INVESTMENT VALUATION

CRITERIA

Lecture 9th

Outline

What is capital budgeting?

NPV rule for making investment decisions

Other alternative investment criteria

Payback period (traditional and discounted)

Internal rate of return

Profitability index and capital rationing

What is capital budgeting?

Capital budgeting deals with the analysis of

potential additions to firms fixed assets
These are long-term decisions that generally
involve large expenditures and are typically

quite difficult to reverse

Capital budgeting is very important for a

firms future
3

Capital budgeting process

Accounting,
finance,
engineering

Idea
development

Collection of
data

Project
analysis

Decision
making

Results

Reevaluation

What is a project?

Any of the following decisions would qualify as

projects:

Major strategic decisions to enter a new area of

business or new markets
Acquisitions of other firms
Decisions on new ventures with existing business or
markets
Decisions that may change the way existing ventures
and projects are run
Decisions on how best to deliver a service that is
necessary for the business to run smoothly
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Types of projects

Independent projects
Mutually exclusive projects
Expansion projects

Replacement projects

Existing products / markets

New products / markets
Maintenance of business
Cost reduction

Research & development projects

Other projects (safety / environmental projects)
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Net Present Value (NPV)

Definition: Present value of cash flows minus initial

investments.
n

CFt
TV
NPV

I0
t
n
1 r
t 1 1 r

r is the required rate of return (this shoud reflect both

the time value of money and the risk involved in
project).

This will be the discount rate we will use to discount all future
project cash flows
This is usually the firms cost of capital.

Net Present Value (NPV)

Decision Rules:
Independent Projects:
NPV 0 - Accept means you make money
An NPV of 0 means you break even
NPV < 0 - Reject means you lose money
Mutually Exclusive Projects:
Select
the project with the highest NPV,
assuming NPV 0.

NPV rule illustrated

Assume you have the following information on

Project X:

Initial outlay -$1,100

Required return = 10%
Annual cash revenues and expenses are as follows:

Year
1
2

Revenues
$1,000
2,000

Expenses
$500
1,000

Draw a time line and compute the NPV of project X

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NPV rule concluded

0
Initial outlay
($1,100)

Revenues $1,000
Expenses
500

Revenues $2,000
Expenses 1,000

Cash flow

Cash flow $1,000

$500

$1,100.00
$500 x
+454.55

1
1.10
$1,000 x

+826.45

1
1.102

+$181.00 NPV
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Foundations of the NPV rule

Why does NPV work? And what does work mean?

A firm is created when security holders supply the

funds to acquire assets that will be used to produce
and sell goods and services
The market value of the firm is based on the free
cash flows it is expected to generate
Thus, good projects are those which increase firm
value good projects are those projects that have
positive NPVs

Moral:
INVEST ONLY IN PROJECTS WITH POSITIVE NPVs
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Why do we like NPV that much?

NPV

uses

cash

flows,

NPV uses all the cash flows generated by the

and
accounting artificial constructs

not

other

project during its life

NPV discounts the cash flows properly, since

it takes into account TVM
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Payback Period

Payback Period (PB): The length of time it takes

to recover the original costs (of the project) from
expected cash flows.
Rationale: The sooner investment costs are
recovered, the better.
Process: Simply add up the expected cash flows
until they equal (or exceed) the original investment.
The number of years it take to do this is the
payback period.
Note: no discounting of cash flows is required

Payback Period
Number of years before
full recovery of
original investment

PB =

Uncovered cost at start

of full-recovery year
Total cash flow during
full-recovery year

Example: Find the payback period for a project which has the
following cash flows
Full-recovery year

Cash Flow
Cumulative
Net CF

-3,000

1,500

1,200

800

300

-3,000

-1,500

-300

500

800

PB =

PB

2 + 300/800 = 2.375 years

Payback Period

Decision Rules:
PP = payback period
MDPP = maximum desired payback period
Independent Projects:
PP MDPP - Accept
PP > MDPP - Reject
Mutually Exclusive Projects:
Select the project with the fastest payback,
assuming PP MDPP.

Pitfalls in using the payback period

Which project would you choose from the

followings, given a 2 years payback?
Project

C0

C1

C2

C3

Payback
period

500 5000

-2,000

500

-2,000

500

1800

-2,000 1800

500

16

Pitfalls in using the payback period

Project

C0

C1

C2

C3

500 5000

Payback
period

NPV @
10%

+2,624

-2,000

500

-2,000

500

1800

-58

-2,000 1800

500

+50

17

Pitfalls in using the payback period

By using payback period:

You may select projects that are not acceptable

under NPV rule look at project B

You wont consider the timing of cash flows within

the payback period compare project B and
project C
You wont consider the payments after the payback
period compare project A and project C

You cant compare projects that have no initial

investment
Arbitrary standard for payback period
18

Use of payback period

PB is often used when making relatively

small decisions
PB ensures liquidity
Nevertheless, as a decision grows in
importance, the NPV becomes the order of
the day
19

Discounted Payback Period

Similar to Payback Period Method

Expected future cash flows are discounted by

the projects cost of capital
Thus the discounted payback period is
defined as the number of years required to
recover the investment from discounted net
cash flows.

Discounted Payback Period

Number of years before
full recovery of
original investment

DPB =

Uncovered cost at start

of full-recovery year
Total discounted cash flow during
full-recovery year

Example: Find the discounted payback period for a project which has
the following cash flows
Full-recovery year

-3,000
Cash Flow
Cumulative
-3,000
Net Discounted CF

r =10%

PB

1,500

1,200

800

300

-1,636

-645

-44

161

DPB = 3 + 44/161 = 3.273 years

Discounted payback period

Although recognizes TVM, it has the same

problems as the traditional payback period

Is suitable to be used in case of investments

made in risky markets.

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Internal rate of return

IRR tries to find a single number that

summarizes the merits of a project
This number does not depend on the interest
rate that prevails in the capital market
The number is intrinsic to the project and

only depends on the cash flows of the

project and their timing

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Internal Rate of Return (IRR)

Definition:

The discount rate for what the PV of a projects

expected cash flows is equal with the initial cost
(NPV = 0)

CFt
TV
I0

t
n

IRR
1

IRR
t 1

Internal Rate of Return (IRR)

Decision Rules:
Independent Projects:
IRR opportunity cost of capital
- Accept
IRR < opportunity cost of capital - Reject
Mutually Exclusive Projects:
Select the project with the highest IRR,
assuming IRR opportunity cost of capital.

Internal rate of return illustrated

Year
Cash flow

-200

50

100

150

Find r such that NPV = 0

50
100
150
0 200

2
1 r (1 r)
1 r 3

r 19.44% this r is IRR

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NPV profile
100,00

IRR = 19.44%

80,00
60,00

NPV

40,00
20,00
0,00
1

13

17

21

25

29

-20,00
-40,00
-60,00

Discount rate (%)

27

Trial and error for IRR

Trial and error

IRR is just under 20%

19.44%

Discount rates

NPV

0%

$100

5%

68

10%

41

15%

18

20%

-2

!!! In order to estimate IRR for the project you analyze, you
can use Excel IRR function by selecting the column/row of the
cash flows (inflows or outflows) the investment generates
including the initial cost.
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Internal Rate of Return (IRR)

Example: What is the IRR of a project with the following
cash flows?
0

-3,000

1,500

1,200

800

300

3000 = 1,500
+ 1,200 +
800
+
300
(1+IRR)
(1+IRR)2 (1+IRR)3 (1+IRR)4
NPV = 0 = -3000 + 1,500
+ 1,200 +
800
(1+IRR)
(1+IRR)2 (1+IRR)3
Answer: IRR= 13.114% (Excel function IRR)

+
300
(1+IRR)4

:
Modified Internal Rate of Return (MIRR)
It is basically the same as the IRR, except it assumes
that the revenue (cash flows) from the project are
reinvested back into the company, and are compounded
by the company's cost of capital, but are not directly
invested back into the project from which they came.
MIRR assumes that the revenue is not invested back
into the same project, but is put back into the general
"money fund" for the company, where it earns interest.
We don't know exactly how much interest it will earn,
so we use the company's cost of capital as a good
guess.

Modified IRR

What is the MIRR of a project with the following cash

flows if these cash flows are reinvested in the company at
a rate of return of 10%?
0

-3,000

1
1,500

1,200

800

300

1500 1 0.1 1200 1 0.1 800 1 0.1 300

4
MIRR
1
3000
3

MIRR = 0,115 or 11,5% . If the cost of capital is less than 11,5% we

can accept the investment project.

Profitability index
NPV of the investment
Profitabil ity index
Initial cost of the investment

PI Rule for independent projects:

Accept project if PI 0
Reject project if PI < 0

Look at this!
NPV 0

PI 0

IRR discount rate

ACCEPT PROJECT

NPV < 0 PI < 0

IRR < discount rate

REJECT PROJECT

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Problems with PI

Making decisions with PI for mutually exclusive

projects
Cash flows
Project

C0

C1

C2

PV @ 12%

PI

NPV @ 12%

-20

70

10

70.5

2.53

50.5

-10

15

40

45.3

3.53

35.3

Same problems as in the case of scale problem form

IRR decide using NPV
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Capital rationing
Cash flows

Project

C0

C1

C2

PV @ 12%

PI

NPV @ 12%

-20

70

10

70.5

2.53

50.5

-10

15

40

45.3

3.53

35.3

-10

-5

60

43.4

3.34

33.4

Suppose the projects above are independent, but

you have only $25 mil. to invest. Which project(s)
do you choose?
USE PROFITABILITY INDEX
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Equivalent Annual Cost

Equivalent Annual Cost - The cost per

period with the same present value as
the cost of buying and operating a
machine.

Equivalent Annual Cost

Equivalent Annual Cost - The cost per period
with the same present value as the cost of
buying and operating a machine.
present value of costs
Equivalent annual cost =
annuity factor

Equivalent Annual Cost

Example
Given the following costs of operating two
machines and a 6% cost of capital, select the
lower cost machine using equivalent annual cost
method.

Equivalent Annual Cost

Example
Given the following costs of operating two
machines and a 6% cost of capital, select the
lower cost machine using equivalent annual cost
method.

Machine
A
B

Year
1
15
10

2
5
6

3
5
6

4
5

PV@6%
28.37
21.00

EAC

Equivalent Annual Cost

Example
Given the following costs of operating two
machines and a 6% cost of capital, select the
lower cost machine using equivalent annual cost
method.

Machine
A
B

Year
1
15
10

2
5
6

3
5
6

4
5

PV@6%
28.37
21.00

EAC
10.61
11.45

Machinery Replacement
Annual operating cost of old machine = 8
Cost of new machine
Year:

0
15

1
5

2
5

3
5

NPV @ 10%
27.4

Equivalent annual cost of new machine =

27.4/(3-year annuity factor) = 27.4/2.5 = 11

MORAL: Do not replace until operating cost

of old machine exceeds 11.

Decision problem!

If you had to choose between these four

efficiency indicators, which one will be?
And why?

Quick Quiz (I)

As the opportunity cost of capital increases, the net

present
value
of
a
project
decreases.
A.True
B.False
When calculating IRR with a trial and error process,
discount rates should be raised when NPV is positive.
A.True
B.False
Projects with an NPV of zero decrease shareholders'
wealth
by
the
cost
of
the
project.
A.True
B.False

Quick Quiz (II)

The NPV of an investment made today is $7,500. If

postponed for one year, the NPV at that time will
increase by $500. Which of the following is correct if
the opportunity cost of the investment is 8%?
a) postpone; the NPV increases by a positive amount.
b) postpone; the NPV will remain positive.
c) invest now; NPV does not grow at a sufficient rate.
d) invest now; always accept positive NPV projects.

Quick Quiz (III)

Which of the following statements is most likely

correct for a project costing $50,000 and returning
$14,000
per
year
for
five
years?
a) NPV = $36,274.
b) NPV = $20,000.
c) IRR = 1.4%.
d)
IRR
is

greater

than

10%.

Quick Quiz (IV)

The opportunity cost of capital is equal to:
a)
the discount rate that makes project NPV equal
zero.
b) the return offered by other projects of equal risk.
c) a project's internal rate of return.
d) the average rate of return for a firm's projects.

Quick Quiz (V)

If two projects offer the same, positive NPV, then:

a) they also have the same IRR.

b) they have the same risk.
c) they have the same opportunity cost of capital.
d) they add the same amount to the value of the
firm.

Quick Quiz (VI)

The decision rule for net present value is to:

a) accept all projects with cash inflows exceeding

initial cost.
b) reject all projects with rates of return exceeding
the opportunity cost of capital.
c) accept all projects with positive net present
values.
d) reject all projects lasting longer than 10 years.

Quick Quiz (VII)

Two mutually exclusive investment proposals

have "scale differences" (i.e., the cost of the
projects differ). Ranking these projects on
the basis of IRR, NPV, methods
give
contradictory results.
will never
will always
may
will generally

Suggested quizzes and problems

BM, Chapter 5

Quizzes/p. 108 1, 2, 5-10

Questions & problems/p. 110 1; 3-8; 10; 12

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