CHAPTER 7

Net Present Value and

Other Investment Rules
To understand this chapter, you must be very
familiar with the TVM concept covered in Ch. 4.

FIN 6301: Financial Management

Instructor: Dr. Hiro Nishi

The University of Texas at Dallas

Naveen Jindal School of Management

LEARNING OBJECTIVES

Capital Budgeting is a decision-making

process with respect to investments in fixed
assets.

Q: Should a project be accepted or rejected?

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LEARNING OBJECTIVES
1. Understand different capital budgeting
criteria:
- Whether a project should be accepted or
rejected
- Advantages & disadvantages

2. Learn how “mutually exclusive” projects

can be ranked.
- Unequal sizes
- Unequal or perpetual lives
2

LEARNING OBJECTIVES
There are various decision-making criteria:
1. Payback Period (PP)
2. Net Present Value (NPV)
3. Profitability Index (PI)
4. Internal Rate of Return (IRR)
5. Modified Internal Rate of Return (MIRR)
6. Incremental IRR
7. Equivalent Annual Cost (EAC)
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PAYBACK PERIOD

Payback period (PP) is the number of years

needed to recover the initial cash outlay
related to an investment.

• How long does it take before the

“cumulative cash flow” becomes positive?

EXAMPLE #1
Consider a project that requires an initial
investment of $20,000 and generates the
following free cash flows for the next 6 years.
What is the payback period for this project?
Year Cash Flow
1 5,000
2 5,000
3 5,000
4 3,000
5 10,000
6 10,000

PP = 4 + 2,000/10,000 = 4.2 years

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PAYBACK PERIOD
Decision Rule

If PP ” A firm’s maximum desired “period”

ĺ Accept the project
(Project will be paid off within the specific
period a firm desires)

If PP > A firm’s maximum desired “period”

ĺ Reject the project

PAYBACK PERIOD
Advantages
• Easy to compute and understand
• Useful for firms that have capital constraints

Disadvantages
• Ignores the time value of money

• Does not consider cash flows beyond the

payback period

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 NET PRESENT VALUE

• Consider the project in Example #1.

• Further assume that the firm has a 10%
required rate of return.

Years 0 1 2 3 4 5 6
($20,000) $5,000 $5,000 $5,000 $3,000 $10,000 $10,000

N PV
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NET PRESENT VALUE

Net Present Value (NPV) is the present value
of a project’s future free cash flows (FCF) less
the initial investment (IV).

FCF1 FCF2 FCFn

NPV = 1 + 2 +…+ n – IV
1+r 1+r 1+r

$5K $5K $10K

= 1 + 2 +…+ 6 – $20K
1 + .10 1 + .10 1 + .10

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 NET PRESENT VALUE
CF ---> 2nd ---> Clr Work
First, hit CF to view the Cash-Flow screen:
1. CF0 = $ value of initial investment
2. Use Ĺ and Ļ to switch and ENTER to set
a value
• C01 (Cash 01) = Value of FCF per period
during the 1st period set
• F01 (Frequency 01) = Number of times
C01 is repeated
3. Repeat #2
4. Hit NPV and I = Required rate of return
5. When NPV is displayed, hit CPT 10

NET PRESENT VALUE

To clear the memory in the cash-flow function:

1. Hit CF

2. Hit 2ND

3. Hit CLR WORK (= CE|C)

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EXAMPLE #2
Consider the project in Example #1. If the firm
has a 10% required rate of return, what is the
NPV for this project?
Year Cash Flow CF0 = -20,000
Initial Inst. -20,000
C01 = 5,000, F01 = 3
1 5,000
2 5,000 C02 = 3,000, F02 = 1
3 5,000 C03 = 10,000, F03 = 2
4 3,000
5 10,000 NPV ĺ I = 10
6 10,000 NPV = $6,337

12

EXAMPLE #3
Consider a project that requires an initial
investment of $10,000 and generates FCFs of
$7,500 at the end of year 4 and 5. If the firm
has a 10% required return, what is the NPV?
Years 0 1 2 3 4 5

($10,000) $0 $0 $0 $7,500 $7,500

CF0 = -10,000
C01 = 0, F01 = 3
C02 = 7,500, F02 = 2
NPV ĺ I = 10
NPV = $-220.5
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NET PRESENT VALUE

Decision Rule

If NPV > $0
ĺ Accept the project
(Project is expected to add value to the firm)

If NPV < $0
ĺ Reject the project

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NET PRESENT VALUE

Advantages

• Recognizes time value of money

• Considers all cash flows

Disadvantage

• Requires long-term forecast of cash flows

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IN-CLASS EXERCISE #1

Capulet Industries Inc. is considering a project

that provides an annual cash inflow of $200,000
for the first ten years and $500,000 per year for
Year 11 through Year 15. The project requires an
initial investment of $1.8 million. If the firm’s
required return for this project is 10%, what is
the net present value (NPV)?

16

PROFITABILITY INDEX

Profitability Index (PI) is the ratio of the

present value of a project’s future FCF to the
initial cash investment.

PV of all the future FCFs

PI =
Initial Investment

FCF1బ FCF2బ FCFnబ

NPV = 1 + 2 +…+ n – Initial Invest.
1+r 1+r 1+r

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EXAMPLE #4

Using your answer in Example #2, calculate

the profitability index for the project.

Year Cash Flow

Initial Inst. -20,000
1 5,000
2 5,000
3 5,000
4 3,000
26,337
PI = = 1.317
5 10,000
20,000
6 10,000

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PROFITABILITY INDEX

Decision Rule

If PI > 1
ĺ Accept the project
(NPV and PI always lead to the same
accept-or-reject decision)

If PI < 1
ĺ Reject the project

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IN-CLASS EXERCISE #2

Capulet Industries Inc. is considering a project

that provides an annual cash inflow of $200,000
for the first ten years and $500,000 per year for
Year 11 through Year 15. The project requires an
initial investment of $1.8 million. If the firm’s
required return for this project is 10%, what is
the profitability index (PI) of this project?

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INTERNAL RATE OF RETURN

Internal Rate of Return (IRR) is the discount
rate that equates 1) the PV of a project’s future
cash flows to 2) the initial cash investment.
• IRR is the discount rate when NPV = $0.

FCF1 FCF2 FCFn

Initial Invest. = 1 + 2 + … + n
1 + IRR 1 + IRR 1 + IRR

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RELATIONSHIP: NPV & IRR

The curve represents the relationship between

the discount rate (X-axis) and NPV (Y-axis).

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INTERNAL RATE OF RETURN

First, hit CF to view the Cash-Flow screen:
1. CF0 = $ value of initial outlay
2. Use Ĺ and Ļ to switch and ENTER to set
a value
• C01 (Cash 01) = Value of FCF per period
during the 1st period set
• F01 (Frequency 01) = Number of times
C01 is repeated
3. Repeat #2

4. Hit IRR and hit CPT

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EXAMPLE #5
Consider the project in Example #2 and #4. What
is the IRR for this project?

Year Cash Flow

Initial Inst. -20,000 CF0 = -20,000
1 5,000 C01 = 5,000, F01 = 3
2 5,000 C02 = 3,000, F02 = 1
3 5,000
C03 = 10,000, F03 = 2
4 3,000
5 10,000 IRR, CPT = 18.84%
6 10,000

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INTERNAL RATE OF RETURN

Decision Rule

If IRR > Required rate of return (discount rate)

ĺ Accept the project

If IRR < Required rate of return

ĺ Reject the project

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INTERNAL RATE OF RETURN
Advantages
• Recognizes time value of money
• Considers all cash flows
• Preferred by executives – it is intuitive!

Disadvantage
• Cannot rank mutually exclusive investment
decisions
• Can produce multiple answers
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IN-CLASS EXERCISE #3

Capulet Industries Inc. is considering a project

that provides an annual cash inflow of $200,000
for the first ten years and $500,000 per year for
Year 11 through Year 15. The project requires an
initial investment of $1.8 million. If the firm’s
required return for this project is 10%, what is
the internal rate of return (IRR) of this project?

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MULTIPLE IRR
A. Typical cash-flow pattern
• Negative initial investment followed by
positive cash flows only
• Ex: –, +, +, +, +, + …

B. Atypical cash-flow pattern

• Some of the cash flows following the
initial investment are negative
• Ex: –, +, +, +, –, + …
• There can be more than one IRR.
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MODIFIED IRR
Modified Internal Rate Of Return (MIRR)

• MIRR eliminates the problem that causes

multiple solutions.

• MIRR also assumes that positive cash

flows are reinvested at the firm’s required
rate of return
- Cost of financing, instead of IRR

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MODIFIED IRR
1. Discount all the negative cash flows back to
the present
2. Compound all the positive cash flows to the
end of the project’s life

Period CF Adjusted CF
0 (20,000) (24,050)
1 9,000 -
2 20,000 -
3 (6,000) 34,496

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IN-CLASS EXERCISE #4
Escalus Corporation is considering a project that
requires an initial investment of $12,000 at the
beginning. The project provides annual cash
inflows as following: $10,000 in Year 1, $10,000 in
Year 2, and $-5,000 in Year 3. The firm’s required
return for this project is 14%. What is the project’s
modified internal rate of return (MIRR)?

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 RANKING PROJECTS

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RANKING PROJECTS
• Mutually exclusive projects serve the
same purpose and therefore only one will be
selected.

• Different decision criteria may lead to

“conflicting ranking” due to:
ProjectA
1. Unequal sizes
ProjectB
2. Unequal lives ProjectC
3. Perpetual lives ProjectD
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1. UNEQUAL SIZES
Occurs when we examine mutually exclusive
projects of unequal size:
Example Project A
IV = $1mm
Project B
NPV = $250K
PI = 1.25
IV = $10mm
NPV = $1mm
PI = 1.10
• When there is size disparity, use NPV.
- If there is no budget constraint, project with
the largest NPV will be selected.
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1. UNEQUAL SIZES
An alternative method is Incremental IRR:

Year Project A Project B

0 (1,200,000) (500,000)
1 100,000 150,000
2 100,000 150,000
3 300,000 0
4 300,000 0
5 550,000 200,000
6 350,000 200,000

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1. UNEQUAL SIZES

Calculate the IRR of the “incremental” cash flows.

Larger project minus Smaller project

Year "Larger" Project "Smaller" Project Incremental Cash Flows

0 (1,200,000) (500,000) (700,000)
1 100,000 150,000 (50,000)
2 100,000 150,000 (50,000)
3 300,000 0 300,000
4 300,000 0 300,000
5 550,000 200,000 350,000
6 350,000 200,000 150,000

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IN-CLASS EXERCISE #5

Montague Healthcare Inc. is considering two

mutually exclusive projects as following. The firm’s
required return for this project is 10%. Calculate the
incremental IRR between Project A and Project B.

Year Project A Project B

0 (750,000) (150,000)
1 100,000 50,000
2 100,000 50,000
3 300,000 200,000
4 300,000 200,000
5 850,000 250,000

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2. UNEQUAL LIVES
Occurs when we compare mutually exclusive
projects with different life spans:
Example: Year Project A Project B
1
2 NPV =
3 $6mm
4 NPV =
5 $10mm
6
7
8
9
10
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2. UNEQUAL LIVES
NPV ignores the benefit of a shorter-life
project after its life span
• NPV is NOT appropriate!

Equivalent Annual Cost (EAC)

• Annual annuity (= PMT) determined by
setting the PV equal to NPV
• Determine the level of annuity cash flow that
would produce the NPV

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EXAMPLE #6
Assuming that the firm has a 10.0% required rate
of return, calculate the EAC for each project.

Year Project A Project B Project A

N = 10
1
I/Y = 10
2 NPV =
3 $6mm PV = $-10 million
4 NPV = CPT PMT = $1,627,454
5 $10mm
6 Project B
7 N=5
8 I/Y = 10
9 PV = $-6 million
10 CPT PMT = $1,582,785

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3. PERPETUAL LIVES
What if the project has a perpetual life? How
do you determine the value of the project
beyond Year 10?
Year Project A Project B
1
2
3
4
5 $10 million NPV $9 million NPV
6
7
8
9
10
11
12
Â
Â
Â
Year T 41