Principles
of
Corporate
Finance
Ninth Edition
Chapter 6
Why Net Present Value Leads
to Better Investment Decisions
Than Other Criteria
Slides by
Matthew Will
McGraw Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
6- 2
Topics Covered
A Review of The Basics
– NPV and its Competitors
The Payback Period
– The Book Rate of Return
Internal Rate of Return
Capital Rationing
6- 3
NPV and Cash Transfers
Every possible method for evaluating projects
impacts the flow of cash about the company
as follows.
Cash
Investment
opportunity (real
asset)
Firm
Invest
Shareholder
Alternative:
pay dividend
to shareholders
Investment
opportunities
(financial assets)
Shareholders invest
for themselves
6- 4
CFO Decision Tools
Survey Data on CFO Use of Investment Evaluation Techniques
NPV, 75%
IRR, 76%
Payback, 57%
Book rate of
return, 20%
Profitability
Index, 12%
0%
20%
40%
60%
SOURCE: Graham and Harvey, “The Theory and Practice of Finance: Evidence from the Field,”
Journal of Financial Economics 61 (2001), pp. 187-243.
80%
100%
6- 5
Book Rate of Return
Book Rate of Return - Average income divided by average
book value over project life. Also called accounting rate
of return.
book income
Book rate of return 
book assets
Managers rarely use this measurement to make decisions.
The components reflect tax and accounting figures, not
market values or cash flows.
6- 6
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
ignores later year cash flows and the the present
value of future cash flows.
6- 7
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.
Project
C0
C1
C2
C3
A
- 2000
500
500
5000
B
- 2000
500
1800
0
C
- 2000 1800
500
0
Payback
Period
NPV@ 10%
6- 8
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.
C3
Payback
Project
C0
C1
C2
A
- 2000
500
500
B
- 2000
500
1800
0
2
- 58
C
- 2000 1800
500
0
2
 50
Period
5000
3
NPV@ 10%
 2,624
6- 9
Internal Rate of Return
Example
You can purchase a turbo powered machine tool
gadget for $4,000. The investment will generate
$2,000 and $4,000 in cash flows for two years,
respectively. What is the IRR on this investment?
6- 10
Internal Rate of Return
Example
You can purchase a turbo powered machine tool gadget for $4,000.
The investment will generate $2,000 and $4,000 in cash flows for two
years, respectively. What is the IRR on this investment?
2,000
4,000
NPV  4,000 

0
1
2
(1  IRR ) (1  IRR )
IRR  28.08%
6- 11
Internal Rate of Return
2500
2000
IRR=28%
1000
500
-1000
-1500
-2000
Discount rate (%)
10
0
90
80
70
60
50
40
30
-500
20
0
10
NPV (,000s)
1500
6- 12
Internal Rate of Return
Pitfall 1 - Lending or Borrowing?
 With some cash flows (as noted below) the NPV of the
project increases s the discount rate increases.
 This is contrary to the normal relationship between NPV and
discount rates.
Project
C0
C1
IRR
NPV @ 10%
A
 1,000  1,500  50%
 364
B
 1,000  1,500  50%
 364
6- 13
Internal Rate of Return
Pitfall 2 - Multiple Rates of Return
 Certain cash flows can generate NPV=0 at two different discount rates.
 The following cash flow generates NPV=$A 3.3 million at both IRR%
of (-44%) and +11.6%.
Cash Flows (millions of Australian dollars)
C0
 600
C1...... ......C9
120
120
C10
 150
6- 14
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=$A 3.3 million at both IRR% of
(-44%) and +11.6%.
NPV
600
IRR=11.6%
300
Discount
Rate
0
-30
-600
IRR=-44%
6- 15
Internal Rate of Return
Pitfall 2 - Multiple Rates of Return
 It is possible to have a zero IRR and a positive NPV
Project
C
C0
C1
C2
IRR
 1,000  3,000  2,500 None
NPV @ 10%
 339
6- 16
Internal Rate of Return
Pitfall 3 - Mutually Exclusive Projects
 IRR sometimes ignores the magnitude of the project.
 The following two projects illustrate that problem.
Project
C0
C1
IRR
NPV @10%
D
 10,000  20,000 100%
 8,182
E
 20,000  30,000  75%
 11,818
6- 17
Internal Rate of Return
Pitfall 3 - Mutually Exclusive Projects
6- 18
Internal Rate of Return
Pitfall 4 - Term Structure Assumption
 We assume that discount rates are stable during
the term of the project.
 This assumption implies that all funds are
reinvested at the IRR.
 This is a false assumption.
6- 19
Profitability Index
 When resources are limited, the profitability index
(PI) provides a tool for selecting among various
project combinations and alternatives
 A set of limited resources and projects can yield
various combinations.
 The highest weighted average PI can indicate
which projects to select.
6- 20
Profitability Index
Cash Flows ($ millions)
Project
C0
C1
C2
NPV @ 10%
A
 10  30
5
21
B
5
5
 20
16
C
5
5
 15
12
D
0
 40
60
13
6- 21
Profitability Index
Cash Flows ($ millions)
Project
Investment ($) NPV ($) Profitabil ity Index
A
10
21
2.1
B
5
16
3.2
C
5
12
2.4
D
0
13
0.4
6- 22
Profitability Index
NPV
Profitabil ity Index 
Investment
Example
We only have $300,000 to invest. Which do we select?
Proj
A
B
C
D
NPV
230,000
141,250
194,250
162,000
Investment
200,000
125,000
175,000
150,000
PI
1.15
1.13
1.11
1.08
6- 23
Profitability Index
Example - continued
Proj NPV
A
230,000
B
141,250
C
194,250
D
162,000
Investment
200,000
125,000
175,000
150,000
PI
1.15
1.13
1.11
1.08
Select projects with highest Weighted Avg PI
WAPI (BD) = 1.13(125) + 1.08(150) + 0.0 (25)
(300)
(300)
(300)
= 1.01
6- 24
Profitability Index
Example - continued
Proj NPV
A
230,000
B
141,250
C
194,250
D
162,000
Investment
200,000
125,000
175,000
150,000
PI
1.15
1.13
1.11
1.08
Select projects with highest Weighted Avg PI
WAPI (BD) = 1.01
WAPI (A) = 0.77
WAPI (BC) = 1.12
6- 25
Linear Programming
 Maximize Cash flows or NPV
 Minimize costs
Example
Max NPV = 21Xn + 16 Xb + 12 Xc + 13 Xd
subject to
10Xa + 5Xb + 5Xc + 0Xd <= 10
-30Xa - 5Xb - 5Xc + 40Xd <= 12
6- 26
Vegetron Case
YEAR
1.Revenue
2. Operating costs
3. Depreciation a
4. Net income
5. Start-of-year book value
Book rate of return
(4÷5)
1
180
70
80
30
400
2
180
70
80
30
320
3
180
70
80
30
240
4
180
70
80
30
160
5
180
70
80
30
80
7.50%
9.40%
12.50%
18.75%
37.50%
6- 27
Vegetron Case
YEAR
1.Reyenue
2. Operating costs
3. Depreciation a
4. Net income
5. Start-of-year book value
6. Book rate of return
(4÷5)
1
140
55
57
28
400
2
140
55
57
28
343
3
140
55
57
28
286
4
140
55
57
28
229
5
140
55
57
28
171
6
140
55
57
28
114
7
140
55
57
28
57
7.00%
8.20%
9.80%
12.20%
16.40%
24.60%
49.10%
6- 28
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