The Investment Decision

NPV as Investment Decision

Criteria
 Importance of Investment Decisions

They influence the firm’s growth in the long

run
They affect the risk of the firm
They involve commitment of large amount of
funds
They are irreversible or reversible at
substantial loss
Appraisal of investment decision involves
Technical appraisal
Financial appraisal
Economic appraisal
Investment Decision

It includes decision for

Expansion to new product or new market or
capacity
Replacement of existing assets
Up gradation of existing assets
Steps of evaluation

A manager faces three major steps when

he makes an investment decision:
Search out new opportunities or new
technologies which are the basis of growth
The expected cash flow from the projects
have to be estimated
Projects have to be evaluated using a
sound decision rule or capital budgeting
technique.
 Assumptions

To begin with the assumptions are:

The stream of cash flows generated by a
project can be estimated with absolute
certainty.
The opportunity cost of fund provided to the
firm is known and will remain same over the
time period.
The capital market is frictionless, i.e the
managers can separate investment decision
from individual shareholders’ preferences.
 Essential properties of a capital
budgeting technique

The best technique will possess the properties:

All cash flows should be considered.
The time at which a cash flow is generated
should be taken into consideration.
The technique should select the project among
available set of mutually exclusive projects which
maximizes shareholders’ wealth; i.e it should be
consistent with the basic objective of a firm.
Allow for differences in risk
Manager should be able to consider one project
independently from all others.( Value-additivity
principle)
Capital Budgeting Techniques

Many capital budgeting techniques are in

use in practice. Few of them, which will be
discussed:
Net Present Value
Internal rate of return
The payback method
Accounting rate of return
 However only one of these techniques fulfills all
essential properties.
Payback
The payback period of a project is the
number of years it takes before the
cumulative forecasted cash flow equals the
initial outlay.
The payback rule says only accept projects
that “payback” in the desired time frame.
This method is flawed, primarily because it
the time value of money, and completely
ignores the value of cash flows beyond the
payback horizon.
 Payback
Example
Examine the three projects and note the
mistake we would make if we insisted on
only taking projects with a payback
period of 2 years or less.
Payback
Project C0 C1 C2 C3 NPV@ 10%
Period
A - 2000 500 500 5000
B - 2000 500 1800 0
C - 2000 1800 500 0
Payback
Example
Examine the three projects and note the
mistake we would make if we insisted on
only taking projects with a payback
period of 2 years or less.
 Book Rate of Return

Book Rate of Return - average income divided by

average book value over project life. Also called
accounting rate of return
The components reflect accounting figures, not
market values or cash flows. No account is taken
of time and risk.
Av' book income
Book rate of return 
Av' book assets
Internal Rate of Return
Example
The rate of return for which NPV = 0
You can purchase a turbo powered
machine tool gadget for Rs.4,000. The
investment will generate Rs.2,000 and
Rs.4,000 in cash flows for two years,
respectively. 2,000is the 4IRR
What ,000on this
NPV  4,000   0
investment? (1  IRR ) (1  IRR )
1 2

IRR  28.08%
Net Present value
NPV is calculated by discounting the cash flows
at the firm’s opportunity cost of capital.
Mathematically this can be represented as:

NPV = Σ FCFt / (1+k)t - I0

t=1

 Where FCFt are the free cash flow in time period t,

 I0 is the initial cash outlay,
 K is the firm’s opportunity cost of capital
 N is the no. of years of the project

The NPV criteria will accept project that have an

NPV>0
 Illustration
The following table reflects the cash flow for
four projects each of which have a five year
life.
Cash Flows

Year A B C D PVIF@10%

0 -1000 -1000 -1000 -1000 1

1 100 0 100 200 0.909

2 900 0 200 300 0.826

3 100 300 300 500 0.751

4 -100 700 400 500 0.683

5 -400 1300 1250 600 0.621

Net Present value
Considering the opportunity cost as 10%, the NPV for Project A
can be calculated by discounting each of the cash flows back to
its present and summed them.
Year (Cash Flow)A X PV Factor = PV
0 -1000 1 -1000
1 100 0.909 90.9
2 900 0.826 743.4
3 100 0.751 75.1
4 -100 0.683 -68.3
5 -400 0.621 -248.4
NPV = -407.3

Calculating in the similar way, the NPV of the four projects are:

Project A: NPV = -407.30 Project C: NPV = 530.85

Project B : NPV = 510.70 Project D : NPV = 519.20

Net Present value

If the projects are independent , project A

would be rejected and project B,C & D will
be accepted
If the projects are mutually exclusive
project C will be accepted.
The NPV of a project will be exactly same
with the increase in shareholders’ wealth.
Internal Rate of Return

IRR=28%
Internal Rate of Return
Pitfall1 - Lending or Borrowing?
 With some cash flows (as noted below) the NPV
of the project increases s the discount rate
increases.
 This is contrary to the normal relationship
between NPV and discount rates.

C0 C1 C2 C3 IRR NPV @ 10%

 1,000  3,600  4,320  1,728  20%  .75
Internal Rate of Return
Pitfall 1 - Lending or Borrowing?
 With some cash flows (as noted below) the
NPV of the project increases the discount rate
increases.
 This is contrary to the normal relationship
betweenNPV NPV and discount rates.

Discount
Rate
 Internal Rate of Return
Pitfall 2 – Multiple Rates of Return
Certain cash flows can generate NPV=0 at two different
discount rates.
The following cash flow generates NPV=0 at both 25%
and 400%.

C0 C1 C2 IRR NPV @ 10%

 4000  25000  25000  25%;400%  1934
 Internal Rate of Return
Pitfall 2 - Multiple Rates of Return
 Certain cash flows can generate NPV=0 at two different
discount rates.
 The following
NPVcash flow generates NPV=0 at both 25% and
400%. 1000

IRR=400
500
%

0 Discoun
t Rate

-500 IRR=25%

-1000
Internal Rate of Return
Pitfall 2 - No Rate of Return
The problem of ‘No IRR’

C0 C1 C2 IRR NPV @ 10%

 1,000  3,000  2500   339
 Internal Rate of Return
Pitfall 3 - Mutually Exclusive Projects (one
excludes the other)
The following two projects illustrate the
problem. C0
Project Ct IRR NPV @ 10%
F  10,000  20,000 100  8.182
G  20,000  35,000 75  11,818

F has the highest IRR, but G makes you

wealthier
 Internal Rate of Return
Pitfall 4 - Term Structure Assumption
We assume that discount rates are constant
for the term of the project.
What do we compare the IRR with, if we have
different rates for each period, r1, r2, r3, …
and so on?
Internal Rate of Return
Pitfall 5 Misinterpretation
An IRR of 10% for 3 years on a Rs.1000
investment, does not necessarily mean the
same thing as investing Rs.1000 for three
years at 10% compound return.
It does mean that you will earn 10% on
each dollar that remains invested each
year
some projects repay capital early in their life.
IRR and NPV
Both IRR and NPV are DCF methods, so
both can allow for risk and the time value
of money
Both, properly used, give the same accept
reject decisions
But they may not give the same ranking
This is a problem when selecting from
mutually exclusive projects
NPV is typically the better technique
Weaknesses of NPV
NPV ignores the value of real options
 Eg. Expansion, abandonment, change of use
NPV calculations are only a part of capital
budgeting. Other parts include:
generating ideas for projects
developing forecasts
organisational politics
Profitability Index
When resources are limited, the profitability
index (PI) provides a tool for selecting
among various project combinations and
alternatives.
The idea is to get the biggest bang for our
bucks
So we take projects with the maximum
ratio of NPV to investment.
Profitability Index
NPV
Profitabil ity Index 
Investment
Example