Why NPV Leads to Better Investment Decisions Than Other Criteria

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Why NPV Leads to Better Investment Decisions Than
Other Criteria

• Chapter 5

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CFO Decision Tools
Survey Data on CFO Use of Investment Evaluation
Techniques
SOURCE Graham and Harvey, The Theory and
Practice of Finance Evidence from the Field,
Journal of Financial Economics 61 (2001), pp.
187-243.
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Payback

• Years it takes before the cumulative forecasted
  cash flow equals the initial outlay
• Accept projects that payback in the desired
  time frame.
• Flawed
• Ignores later year cash flows and the the present
  value of future cash flows

4
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.

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Internal Rate of Return

• Discount rate that makes ______________
• Accept when ____________
• 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?

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Internal Rate of Return
IRR28
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Internal Rate of Return

• Pitfall 1 - Lending or Borrowing?
• With some cash flows the NPV of the project
  increases as the discount rate increases

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Internal Rate of Return

• Pitfall 2 - Multiple Rates of Return
• Certain cash flows can generate NPV0 at two
  different discount rates.
• The following cash flow generates NPVA 3.3
  million at both IRR of (-44) and 11.6.

Cash Flows (millions of Australian dollars)
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Internal Rate of Return

• Why? When is this likely to occur?

NPV
600
IRR11.6
300
Discount Rate
0
-30
IRR-44
-600
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Internal Rate of Return

• Pitfall 2 - Multiple Rates of Return
• Related It is possible to have no IRR and a
  positive NPV

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Internal Rate of Return

• Pitfall 3 - Mutually Exclusive Projects
• Mutually exclusive __________________
• IRR sometimes ignores the magnitude of the
  project.

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Internal Rate of Return

• In this case, can IRR be salvaged?
• Look at smaller project
• Acceptable? Yes.
• So, should you invest extra for larger
  project.
• Look at incremental CFs.
• Now, which project is better?

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Internal Rate of Return

• Pitfall 4 - Term Structure Assumption
• Assume that discount rates are stable during the
  term of the project
• Implies that all funds are reinvested at the IRR.
  
• What does NPV assume about reinvested funds?

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Profitability Index

• Example
• We only have 300,000 to invest. Which do we
  select?
• Proj NPV Investment PI
• A 230,000 200,000 1.15
• B 141,250 125,000 1.13
• C 194,250 175,000 1.11
• D 162,000 150,000 1.08