This document covers various capital budgeting techniques including net present value (NPV), internal rate of return (IRR), payback period, discounted payback period, average accounting return, and profitability index. It provides examples and explanations of how to calculate each metric and compares their advantages and disadvantages. It emphasizes that NPV is the best method since it incorporates the time value of money and considers all cash flows rather than just the initial period. The document also highlights potential issues with techniques like IRR when projects have multiple rates of return or non-conventional cash flows.

1. Fundamentals of Corporate Finance
Chapter 8
Net Present Value and other Investment
Criteria

2. Overview of Lecture
Net Present Value
The Payback Rule
The Discounted Payback
The Average Accounting Return
The Internal Rate of Return
The Profitability Index
The Practice of Capital Budgeting

3. Corporate Finance in the News
Insert a current news story here to frame the material you will cover in the lecture.

4. Net Present Value
The difference
between an
investment’s market
value and its cost.

5. Discounted Cash Flow Valuation
The process of
valuing an investment
by discounting its
future cash flows.

6. Estimating NPV - Example
Cash revenues from our fertilizer business will be
£20,000 per year, assuming everything goes as
expected.
Cash costs (including taxes) will be £14,000 per year.
We shall wind down the business in eight years.
Plant, property and equipment will be worth £2,000 as
salvage at that time. The project costs £30,000 to
launch. We use a 15 per cent discount rate on new
projects such as this one. Is this a good investment?
If there are 1,000 shares of equity outstanding, what
will be the effect on the share price of taking this
investment?

7. Estimating NPV - Example

8. Estimating NPV - Example
The total present value is:
£6,000  [1  (1/1.158)]/.15 + (2,000/1.158)
= (£6,000  4.4873) + (2,000/3.0590)
= £26,924 + 654 = £27,578
When we compare this to the £30,000 estimated
cost, we see that the NPV is:
NPV = £30,000 + 27,578 = £2,422

9. Net Present Value Rule
An investment should
be accepted if the net
present value is
positive and rejected
if it is negative.

10. Example 8.1
Using the NPV Rule
Suppose we are asked to decide whether a
new consumer product should be launched.
Based on projected sales and costs, we
expect that the cash flows over the five-year
life of the project will be £2,000 in the first
two years, £4,000 in the next two, and
£5,000 in the last year. It will cost about
£10,000 to begin production. We use a 10
per cent discount rate to evaluate new
products. What should we do here?

11. Example 8.1
Using the NPV Rule
Given the cash flows and discount rate, we can calculate
the total value of the product by discounting the cash flows
back to the present:
Present value = (£2,000/1.1) + (2,000/1.12)
+ (4,000/1.13) + (4,000/1.14) + (5,000/1.15)
= £1,818 + 1,653 + 3,005 + 2,732 + 3,105
= £12,313
The present value of the expected cash flows is £12,313,
but the cost of getting those cash flows is only £10,000, so
the NPV is £12,313  10,000 = £2,313.

12. Spreadsheet Strategies
This is a good time to show students how to set up capital budgeting cases in a
spreadsheet. After you introduce each investment appraisal rule, you should
return to the spreadsheet to illustrate how the problem can be easily solved
with spreadsheet functions.

13. NPV Investment Rule
•NPV is Greater
than Zero
Accept
•NPV is Less
than Zero
Reject

14. Strengths of NPV
Uses Cash
Flows
• Cash Flows
are better
than
Earnings
Uses all Cash
Flows
• Other
approaches
ignore cash
flows beyond
a certain
date
Discounts
Cash Flows
• Fully
incorporates
the Time
Value of
Money

15. The Payback Rule
The amount of time
required for an
investment to generate
cash flows sufficient to
recover its initial cost.

16. The Payback Period Method
• Payback Period is
less than
benchmark
Accept
• Payback Period is
greater than
benchmark
Reject

17. What is the Payback Period?

18. Example 8.2
Calculating Payback
The Project
Costs £500

19. Analysis of the Payback Period Rule

20. The Payback Period Rule

21. The Discounted Payback
The length of time
required for an
investment’s
discounted cash flows
to equal its initial cost.

22. Discounted Payback Period
• Discounted Payback
Period is Less than
Benchmark
Accept
• Discounted Payback
Period is Greater
than Benchmark
Reject

23. Ordinary and Discounted Payback

24. Features of Discounted Payback

25. Advantages and Disadvantages of Discounted
Payback Period

26. Example 8.3
Calculating Discounted Payback
Consider an investment that
costs £400 and pays £100 per
year forever. We use a 20 per
cent discount rate on this type
of investment. What is the
ordinary payback? What is the
discounted payback? What is
the NPV?

27. The Average Accounting Return
An investment’s
average net income
divided by its average
book value.

28. The Average Accounting Return
Some measure of average accounting profit
Some measure of average accounting value
Average net income
Average book value

29. The Average Accounting Return
Suppose we are deciding whether to open a
store in a new shopping centre. The
required investment in improvements is
£500,000. The store would have a five-year
life because everything reverts to the mall
owners after that time. We will assume that
the required investment would be 100 per
cent depreciated (straight-line) over five
years , so the depreciation would be
£500,000/5 = £100,000 per year. The tax
rate is 25 per cent.

30. The Average Accounting Return

31. The Average Accounting Return
Average net income £50,000
AAR = 20%
Average book value £250,000
 

32. The Average Accounting Return
• Average Accounting
Return is Greater
than Target Return
Accept
• Average Accounting
Return is Less than
Target Return
Reject

33. Advantages and Disadvantages of Accounting
Rate of Return

34. The Internal Rate of Return
The discount rate that
makes the NPV of an
investment zero.

35. The Internal Rate of Return
• Internal Rate of
Return is greater
than discount rate
Accept
• Internal Rate of
Return is less
than discount rate

36. The Internal Rate of Return
An investment costs
€100 and has a cash
flow of €60 per year for
two years. What is its
Internal Rate of Return?

37. The Internal Rate of Return

38. The Internal Rate of Return

39. Example 8.4
Calculating IRR
A project has a total up-front
cost of €435.44. The cash flows
are €100 in the first year, €200
in the second year, and €300 in
the third year. What’s the IRR?
If we require an 18 per cent
return, should we take this
investment?

40. Example 8.4
Calculating IRR
Since the required rate of return is 18% and the IRR is 15%, we should
not take the investment.

41. Spreadsheet Strategies
Now is a good time to show students how to use Solver and Goal
Seek (or their equivalent) to solve IRR problems.

42. Problems with IRR – Nonconventional Cash
Flows

43. Multiple Rates of Return
The possibility that
more than one
discount rate will
make the NPV of an
investment zero.

44. Example 8.5
What’s the IRR?
You are looking at an
investment that requires you
to invest €51 today. You’ll
get €100 in one year, but
you must pay out €50 in two
years. What is the IRR on
this investment?

45. Example 8.5
What’s the IRR?
There is no IRR. The
NPV is negative at
every discount rate, so
we shouldn’t take this
investment under any
circumstances.

46. Example 8.6
A Rule of Thumb on Multiple IRRS
The maximum number of
IRRs that there can be is
equal to the number of
times that the cash flows
change sign from positive to
negative and/or negative to
positive.

47. Problems with IRR – Mutually Exclusive
Investments
A situation in which
taking one investment
prevents the taking of
another.

48. Mutually Exclusive Investments
The IRR for A is 24 per cent, and the IRR for B is 21
per cent. Because these investments are mutually
exclusive, we can take only one of them. Simple
intuition suggests that investment A is better because
of its higher return. Unfortunately, simple intuition is
not always correct.

49. Mutually Exclusive Investments

50. Mutually Exclusive Investments

51. Problems with IRR: Investing or Financing?

52. Advantages and Disadvantages of IRR

53. General Investment Rules:
IRR and NPV
• Number of IRRs: 1
• Accept if IRR > R; Reject if IRR < R
• Accept if NPV > 0; Reject if NPV < 0
1st Cash Flow
Negative; Remaining
Cash Flows Positive
• Number of IRRs: 1
• Accept if IRR < R; Reject if IRR > R
• Accept if NPV > 0; Reject if NPV < 0
1st Cash Flow
Positive; Remaining
Cash Flows Negative
• Number of IRRs: Usually More than 1
• No Valid IRR
• Accept if NPV > 0; Reject if NPV < 0
Mixture of Positive
and Negative Cash
Flows

54. Modified Internal Rate of Return
Discounting
Approach
• Discount all
negative cash
flows back to
the present at
the required
return and
add them to
the initial cost.
Then,
calculate the
IRR.
Reinvestment
Approach
• Compound all
cash flows
(positive and
negative)
except the
first out to the
end of the
project’s life
and then
calculate the
IRR.
Combination
Approach
• Negative cash
flows are
discounted
back to the
present, and
positive cash
flows are
compounded
to the end of
the project

55. The Profitability Index
The present value of an
investment’s future cash
flows divided by its
initial cost. Also called
the benefit–cost ratio.

56. Advantages and Disadvantages of the
Profitability Index

57. Example 8.8
Bringing it all Together
Sandy Grey Ltd. is in the process of deciding whether or
not to revise its line of mobile phones which they
manufacture and sell. Their sole market is large
corporations and they have not as yet focused on the
retail sector. They have estimated that the revision will
cost £220,000. Cash flows from increased sales will be
£80,000 in the first year. These cash flows will increase
by 5% per year. The firm estimates that the new line
will be obsolete five years from now. Assume the initial
cost is paid now and all revenues are received at the
end of each year. If the company requires a 10 per cent
return for such an investment, should it undertake the
revision? Use three investment evaluation techniques
to arrive at your answer.

58. Example 8.8
Bringing it all Together
2 3 4 5
£80,000 £84,000 £88,200 £92,610 £97,240.5
£220,000 £112,047
(1 0.10) (1 0.10) (1 0.10) (1 0.10) (1 0.10)
NPV        
    
2 3 4 5
£80,000 £84,000 £88,200 £92,610 £97,240.5
0 £220,000
(1 ) (1 ) (1 ) (1 ) (1 )
27.69%
NPV
IRR IRR IRR IRR IRR
IRR
       
    

2 3 4 5
£80,000 £84,000 £88,200 £92,610 £97,240.5
/ £220,000
(1 ) (1 ) (1 ) (1 ) (1 )
1.509
PI
IRR IRR IRR IRR IRR
PI
 
    
 
    
 


59. The Practice of Capital Budgeting

60. Activities for this Lecture
Reading
• Insert here
Assignment
• Insert here

61. Thank You