Economics 360

Lecture 4: Investment Rules

Jesse Davis

Last Lecture

Tracking principal and interest payments

APR and EAY
Inflation and inflation protection
Real and nominal cash flows and interest rates

Today

Decision-making tools for investment

NPV
IRR
Profitability Index
Payback Period

Strengths and shortcomings of each

Net Present Value (NPV)

NPV: the sum of the present value of future cash
flows plus todays cash flow
N

Ct
NPV C0
t
t 1 (1 r )
NPV decision rule:
Accept project if NPV is greater than zero
Reject project is NPV is less than zero

If you have to choose between several mutually

exclusive projects, pick the one with the highest
NPV

Example: Capital Gains and NPV

You are thinking about building a house today for

$150,000, and you would be able to sell it two years
later for $200,000. Assuming a discount rate of 10%,
should you make this investment?
How might a capital gains tax affect your decision?
What if theres an annual property tax of 7% based
on the last sales price?

Example: Product Improvement

Your company sells 10,000 cars per year, for $20,000

per car. You are thinking of upgrading the tires on
your line of cars for $30M, for just one year.
Sales would increase by 10%, and the price per car
would increase by 5% for that year. The discount rate
is 12%. Should you make the investment?

Should you use NPV?

NPV is an excellent investment decision-making tool for
several reasons:
Uses actual cash flows: some tools rely on accounting
figures
Uses every cash flow: some tools only use some cash
flows, even though all are relevant
Uses proper discounting: some tools ignore the time value
of money

Shortcomings:
Does not provide an overall picture of the gain or loss
associated with a project
Projects with negative NPV can be rejected, but a firm may
be worse off if they do not accept the project

Internal Rate of Return (IRR)

Definition: The IRR is the discount rate that causes the
NPV of the project to be zero:
N

Ct
C0
0
t
t 1 (1 IRR )
IRR Decision Rule:
Accept the project if IRR is greater than the discount rate
Reject the project if IRR is less than the discount rate

The IRR is internal to the project, and depends on

nothing except the cash flows of the project
We break even if we discount at the IRR; any lower
discount rate will give a positive NPV

Example

A project costs $80K today and will pay $84K dollars

next year. What is the IRR?
Your discount rate is 2%. Should you accept the
project?

Example: Varying cash flows

Your project has the following cash flows:
Year

Project CF

-10,000

3,000

6,000

4,000

Your firm has a cost of capital of 15%. Should you

accept this project on the basis of IRR?

Example: Varying cash flows

3K
6K
4K
0 10 K

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

This implies an IRR of about 13.7%

A closed form solution would involve solving a
cubic polynomial
This only gets worse with more time periods
Accept or reject the project? We reject since the IRR
is less than the cost of capital. Wed be better off
investing the $10K at the 15% rate!

Solving for the IRR

Obtaining the IRR requires us to solve a higher-order

polynomial.
Calculator: Some financial calculators can solve
directly for the IRR
Excel: Use the IRR function in Excel, or use Solver in
Excel
Blood, sweat and tears: This is not a good idea

Should you use IRR?

IRR and NPV are the most common investment
decision tools used by CEOs
One slight advantage of IRR
Rates of return can be easier to understand

IRR makes a good supplement to NPV

However, IRR has several shortcomings that NPV
does not

Shortcoming #1: Project Scale

Suppose you have two mutually exclusive projects:

Year

Project A

Project B

-10,000

-20,000

20,000

36,000

Your cost of capital is 10%. Which project should you

choose based on IRR? NPV?

Shortcoming #1: Project Scale

IRRA = 100%, NPVA = $8,181
IRRB = 80%, NPVB = $12,727
NPV is always correct. Why does IRR favor project A?
Higher return on investment, even though B yields
a higher profit
We cant use individual IRRs to pick a project if they
both have different initial outlays
What is assumed about the scale of the investment?

Shortcoming #2: Changes of Sign

If the cash flows of a project change sign twice or
more, it is possible to get more than one IRR.
Suppose we have the following cash flows:
Year

Cash Flow

-$500,000

$1,605,000

-$1,716,900

$612,040

Shortcoming #2: Changes of Sign

Very easy to calculate the NPV of this project

However, using IRR, we get three solutions:
IRR1 = 4%, IRR2 = 7%, IRR3 = 10%
Suppose the cost of capital was 8%. How would we
make an investment decision using IRR?

Fixing Shortcoming #2
Use Modified IRR (MIRR)
Assumes that any cash inflows are reinvested until
the final period (N) of the project

FVN (cash inflows)

PV (cash outflows)
(1 MIRR) N
Decision Rule:
Accept if the MIRR is greater than the cost of capital
Reject if the MIRR is less than the cost of capital

Example: MIRR
Suppose we had the following cash flows:
Year

Project CF

-50,000

110,000

-70,000

Assuming a cost of capital of 10%, what is the MIRR?

Confirm your decision using NPV.

Shortcoming #3: Investing or Financing?

Suppose you have the following cash flows:
Year

Project A

Project B

-100,000

100,000

120,000

-120,000

Clearly, the IRRs of both projects are 20%

The usual decision rule applies for the investment
project, Project A
However, the financing project, Project B, applies the
opposite decision rule:
Accept if the IRR is less than the cost of capital
Reject if the IRR is greater than the cost of capital

Shortcoming #4: Timing of CFs

One project may have higher cash flows toward the
end of the project, while the other has higher cash
flows toward the beginning
Therefore, a higher discount rate has a bigger
effect on the former, and thus IRR would likely
favor the latter
If the discount rate is high, NPV aligns with IRR
However, a low discount rate would likely favor
the former, rendering the IRR decision rule
incorrect

Example: CF Timing
Consider the following two projects:
Year

Project A

Project B

-10K

-10K

10K

1K

1K

1K

1K

12K

What is the IRR of each project?

What is the NPV of each project? First assume a 10%
discount rate, then a 15% discount rate.

Summary of IRR Shortcomings

1. Scale of investment
2. Multiple IRRs
Solution: Use Modified IRR
3. Different decision rule for whether you are investing
or financing
Solution: Note the type of project
4. Timing of cash flows
Remember: NPV is always right!

Profitability Index
Definition: Take the PV of all future cash flows and
divide it by the initial outflow
Decision rule:
Accept project if this ratio is greater than 1
Reject if this ratio is less than 1
Analogous to the NPV calculation, but is essentially a
gross return

Should you use the Profitability Index?

Ranking projects by the profitability index might
favor the project with the lower NPV (problem of
scaling investment)
Higher return, but a lower profit
However, the profitability index is very useful if you
have multiple projects and only so much money to
go around
This is a case of capital rationing , or scarce capital

Example: NPV v. PI
Suppose you have $1,000,000 available in venture
capital and you can choose to take on any
combination of the following projects:
Project

Cost

PV(Future CFs) NPV

PI

200K

300K

100K

1.50

500K

620K

120K

1.24

400K

700K

300K

1.75

200K

275K

75K

1.38

100K

130K

30K

1.30

100K

140K

40K

1.40

Example: NPV v. PI

Which projects do you choose?

Solution: Constrained Maximization
Summing NPV (wrong way): C, B, F
Using Profitability Index (possibly correct):
Rank the projects by their PI
Choose the projects according to rank until you
run out of cash
Therefore choose projects C, A, F, D, E

Payback Period
Definition: the number of years it takes to recover
the initial cost of the investment
An investment costs $100,000 and the future cash
flows at t = 1, 2, 3 are $60,000, $50,000, and
$40,000, respectively
Thus the payback period is 2 years
Discounting is ignored
Payback Period Rule: if the payback period is less
than or equal to t years, invest. Otherwise, reject.

Example: ST v. LT Cash Flows

Year

Project A

Project B

-$100

-$100

$150

$50

$50

$20

$10

$1000

Suppose we are given mutually exclusive projects, as

defined below
Our payback period rule is 2 years. Which project
should we choose?
Why does that seem problematic?

Should you use the Payback Rule?

Advantages: Simplicity?
Shortcomings:
Does not consider the time value of money
The discounted payback period method corrects for
this by discounting cash flows

Ignores cash flows after the payback period

Payback rule is set arbitrarily

Summary

Investment Decision Tools

NPV
IRR
Profitability Index
Payback Period
Remember: NPV is always correct

Next Class

Capital Budgeting
Calculating cash flows from accounting figures
Revenues and costs
Depreciation
Net working capital
Salvage value