INVESTMENT DECISION RULES NPV IRR AND PAYBACK TIME Alternative Decision Rules FIGURE The Most Popular Decision Rules Used by CFOs The NPV Rule NPV PV Benefits PV Costs The NPV rule implies that we should Accept all projects with NPV 0 Reject all projects with NPV 0 accepting them would reduce the value of the firm whereas rejecting them has no cost NPV 0 Similarly buy a security if the PV of its future cash flows is greater than the purchase price Example Using the NPV Rule A fertilizer company is considering creating a new environmentally friendly fertilizer The fertilizer will require a new factory that can be built at a cost of 81 6 million The estimated profit on the new fertilizer will be 28 million in the first year and these profits will last four years What s the NPV of this project Example Using the NPV Rule Given a discount rate r the NPV of this project is 28 28 28 28 NPV 81 6 2 3 1 r 1 r 1 r 1 r 4 What discount rate r Assume that investing in an alternative project with equivalent risk has an expected return of 10 10 is therefore the opportunity cost of capital in this example this is the correct discount rate Whether NPV is positive or negative depends strongly on the cost of capital If the company s cost of capital is 10 the NPV is 7 2 million and they should undertake the investment The Internal Rate of Return IRR Discount rate that sets the NPV of cash flows equal to zero IRR Decision Rule Take any investment opportunity where IRR exceeds the cost of capital Turn down any investment where IRR is less than the cost of capital In the previous example the IRR Decision Rule says Take the investment because the IRR 14 is greater than the cost of capital 10 IRR Rule and Differences in Risk An IRR that is attractive for a safe project need not be attractive for a riskier project Companies cannot use the same IRR cutoff to evaluate projects of different riskiness IRR Rule vs NPV Rule The NPV rule and IRR rule often give the same answer BUT the IRR rule sometimes disagrees with the NPV rule for example Delayed investment If negative cash flows follow positive cash flows then a lower discount rate is better Multiple IRRs or No IRR Cannot use the IRR Rule Differences in scale Example If benefits upfront and costs later Example If multiple IRRs IRR Rule and Differences in Scale If a project s size is doubled its NPV will double This is not the case with IRR IRRs cannot be used to compare projects of different scales The Payback Rule Based on the idea that an investment opportunity that pays back the initial investment quickly is the best Payback period The amount of time it takes to earn back the initial investment The Payback Rule implies that we should Take any investment opportunity where the payback period is less than a required cutoff Turn down any investment where the payback period is greater than this cutoff Example Using the Payback Rule Problem Assume the fertilizer company in the previous example requires all projects to have a payback period of two years or less Would the firm undertake the project under this rule Solution The sum of the cash flows from year 1 to year 2 is 28m x 2 56 million This will not cover the initial investment of 81 6 million Because the payback period is 2 years the project will be rejected Problems with the Payback Rule Payback rule is simple to compute BUT Requires us to use an arbitrary cutoff period Ignores cash flows after the payback period Does not discount future cash flows i e ignores the time value of money Can therefore lead to rejection of a project that would have increased the value of the firm Choosing Between Projects If you can t pick every project with a positive NPV e g if there are mutually exclusive projects Pick the project s with the highest NPV Ranking projects based on IRR or Payback Period can lead to the wrong answer Sometimes IRR and Payback Period rank projects in the same order as NPV but at other times they disagree Example Choosing Between Projects Solution Summary of decision rules NPV Definition Difference between present value of project s benefits and present value of its costs NPV Rule Take projects that have a positive NPV don t take projects with a negative NPV IRR Definition The discount rate that sets NPV of cash flows equal to zero IRR Rule Take projects where IRR Cost of capital Often gives the same answer as the NPV Rule but there are exceptions Payback Period Definition Amount of time to pay back initial investment Payback Rule Take a project where payback period is less than a set cutoff Is simple to compute but has several disadvantages