NET PRESENT VALUE
Session 4
Net Present Value
The difference between the market value of a
project and its cost
How much value is created from undertaking an
investment?
The first step is to estimate the expected future cash
flows.
The second step is to estimate the required return for
projects of this risk level.
The third step is to find the present value of the cash
flows and subtract the initial investment.
Project Example Information
You are reviewing a new project and have
estimated the following cash flows:
Year 0: CF = -165,000
Year 1: CF = 63,120; NI = 13,620
Year 2: CF = 70,800; NI = 3,300
Year 3: CF = 91,080; NI = 29,100
Average Book Value = 72,000
Your required return for assets of this risk level
is 12%.
NPV – Decision Rule
If the NPV is positive, accept the project
A positive NPV means that the project is
expected to add value to the firm and will
therefore increase the wealth of the owners.
Since our goal is to increase owner wealth, NPV
is a direct measure of how well this project will
meet our goal.
Computing NPV for the Project
Using the formulas:
NPV = -165,000 + 63,120/(1.12) + 70,800/(1.12)2 +
91,080/(1.12)3 = 12,627.41
Do we accept or reject the project?
Discount Cash Flows not Profit
Calculate net present value you need to
discount cash flows, not accounting profits
For example, suppose that you are analyzing an investment
proposal. It costs $2,000 and is expected to bring in a cash flow of
$1,500 in the first year and $500 in the second. You think that the
opportunity cost of capital is 10%
Discount Cash Flows not Profit
Payback Period
How long does it take to get the initial cost back
in a nominal sense?
Computation
Estimate the cash flows
Subtract the future cash flows from the initial cost until
the initial investment has been recovered
Decision Rule – Accept if the payback period
is less than some preset limit
Computing Payback for the Project
Assume we will accept the project if it pays back
within two years.
Year 1: 165,000 – 63,120 = 101,880 still to recover
Year 2: 101,880 – 70,800 = 31,080 still to recover
Year 3: 31,080 – 91,080 = -60,000 project pays back
in year 3
Do we accept or reject the project?
Advantages and Disadvantages of
Payback
Advantages Disadvantages
Easy to understand Ignores the time value
of money
Requires an arbitrary
Adjustsfor cutoff point
uncertainty of later Ignores cash flows
cash flows beyond the cutoff date
Biased against long-
term projects, such as
research and
development, and new
projects
Discounted Payback Period
Compute the present value of each cash flow
and then determine how long it takes to pay
back on a discounted basis
Compare to a specified required period
Decision Rule - Accept the project if it pays
back on a discounted basis within the
specified time
Computing Discounted Payback for
the Project
Assume we will accept the project if it pays back on a
discounted basis in 2 years.
Compute the PV for each cash flow and determine the
payback period using discounted cash flows
Year 1: 165,000 – 63,120/1.121 = 108,643
Year 2: 108,643 – 70,800/1.122 = 52,202
Year 3: 52,202 – 91,080/1.123 = -12,627 project pays back
in year 3
Do we accept or reject the project?
Advantages and Disadvantages of
Discounted Payback
Advantages Disadvantages
Includes time value May reject positive NPV
of money investments
Easy to understand Requires an arbitrary
Does not accept cutoff point
negative estimated Ignores cash flows
NPV investments beyond the cutoff point
when all future cash Biased against long-
flows are positive term projects, such as
R&D and new products
Internal Rate of Return
This is the most important alternative to NPV
It is often used in practice and is intuitively
appealing
It is based entirely on the estimated cash flows
and is independent of interest rates found
elsewhere
IRR – Definition and Decision Rule
Definition: IRR is the return that makes the
NPV = 0
Decision Rule: Accept the project if the
IRR is greater than the required return
Computing IRR for the Project
Rate of Return= profit/investment
=C-investment/investment
You planned to invest $350,000 to get back a
cashflow of C=$400,000 in 1 year. Calculate
rate of return?
Do we accept or reject the project?
Advantages of IRR
Knowing a return is intuitively appealing
It is a simple way to communicate the value of a
project to someone who doesn’t know all the
estimation details
If the IRR is high enough, you may not need to
estimate a required return, which is often a
difficult task
Summary of Decisions for the
Project
Summary
Net Present Value Accept
Payback Period Reject
Discounted Payback Period Reject
Internal Rate of Return Accept
NPV Rule v/s Rate of Return Rule
NPV rule: Invest in any project that has a
positive NPV when cashflows are discounted
at the opportunity cost of capital (expected rate
of return).
Rate of Return rule: Invest in any project
offering a rate of return that is higher than the
opportunity cost of capital.
NPV vs. IRR
NPV and IRR will generally give us the same
decision
NPV=Initial
investment + Cashflow(year1)/1+r
-$350,000+$400,000/1+1.143=0
Exceptions
Mutually exclusive projects
Initial
investments are substantially different (issue of
scale)
Timing of cash flows is substantially different
IRR and Mutually Exclusive
Projects
Mutually exclusive projects
If you choose one, you can’t choose the other
Example: You can choose to attend graduate
school at either Harvard or Stanford, but not
both
Intuitively, you would use the following
decision rules:
NPV – choose the project with the higher NPV
IRR – choose the project with the higher IRR
Example With Mutually
Exclusive Projects
Period Project Project The required return
A B for both projects is
0 -500 -400 10%.
1 325 325
2 325 200 Which project
should you accept
IRR 19.43% 22.17% and why?
NPV 64.05 60.74
NPV Profiles
IRR for A = 19.43%
$160.00
$140.00 IRR for B = 22.17%
$120.00
$100.00 Crossover Point = 11.8%
$80.00
NPV
A
$60.00
B
$40.00
$20.00
$0.00
($20.00) 0 0.05 0.1 0.15 0.2 0.25 0.3
($40.00)
Discount Rate
Conflicts Between NPV and IRR
NPV directly measures the increase in value to
the firm
Whenever there is a conflict between NPV and
another decision rule, you should always use
NPV
IRR is unreliable in the following situations
Nonconventional cash flows
Mutually exclusive projects
Profitability Index
Measures the benefit per unit cost, based on
the time value of money
A profitability index of 1.1 implies that for every
$1 of investment, we create an additional
$0.10 in value
This measure can be very useful in situations
in which we have limited capital
Profitability Index
Profitability Index (PI)= Net Present Value/ Initial
Invt
Project PV Invt NPV PI
J $4 $3 $1 1/3=0.33
K $6 $5 $1 1/5=0.20
L $ 10 $7 $3 3/7=0.43
M $8 $6 $2 2/6=0.33
N $5 $4 $1 ¼=0.25
Which project to be opted first?
Project L, J, M
The End
