ADMS 3530 Winter 2012 – Professor Lois King
Lecture 6 – NVP and Other Investment Criteria – Feb 7
6.1 Net Present Value (NPV)
− The financial manager was responsible for 2 major decisions:
o Capital budgeting decision
Which projects or assets should a firm invest in?
o Financing decision
How should the firm pay for projects that are accepted?
− Unit 6 ▯we will look at different decision criteria that managers use in making the first
decisions, the capital budgeting decision.
− Capital Project – an investment in a project that is expected to generate revenues or cash
inflows for the firm for a period of more than one year.
− Tangible Assets – new pipeline for an oil company.
− Intangible assets – research expenditures for a pharmaceutical company.
− Project Analysis
o ▯ PV
o ▯Payback (simple or discounted)
o ▯Book rate of return
− NPV investment criteria:
o ‘Gold standard’ of investment criteria.
o Single best rule.
o A company will maximize shareholder wealth by accepting all projects that have a
− The NPV of a project = sum of the PV of all future cash flows – PV of the cost(s).
− NPV Rule – accept any project as long as the project NPV > 0.
− Advantage of NPV
o It always gives the correct investment decision as NPV is the amount that a
project will add to shareholder wealth.
− Disadvantage of NPV
o It may have to be adapted slightly when looking at competing projects.
6.2 Internal Rate of Return (IRR)
− Another popular investment criteria that is used in the real world.
− Can be defined as the discount rate which gives the project a zero NPV. − NOTE:
o The project’s IRR measures the profitability of the project. It is an internal rate of
return as it depends only on the project’s own cash flows.
o In IRR valuations, the opportunity cost of capital is the standard for deciding
whether or not to accept the project.
− IRR rule – accept any project as long as:
o Project IRR > Opportunity cost of capital (or the discount rate).
− Advantage of IRR
o It gives the same answer an NPV rule, as long as the NPV of a project declines
smoothly as the discount rate increases.
− Disadvantages of IRR (3 problems):
o For mutuallyexclusive projects, IRR mistakenly favours quick payback projects.
o IRR tends to be confusing when dealing with lending vs. borrowing situations.
o Some projects can have multiple IRRs – that is, there can be as many different
IRR’s as there are changes in the cashflow stream.
6.3 Other Investment Criteria
− Investment criteria for evaluating capital projects:
o NPV – ‘The gold standard’
o IRR – often used in real world but has a few disadvantages.
− Other investment criteria:
o Discounted payback
o Book rate of return
− Payback (or simple payback)
o A project’s payback is the length of time before you recover (or payback) your
It is simple to use and easy to understand.
Payback does not consider any cash flows that arrive after the payback
period ▯it biases the firm against accepting longterm projects.
It gives equal weight to all cash flows arriving before the cut off period ▯it
ignores the time value of money (there is no discounting!)
− Payback period = initial cost / cash flow per period.
− Payback Rule
o A project should only be accepted if: the payback period