1

Net Present Value (NPV)

To determine net present value we . . .
Calculate the present value of cash inflows,
 Calculate the present value of cash outflows,
Subtract the present value of the outflows from the
present value of the inflows.
General decision rule . . .
 2

Net Present Value (NPV)

Net Present Value
 Present Value of all costs and benefits of a project.
 Concept is similar to Intrinsic Value of a security but subtracts
of cost of project.

NPV = PV of Inflows - Initial Outlay

CF1 CF2 CF3

NPV = (1+ k )
+ (1+ k )2
+ +···+ CFn n – IO
(1+ k )3 (1+ k )

CFn = Cash flow at time n

k = required rate of return
IO = Initial Investment
 3

Net Present Value (NPV)

Net Present Value P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

k=10%
0 1 2 3 4

(10,000) 500 500 4,600 10,000

Find Present Value of Cash Flows…

 4

Net Present Value (NPV)

Net Present Value P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

k=10%
0 1 2 3 4

(10,000) 500 500 4,600 10,000

455 $500
(1.10)
 5

Net Present Value (NPV)

Net Present Value P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

k=10%
0 1 2 3 4

(10,000) 500 500 4,600 10,000

$500
455
(1.10) 2
413
 6

Net Present Value (NPV)

Net Present Value P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

k=10%
0 1 2 3 4

(10,000) 500 500 4,600 10,000

455
$4,600
413
(1.10) 3
3,456
 7

Net Present Value (NPV)

Net Present Value P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

k=10%
0 1 2 3 4

(10,000) 500 500 4,600 10,000

455
413
$10,000
3,456
(1.10) 4
6,830
 8

Net Present Value (NPV)

P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

k=10%
0 1 2 3 4

(10,000) 500 500 4,600 10,000

455 NPV =
413
Accept Project
PV Benefits - PV Costs since NPV > 0
3,456
= $11,154 - $10,000
6,830
$11,154
= $1,154
 9

Net Present Value

P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
k=10%
0 1 2 3 4

(10,000) 3,500 3,500 3,500 3,500

3,500 3,500 3,500 3,500
NPV = (1+ .1 ) + (1+ .1)2 + (1+ .1 )3+ (1+ .1 )4 – 10,000

PV of 3,500 Annuity for 4 years at 10%

 10

Net Present Value

P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
k=10%
0 1 2 3 4

(10,000) 3,500 3,500 3,500 3,500

3,500 3,500 3,500 3,500
NPV = + (1+ .1)2 + (1+ .1 )3+ (1+ .1 )4 –
(1+ .1 ) 10,000
1 1
= 3,500( .10 .10(1+.10)4 ) - 10,000
= 11,095 – 10,000 = $1,095
Net Present Value (NPV)
11

NPV Decision Rules

 If projects are independent then accept
ACCEPT A & B
all projects with NPV ≥ 0.
 If projects are mutually exclusive, ACCEPT B only
accept project with higher NPV.

Mutually Exclusive:
Means that the acceptance of one project precludes the
acceptance of the other projects under consideration.
(You may only choose one.)
 12
Net Present Value Profile
Net Present Value Profile:
a graph of the NPV of a project at different
discount rates shows the NPV at 3 different
points:
a zero discount rate
the normal discount rate (or cost of capital)
the IRR
allows an easy way to visualize whether or
not an investment should be undertaken
 13

Net Present Value Profile

 Graphs the Net Present Value of the project with different
required rates
P R O J E C T
Time A B
6,000 0 (10,000.) (10,000.)
N
P
1 3,500 500
V 2 3,500 500
3 3,500 4,600
4 3,500 10,000
3,000

0
5% 10% 15% 20%
Cost of Capital

3,500 3,500 3,500 3,500

NPV(0%) = (1+ 0 ) + (1+ 0)2 + (1+ 0 )3 + (1+ 0)4 – 10,000
= $4,000
 14

Net Present Value Profile

 Graphs the Net Present Value of the project with
different required rates
P R O J E C T
Time A B
6,000 0 (10,000.) (10,000.)
N
P
1 3,500 500
V 2 3,500 500
3 3,500 4,600
4 3,500 10,000
3,000

0
5% 10% 15% 20%
Cost of Capital

NPV(5%) = 3,500 + 3,500 + 3,500

+ 3,500
– 10,000
(1+ .05 ) (1+ .05)
2 3 4
(1+ .05 ) (1+ .05)
= $2,411
 15
Net Present Value Profile

 Graphs the Net Present Value of the project with different

required rates
P R O J E C T
Time A B
6,000 0 (10,000.) (10,000.)
N
P
1 3,500 500
V 2 3,500 500
3 3,500 4,600
4 3,500 10,000
3,000

0
5% 10% 15% 20%
Cost of Capital

NPV(10%) = 3,500 + 3,500 2+ 3,500 + 3,500

– 10,000
(1+ .10 ) (1+ .10)
3
(1+ .10 )
4
(1+ .10)
= $1,095
 16
Net Present Value Profile

 Graphs the Net Present Value of the project with different

required rates
P R O J E C T
Time A B
6,000 0 (10,000.) (10,000.)
N
P
1 3,500 500
V 2 3,500 500
3 3,500 4,600
4 3,500 10,000
3,000

0
5% 10% 15% 20%
Cost of Capital

NPV(15%) = 3,500 + 3,500 2+ 3,500 + 3,500

– 10,000
(1+ .15 ) (1+ .15)
3
(1+ .15 )
4
(1+ .15)
= – $7.58
 17
Net Present Value Profile

 Graphs the Net Present Value of the project with different

required rates
P R O J E C T
Time A B
6,000 0 (10,000.) (10,000.)
N
P
1 3,500 500
V 2 3,500 500
3 3,500 4,600
4 3,500 10,000
3,000

0
5% 10% 15% 20%
Cost of Capital

NPV(20%) = 3,500 + 3,500 2+ 3,500 + 3,500

– 10,000
(1+ .20 ) (1+ .20)
3
(1+ .20 )
4
(1+ .20)
= – $939
 18

Net Present Value Profile

 Graphs the Net Present Value of the project with different
required rates
P R O J E C T
Time A B
6,000 0 (10,000.) (10,000.)
N
P
1 3,500 500
V 2 3,500 500
3 3,500 4,600
4 3,500 10,000
3,000

PROJECT A
0
5% 10% 15% 20%
Cost of Capital

Connect the Points

 19

Net Present Value Profile

 Graphs the Net Present Value of the project with different
required rates
P R O J E C T
Time A B
6,000 0 (10,000.) (10,000.)
N
P
1 3,500 500
V 2 3,500 500
3 3,500 4,600
4 3,500 10,000
3,000

0
5% 10% 15% 20%
Cost of Capital

500
NPV(0%) = + 500 + 4,6003 + 10,000 – 10,000
(1+ 0 ) (1+ 0)2 (1+ 0 ) (1+ 0)
4

= $5,600
 20

Net Present Value Profile

 Graphs the Net Present Value of the project with different
required rates
P R O J E C T
Time A B
6,000 0 (10,000.) (10,000.)
N
P
1 3,500 500
V 2 3,500 500
3 3,500 4,600
4 3,500 10,000
3,000

0
5% 10% 15% 20%
Cost of Capital

500
NPV(5%) = + 500 2 + 4,600 3 + 10,000 4 – 10,000
(1+.05) (1+.05) (1+ .05) (1+ .05)
= $3,130
 21

Net Present Value Profile

 Graphs the Net Present Value of the project with different
required rates
P R O J E C T
Time A B
6,000 0 (10,000.) (10,000.)
N
P
1 3,500 500
V 2 3,500 500
3 3,500 4,600
4 3,500 10,000
3,000

0
5% 10% 15% 20%
Cost of Capital

500
NPV(10%) = + 500 2 + 4,600 3 + 10,000 4 – 10,000
(1+.10) (1+.10) (1+ .10) (1+ .10)
= $1,154
 22

Net Present Value Profile

 Graphs the Net Present Value of the project with different
required rates
P R O J E C T
Time A B
6,000 0 (10,000.) (10,000.)
N
P
1 3,500 500
V 2 3,500 500
3 3,500 4,600
4 3,500 10,000
3,000

0
5% 10% 15% 20%
Cost of Capital

500
NPV(15%) = + 500 2 + 4,600 3 + 10,000 4 – 10,000
(1+.15) (1+.15) (1+ .15) (1+ .15)
= –$445
 23

Net Present Value Profile

 Graphs the Net Present Value of the project with different
required rates
P R O J E C T
Time A B
6,000 0 (10,000.) (10,000.)
N
P
1 3,500 500
PROJECT B
V 2 3,500 500
3 3,500 4,600
4 3,500 10,000
3,000

0
5% 10% 15% 20%
Cost of Capital

Connect the Points

 24

Net Present Value Profile

 Compare NPV of the two projects for different required
rates

6,000 Crossover point

N
P
V PROJECT B

3,000

0
5% 10% 15% 20%
Cost of Capital
 25

Net Present Value Profile

 Compare NPV of the two projects for different required
rates

6,000 Crossover point

N
P
V PROJECT B

3,000

For any discount rate <

crossover
0 point choose B
5% 10% 15% 20%
Cost of Capital
 26
Net Present Value Profile
 Compare NPV of the two projects for different required rates

6,000 Crossover point

N
P
V PROJECT B

3,000 For any discount rate >

crossover point choose A

PROJECT A

0
5% 10% 15% 20%
Cost of Capital
 27

The Internal Rate of Return (IRR)

The internal rate of return is the interest yield
promised by an investment project over its useful
life.
The internal rate of return is computed by finding the
discount rate that will cause the net present value
of a project to be zero NPV=0).
Requires calculating the interest rate that equates
the cash outflow (cost) with the cash inflows

Definition:
The IRR is the discount rate where NPV = 0
 28

The Internal Rate of Return (IRR)

ABC Company can purchase a new machine at a
cost of RM104,320 that will save RM20,000 per
year in cash operating costs.
The machine has a 10-year life.
Future cash flows are the same every year in this
example, so we can calculate the internal rate of
return as follows:

PV factor for the Investment required

=
internal rate of return Net annual cash flows
RM 104, 320
= 5.216
RM 20,000
 29

Using the present value of an annuity of $1 table . . .

Find the 10-period row, move across until

you find the factor 5.216. Look at the top of
the column and you find a rate of 14%.
14%

Periods 10% 12% 14%

1 0.909 0.893 0.877
2 1.736 1.690 1.647
. . . . . . . . . . . .
9 5.759 5.328 4.946
10 6.145 5.650 5.216

If the internal rate of 14 % return is equal to or greater

than the company’s required rate of return, the project
is acceptable.
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Internal Rate of Return Internal Rate of Return

Measures the rate of return on a project

Definition:
The IRR is the discount rate in which NPV = 0

6,000
N
P PROJECT B
V

3,000

NPV = $0

0
5% 10% 15% 20%
Cost of Capital
 31

Internal Rate of Return Internal Rate of Return

Measures the rate of return on a project

Definition:
The IRR is the discount rate in which NPV = 0

6,000
N
P PROJECT B
V

3,000
IRRA ≈ 15%
NPV = $0
IRRB ≈ 14%
0
5% 10% 15% 20%
Cost of Capital
 32

Internal Rate of Return Internal Rate of Return

Determine the mathematical solution for IRR

CF1 CF2 CFn

0 = NPV = + +···+ – IO
(1+ IRR ) (1+ IRR )2 (1+ IRR ) n

CF1 CF2 CFn

IO = + +···+
(1+ IRR ) (1+ IRR ) 2
(1+ IRR )n

Outflow = PV of Inflows
Solve for Discount Rates
 33

Internal Rate of Return

For Project B 6,000
N
P PROJECT B
V
Cannot solve for IRR
directly, must use Trial & 3,000
Error
IRRB ≈ 14%
0
5% 10% 15% 20%
Cost of Capital

10,000 = 500 + 500 2 + 4,600 3 + 10,000 4

(1+ IRR ) (1+ IRR ) (1+ IRR ) (1+ IRR )
TRY 14%
? 500
10,000 = + 500 2 + 4,600 3+ 10,0004
(1+ .14 ) (1+ .14) (1+ .14 ) (1+ .14 )
?
10,000 = 9,849 PV of Inflows too low, try lower rate
 34

Internal Rate of Return

For Project B 6,000
N
P PROJECT B
V
Cannot solve for IRR
directly, must use Trial & 3,000
Error
IRRB ≈ 14%
0
5% 10% 15% 20%
Cost of Capital

10,000 = 500 + 500 2 + 4,600 3 + 10,000 4

(1+ IRR ) (1+ IRR ) (1+ IRR ) (1+ IRR )
TRY 13%
? 500
10,000 = + 500 2 + 4,600 3+ 10,0004
(1+ .13 ) (1+ .13) (1+ .13 ) (1+ .13 )
?
10,000 = 10,155 13% < IRR < 14%
 35

Decision Rule for Internal Rate of Return

Independent Projects
Accept Projects with
IRR ≥ required rate

Mutually Exclusive Projects

Accept project with highest
IRR ≥ required rate
 36

Profitability Index

Very Similar to Net Present Value

PI = PV of Inflows
Initial Outlay

Instead of Subtracting the Initial Outlay from the PV

of Inflows, the Profitability Index is the ratio of Initial
Outlay to the PV of Inflows.

CF1 CF2 CF3 CFn

(1+ k )
+ (1+ k )2
+ +···+
(1+ k )3 (1+ k )n
PI =
Initial Outlay
 37

Profitability Index for Project B

P R O J E C T
Time A B
500 500 4,600 10,000
+ + +
(1+ .1 ) (1+ .1)2 (1+ .1 )3 (1+ .1 )4
0 (10,000.) (10,000.)
PI = 1 3,500 500
10,000 2 3,500 500
3 3,500 4,600
4 3,500 10,000
 38

Profitability Index for Project B

P R O J E C T
Time A B
500 500 4,600 10,000
+ + +
(1+ .1 ) (1+ .1)2 (1+ .1 )3 (1+ .1 )4
0 (10,000.) (10,000.)
PI = 1 3,500 500
10,000 2 3,500 500
3 3,500 4,600
11,154
PI = = 1.1154 4 3,500 10,000
10,000
 39

Profitability Index for Project B

P R O J E C T
Time A B
500 500 4,600 10,000
+ + +
(1+ .1 ) (1+ .1)2 (1+ .1 )3 (1+ .1 )4
0 (10,000.) (10,000.)
PI = 1 3,500 500
10,000 2 3,500 500
3 3,500 4,600
11,154
PI = = 1.1154 4 3,500 10,000
10,000

Profitability Index for Project A

1 1
3,500( .10 .10(1+.10) )
4

PI =
10,000
11,095
PI = = 1.1095
10,000
 40

Profitability Index Decision Rules

 Independent Projects
Accept Project if PI ≥ 1
 Mutually Exclusive Projects
Accept Highest PI ≥ 1 Project
 41

Comparison of Methods

Project A Project B Choose

Payback < 3 years < 4 years A
NPV $1,095 $1,154 B
IRR 14.96% 13.50% A
PI 1.1095 1.1154 B
 42

Comparison of Methods
 Time Value of Money
Payback - Does not adjust for timing differences
NPV, IRR and PI take into account the time value of
money
 Relevant Cash Flows?
NPV, IRR and PI use all Cash Flows
Payback method ignores Cash Flows that occur
after the Payback Period.
Project 1
0 1 2
Both Projects have
(10,000) 5,000 5,000
Identical Payback
Project 2
0 1 2 3

(10,000) 5,000 5,000 10,000

 43

Comparison of Methods
 NPV & PI indicated accept Project B while IRR
indicated that Project A should be accepted. Why?
 Reinvestment Rate
NPV assumes cash flows are reinvested at the
required rate, k.
IRR assumes cash flows are reinvested at IRR.
 Reinvestment Rate of k more realistic as most
projects earn approximately k (due to competition)
 Conclusion: NPV is the Better Method for project
evaluation
 44

Summary Problem:
A project costs $900 and will repay $300, $400, $400,
$500, and $600 over the first five years, respectively.

• Determine the NPV using a discount rate of15%.

• Find the IRR.
• Add back IO and divide by IO to get PI.

(900) 300 400 400 500 600

0 1 2 3 4 5
 45

Summary Problem:

Answers:

• IRR = 34.37%.
• Using a discount rate of 15%,
NPV = $510.52.
• PI = 1.57.

(900) 300 400 400 500 600

0 1 2 3 4 5