CLASS NOTES

WEEK VI

READING ASSIGNMENT
BMA 5

Alex Kane 1 IPCOR421 Finance
 Notes on NPV
• It accounts for the time value of money
• It accounts for the opportunity cost of capital at
the appropriate risk level
• It values incremental cash flows independent of
accounting methods
• NPV is additive, allows separation of pieces of
projects
• Any method that is used to evaluate projects
must have these qualities for legitimacy
Alex Kane 2 IPCOR421  Finance
 Competing measures
• The competing measures we will look at, have
their virtues
• For this reason it is a good idea to compute these
measures and think about their implications
• However, none of them can serve as substitute
for the NPV as the decisive criterion in
accepting/rejecting new projects

Alex Kane 3 IPCOR421  Finance
 The Payback Period
• The Payback period is the time it takes to recover the
investment in the project.
• For an investment project with cash flows:
–I, C(1), C(2),…
• The Payback period (PB) is such that:
I = ΣC(t) ; t=1,…, PB
• The idea is that projects with lower PB are preferred.
• Pitfalls of the PB criterion
Completely ignores CFs after the PB period
Exaggerates value of earlier CFs (no discounting) prior to PB
• Conclusion: PB Discriminates against long-term
projects and is biased in favor of short-term projects

Alex Kane 4 IPCOR421  Finance
 The virtue of PB
• PB is taken as indicating a project’s risk
• A short PB promises some safety of minimizing
loss
• We know that shorter-term forecast are more
accurate than longer-term ones
• In the (very) old days, this was the major
criterion
• There is no question that the pitfalls of this
measure are severe !
Alex Kane 5 IPCOR421  Finance
 IRR (Internal Rate of Return)
• A project has cash flows:
C(0), C(1), … , C(T)
of which at least one is negative
• The IRR is the rate for which the NPV of the
project is zero. It tells us the rate we earn on the
investment(s) -- given by the negative CF
• 0=C(0)+ΣC(t)/(1+IRR)^t
• If the project’s IRR is greater than the cost of
capital, the project has a positive NPV (and vice
versa)
Alex Kane 6 IPCOR421  Finance
 IRR: Example
• Project with annual CF: –100; 60; 70
• IRR: –100 + 60/(1+IRR) + 70/(1+IRR)^2 = 0
• This is a quadratic equation which is relatively
easy to solve: IRR=.1888 (18.88%)
• If you add one CF, say 20, the equation will have
another term: 20/(1+IRR)^3, now the equation
is of the order of three (cubic).
• Most projects are longer, so the equation will be
of higher order and solution can be found only
by trial and error.
• In some cases the equation has more than one
solution, we’ll discuss this possibility later
Alex Kane 7 IPCOR421  Finance
 IRR in the graph of NPV as a function of r
• A project: C(0),…,C(T)
• NPV =C(0)+ ΣC(t)/(1+r)^t ; t=1,…,T
The intersection of the 
• When r –>∞ , NPV = C(0) graph with the x axis 
(NPV=0) is the IRR of 
• When r = 0 , NPV = C(0)+ΣC(t) the project 
• Hence, the graph looks like (exact shapes will vary)

NPV NPV
Project C(0)<0 Loan C(0)>0
ΣC(t) C(0)
IRR
r r
ΣC(t)
C(0)=–I
Payments (negative)
Alex Kane 8 IPCOR421  Finance
 Note on IRR (1)
• An important assumption underlies the IRR
• It assumes that intermediate CF can be re-
invested at the same rate (IRR) for the life of the
project
• This is also true for the NPV. But, the NPV uses
the opportunity cost of capital, which is -- by
definition-- the rate at which you can reinvest CF
• When IRR is significantly higher than r, the IRR
gives an exaggerated assessment of the project
Alex Kane 9 IPCOR421  Finance
 Notes on IRR (2)
• IRR is very widely used because it is a very
intuitive number
• Hence, it is important to investigate problems
with it. like all alternatives, it is inferior to NPV
• Issues
– Multiple solutions for IRR (not often)
– Mutually exclusive projects (scale is missing)
– Needs further work when the yield curve is far from
flat (no problem for NPV)

Alex Kane 10 IPCOR421  Finance
 Mutually exclusive projects
NPV
Project A

Project B
r of equal NPV
IRR(B)

r
IRR(A)

Alex Kane 11 IPCOR421  Finance
 The differential project
• Define Project D = Project A – Project B
• This means that the CF of D for any period t is
C(D,t) = C(A,t) – C(B,t)
• Because NPV is additive, NPV(D)=NPV(A)–NPV(B)
• The IRR of project D is the rate for which
NPV(D) = 0 = NPV(A) – NPV(B)
• Hence, at IRR(D): NPV(A)=NPV(B)
• For investment projects (NPV falls with r),
r>IRR(D) => NPV(B)>NPV(A) and vice versa
• The reverse holds for loan projects (NPV increases with r)

Alex Kane 12 IPCOR421  Finance
 Capital constraints -- the problem
• Suppose a number (n) of projects are available
but the firm cannot invest more than a given
amount (IC). Which projects should be chosen?
• Suppose CF of project k=1,2, … , n are:
–Ik, Ck(1), Ck(2), … (and its NPV=NPVk)
• The constraint is effective when: IC < ΣIk
• We assign to each project an “accept/reject”
variable: xk= 0 = reject k ; xk= 1 = accept k
• Then the total investment is IC ≥ ΣIk*xk
• Total NPV = NPVC = Σ NPVk*xk
Alex Kane 13 IPCOR421  Finance
 Capital constraints -- the solution
• The problem is one of integer programming
– Max(over xk) NPVC = Σ NPVk*xk
– Subject to: Ic ≥ ΣIk*xk
• This problem can be solved by Excel’s Solver
(the solver allows for integer constraints)
• However, it turns out the “profitability index”
PI=PV/C(0) = PV/I, solves the problem
• Choose projects with highest PI, until budget
exhausted
Alex Kane 14 IPCOR421  Finance