.

If you have to use them, make sure you use them in the best possible way and
understand the limitations of them. For example, always compare mutually exclusive
projectsonthebasisofthedifferencebetweentheircashflows.

Remember that it is the cash flows that determine the value of a project. Inadequate
forecast of the cash flows can be far more disastrous than using the wrong appraisal
technique.

Cashflowforecastsaredifficulttomakeandcanbeexpensive.Itdoesnotmakesense
towastetheforecastsbyusinganinferiormethodofevaluation.

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Example 5-7
Bar Breweries is considering an expansion project with an estimated investment of
$1,500,000.Theequipmentwillbedepreciatedtozerosalvagevalueonastraightline
basis over 5 years. The expansion will produce incremental operating revenue of
$400,000annuallyfor5years.Thecompanysopportunitycostofcapitalis12percent.
Ignoretaxes.

Calculate
(a) paybackperiod,
(b) bookrateofreturn,
(c) NPV,
(d) IRR,and
(e) profitabilityindex.

Solution

Firstcalculatetheannualearningsandcashflows:
Operatingrevenues

=$400,000

Lessdepreciation

=$300,000

BookIncome

=$100,000

Cashflow

=$400,000

a. Payback=$1,500,000/$400,000=3.75years

b. Averagebookincome=$100,000,
Averagebookvalueofinvestment=
($1,500,000+0)/2=$750,000

Bookrateofreturn=$100,000/$750,000=13.33%

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c.NPVcalculation:

Amount

Discount

Presentvalue

factor
Year0Initialinvestment

$1,500,000

Years1through5Cashflow

$400,000

NetPresentValue

1 $1,500,00
3.605 $1,442,000
$58,000

d.IRRiscalculatedbytrialanderror.CalculatetheNPVatdifferentdiscountrates:
NPVat10%=$400,000(discountfactorfor10%,5years)$1,500,000
=$400,000x3.791$1,500,000=$16,400
NPVat11%=$400,000x3.696$1,500,000=$21,600

IRRliesbetween10percentand11percent.

IRR=10%+[16,400/(16,400+21,600)]=10.43%

e. ProfitabilityIndex=NPV/Investment=$58,000/$1,500,000=0.04

Example58

Black and Company is considering an investment in a new plant which will entail an
immediate capital expenditure of $4,000,000. The plant is to be depreciated on a
straightline basis over 10 years to zero salvage value. Operating income (before
depreciationandtaxes)isexpectedtobe$800,000peryearoverthe10yearlifeofthe
plant.Theopportunitycostofcapitalis14percent.Therearenotaxes.

Calculate
(a)thebookrateofreturn,
(b)thepaybackanddiscountedpaybackperiods,
(c)NPV,
(d)IRR,and
(e)theprofitabilityindex.
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Solution

1.(a) Operatingrevenues =$800,000

Lessdepreciation

=$400,000

BookIncome

=$400,000

Cashflow

=$800,000

Averagebookincome=$400,000
Averagebookvalueofinvestment=($4,000,000+0)/2=$2,000,000
Bookrateofreturn=$400,000/$2,000,000=20%

(b)Paybackperiod=$4,000,000/$800,000=5years
DiscountedpaybackisthenumberofyearsneededtogetthePVofthecashflows
toequaltheinitialinvestment.

Discountedpayback=9.2years.

(c)NPV:Presentvalueofcashflows=$800,000x5.216=$4,172,800
NPV=$4,172,800$4,000,000=$172,800

(d)IRR=15.1%

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