CHAPTER 6

Some Alternative Investment Rules

1. NPV Uses Cash Flows Cash flows from a project can be used for other corporate
purposes (e.g., dividend payments, other capital-budgeting projects, or payments of
corporate interest). By contrast, earnings are an artificial construct. While earnings are
useful to accountants, they should not be used in capital budgeting because they do not
represent cash.
2. NPV Uses All the Cash Flows of the Project other approaches ignore cash flows
beyond a particular date; beware of these approaches.
3. NPV Discounts the Cash Flows Properly Other approaches may ignore the time value
Of money when handling cash flows. Beware of these approaches as well.

6.2 THE PAYBACK PERIOD RULE

Time taken by the initial investment to recover itself
Cut off time is selected by the entity

Problems with the Payback Method

Problem 1: Timing of Cash Flows within the Payback Period
Problem 2: Payments after the Payback Period
Problem 3: Arbitrary Standard for Payback Period

The payback rule is often used by large and sophisticated companies when making
relatively small decisions. Just as important as the investment decision itself is the
company’s ability to evaluate the manager’s decision-making ability. Under the NPV
rule, a long time may pass before one decides whether or not a decision was correct. With
the payback rule we now in two years whether the manager’s assessment of the cash
flows was correct.
The payback method could be used by small, privately held firms with good growth
prospects but limited access to the capital markets. Quick cash recovery may enhance the
reinvestment possibilities for such firms
When questions of controlling and evaluating the manager become less important than
making the right investment decision, the payback period is used less frequently

6.3 THE DISCOUNTED PAYBACK PERIOD RULE

As long as the cash flows are positive, the discounted payback period will
Never be smaller than the payback period, because discounting will lower the cash flows

6.4 THE AVERAGE ACCOUNTING RETURN

The average accounting return is the average project earnings after taxes and
depreciation, divided by the average book value of the investment during its life.

Step One: Determining Average Net Income

Step Two: Determining Average Investment

This document is the intellectual property of Muhammad Irfan Rashid Khan. All copyrights are reserved.
You can only distribute this document with his consent.
 Step Three: Determining AAR

The most important flaw in the AAR method is that it does not use the right raw
materials.
It uses the net income figures and the book value of the investment (from the
accountant’s books) to figure out whether to take the investment. Conversely, the NPV
rule uses cash flows.
Second, AAR takes no account of timing
Third, just as the payback period requires an arbitrary choice of a cutoff date, the AAR
Method offers no guidance on what the right targeted rate of return should be.

6.5 THE INTERNAL RATE OF RETURN

The IRR is about as close as you can get to the NPV without actually being the NPV
In general,
The IRR is the rate that causes the NPV of the project to be zero
Accept the project if IRR is greater than the discount rate. Reject the project if IRR is less
than the discount rate.
The NPV is positive for discount rates below the IRR and negative for discount rates
above the IRR.
It should also be clear that the NPV is positive for discount rates below the IRR and
negative for discount rates above the IRR.
If this were all there were to it, the IRR rule would always coincide with the NPV rule.
This would be a wonderful discovery because it would mean that just by computing the
IRR for a project we would be able to tell where it ranks among all of the projects we are
considering.

6.6 PROBLEMS WITH THE IRR APPROACH

An independent project is one whose acceptance or rejection is independent of the
acceptance or rejection of other projects

Problem 1: Investing or Financing?

Problem 2: Multiple Rates of Return

Projects financed by lease arrangements also produce negative cash flows followed by
Positive ones. We study leasing carefully in a later chapter, but for now we will give you
a hint. Using leases for financing can sometimes bring substantial tax advantages. These
advantages are often sufficient to make an otherwise bad investment have positive cash
flows following an initial outlay. But after a while the tax advantages decline or run out.
The cash flows turn negative when this occurs. In theory, a cash flow stream with M
changes in sign can have up to M positive internal rates of return
If the initial cash flow is positive—and if all of the remaining flows are negative—there
Can only be a single, unique IRR

For, mutually exclusive events you can accept A or you can accept B
Or you can reject both of them, but you cannot accept both of them

This document is the intellectual property of Muhammad Irfan Rashid Khan. All copyrights are reserved.
You can only distribute this document with his consent.
 Problems Specific to Mutually Exclusive Projects:

The Scale Problem:

In review, we can handle this (or any mutually exclusive example) in one of
three ways:
1. Compare the NPVs of the two choices. The NPV of the large-budget picture is greater
than the NPV of the small-budget picture, that is, $27 million is greater than $22 million.
2. Compare the incremental NPV from making the large-budget picture instead of the
small-budget picture. Because the incremental NPV equals $5 million, we choose the
large-budget picture.
3. Compare the incremental IRR to the discount rate. Because the incremental IRR is
66.67 percent and the discount rate is 25 percent, we take the large-budget picture.
The Timing Problem:
Timing problem focuses on the fact that if there are two projects with the type of cash
flows in which bigger amount comes first and the smaller amount comes second. So in
this case the project having larger first cash flows will have higher npv and vice versa. So
for these types of mutually exclusive events we should calculate an incremental IRR. If
discount rate is below Irr than we should choose the project having smaller initial inflows
and if the rate is above Irr then we should choose the project having bigger initial
inflows.

6.7 THE PROFITABILITY INDEX

It is the ratio of the present value of the future expected cash flows after initial
investment divided by the amount of the initial investment

Profitability index (PI) = PV of cash flows subsequent to initial investment/ Initial

investment
We consider three possibilities:
1. Independent Projects. We first assume that we have two independent projects.
According to the NPV criterion, both projects should be accepted since NPV is positive
in each Case. The NPV is positive whenever the profitability index (PI) is greater than
one. Thus, the PI decision rule is
Accept an independent project if PI > 1. Reject if PI <1
2: Mutually exclusive projects:
The problem with the profitability index for mutually exclusive projects is the same as
the scale problem with the IRR that we mentioned earlier
The pi rule:
In the case of limited funds, we cannot rank projects according to their NPVs. Instead, we
should rank them according to the ratio of present value to initial investment. This is the
PI rule
The profitability index cannot handle capital rationing over multiple time periods.

6.8 THE PRACTICE OF CAPITAL BUDGETING

Firms that are better able to precisely estimate cash flows are more likely to use NPV

This document is the intellectual property of Muhammad Irfan Rashid Khan. All copyrights are reserved.
You can only distribute this document with his consent.