Chapter 5: Net Present Value and Other Investment Criteria

Basics about NPV

Since PVs are all measured in todays dollars you can add them up: NPV(A+B) = NPV(A) + NPV(B) Payback The payback rule states that a project should be accepted if its payback period is less than some specied cutoff period Problem: Ignores all cash ows after the cutoff date The payback rule gives equal weight to all cash ows before the cutoff date Why it is used: Ease of communication (and ease of reception by shareholders) Managers want short-term projects that quickly further their career prospects Discounted payback can still be used but the rst problem still persists. Internal Rate of Return The IRR or the Discount-cash ow rate of return is the discount rate that makes NPV=0. IRR is a measure of protability, while the opportunity cost of capital is a standard of protability IRR Rule: Accept an investment project if the opp. cost of capital < IRR Problems with IRR rule application If we are borrowing money, opp. cost of capital > IRR Multiple Rates of Return: there can be as many IRR for a prject as there are changes in the sign of the cash ows Sometimes there is no IRR at all Mutually Exclusive projects: One has a higher NPV while the other one has a higher IRR Which one should you choose? Absolute gains OR relative gains Assumption that there is no difference between short- and long-term discount rates Choosing Capital Investments When Resources are Limited When capital is rationed, a method of selecting the package of projects that is within the companys resources yet gives the highest possible NPV is needed. When projects are not mutually exclusive and do not depend on each other: Rank the projects using the protability index and select the highest ones: Otherwise, the protability does not yield the projects whose NPC sum is greatest One has to work through all possible combinations of projects (Linear Programming)

 Uses of Capital Rationing Why is LP not extensively accepted and used Very complex calculations Problem of getting good data: Discovery of investment ideas is an unfolding process Why do company presidents tell their subordinates that capital is limited? If they were right, it would make the capital market seriously inefcient Why would they use NPV in the rst place, as it presupposes efcient capital markets Soft rationing: headquarters impose an upper limit on divisional expenditures This constraint is independent from the capital market, and thus does not compromise the validity of the NPV rule It is done to prevent ambitious divisional managers from overstating their investment opportunities Hard Rationing: i.e. the company is passing up good investment opportunities because it cant raise capital This is still OK, as long as the barrier between the rm and capital markets is the only market imperfection. The important thing is that rms shareholders have free access to well-functioning capital markets.