Fundamentals of Corporate Finance

Fourth Edition

Chapter 8
Investment
Decision Rules

Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.
Chapter Outline
8.1 The NPV Decision Rule
8.2 Using the NPV Rule
8.3 Alternative Decision Rules
8.4 Choosing Between Projects
8.5 Evaluating Projects with Different Lives
8.6 Choosing Among Projects When Resources Are Limited
8.7 Putting it all Together
Learning Objectives (1 of 2)
• Calculate Net Present Value
• Use the NPV rule to make investment decisions
• Understand alternative decision rules and their
drawbacks
• Choose between mutually exclusive alternatives
Learning Objectives (2 of 2)
• Evaluate projects with different lives
• Rank projects when a company’s resources are limited
so that it cannot take all positive- NPV projects
8.1 The NPV Decision Rule (1 of 5)
• Net Present Value
– Most firms measure values in terms of Net Present
Value–that is, in terms of cash today
NPV = PV (Benefits) – PV (Costs) (Eq. 8.1)
8.1 The NPV Decision Rule (2 of 5)
• Net Present Value
– A simple example:
 In exchange for $500 today, your firm will receive $550 in
one year. If the interest rate is 8% per year:
– PV(Benefit) = ($550 in one year) ÷ ($1.08 $ in one year/$
today) = $509.26 today
 This is the amount you would need to put in the bank
today to generate $550 in one year
 NPV= $509.26 − $500 = $9.26 today
8.1 The NPV Decision Rule (3 of 5)
• Net Present value
– You should be able to borrow $509.26 and use the
$550 in one year to repay the loan
– This transaction leaves you with $509.26 − $500 =
$9.26 today
– As long as NPV is positive, the decision increases the
value of the firm regardless of current cash needs or
preferences
Example 8.1 The NPV Is Equivalent to Cash Today (1 of 5)

Problem:
• After saving $1500 by waiting tables, you are about to buy
a 50-inch TV. You notice that the store is offering a “one
year same as cash” deal. You can take the TV home today
and pay nothing until one year from now, when you will
owe the store the $1500 purchase price.
• If your savings account earns 5% per year, what is the
NPV of this offer? Show that its NPV represents cash in
your pocket.
Example 8.1 The NPV Is Equivalent to Cash Today (2 of 5)

Solution:
Plan:
• You are getting something worth $1500 today (the TV) and
in exchange will need to pay $1500 in one year. Think of it
as getting back the $1500 you thought you would have to
spend today to get the TV. We treat it as a positive cash
flow.
• Cash flows:
Today In one year
+$1,500 −$1,500
Example 8.1 The NPV Is Equivalent to Cash Today (3 of 5)

Solution:
Plan:
• The discount rate for calculating the present value of the
payment in one year is your interest rate of 5%. You need
to compare the present value of the cost ($1500 in one
year) to the benefit today (a $1500 TV).
Example 8.1 The NPV Is Equivalent to Cash Today (4 of 5)

Execute:
$1500
NPV  $1500   $1500  $1428.57  $71.43
1.05
• You could take $1428.57 of the $1500 you had saved for
the TV and put it in your savings account. With interest, in
one year it would grow to $1428.57 × (1.05) = $1500,
enough to pay the store. The extra $71.43 is money in
your pocket to spend as you like (or put toward the
speaker system for your new media room).
Example 8.1 The NPV Is Equivalent to Cash Today (5 of 5)

Evaluate:
• By taking the delayed payment offer, we have extra net
cash flows of $71.43 today. If we put $1428.57 in the bank,
it will be just enough to offset our $1500 obligation in the
future. Therefore, this offer is equivalent to receiving
$71.43 today, without any future net obligations.
Example 8.1a The NPV Is Equivalent to Cash Today (1 of 5)
Problem:
• After saving $2,500 waiting tables, you are about to buy a
50-inch LCD TV. You notice that the store is offering “one-
year same as cash” deal. You can take the TV home today
and pay nothing until one year from now, when you will
owe the store the $2,500 purchase price.
• If your savings account earns 4% per year, what is the
NPV of this offer? Show that its NPV represents cash in
your pocket.
Example 8.1a The NPV Is Equivalent to Cash Today (2 of 5)

Solution:
Plan:
• You are getting something worth $2,500 today (the TV)
and in exchange will need to pay $2,500 in one year. Think
of it as getting back the $2,500 you thought you would
have to spend today to get the TV. We treat it as a positive
cash flow.
• Cash flows:
Today In one year
+$2,500 −$2,500
Example 8.1a The NPV Is Equivalent to Cash Today (3 of 5)

Solution:
Plan:
• The discount rate for calculating the present value of the
payment in one year is your interest rate of 4%. You need
to compare the present value of the cost ($2,500 in one
year) to the benefit today (a $2,500 TV).
Example 8.1a The NPV Is Equivalent to Cash Today (4 of 5)

Execute:
$2,500
NPV  $2,500   $2,500  $2,403.85  $96.15
1.04
• You could take $2,403.85 of the $2,500 you had saved for
the TV and put it in your savings account. With interest, in
one year it would grow to $2,403.85  (1.04) = $2,500,
enough to pay the store. The extra $96.15 is money in
your pocket to spend as you like.
Example 8.1a The NPV Is Equivalent to Cash Today (5 of
5)

Evaluate:
• By taking the delayed payment offer, we have extra net
cash flows of $96.15 today. If we put $2,403.85 in the
bank, it will be just enough to offset our $2,500 obligation
in the future. Therefore, this offer is equivalent to receiving
$96.15 today, without any future net obligations.
8.1 The NPV Decision Rule (4 of 5)
• Logic of the decision rule:
– When making an investment decision, take the
alternative with the highest NPV, which is equivalent to
receiving its NPV in cash today
8.1 The NPV Decision Rule (5 of 5)
• The NPV decision rule implies that we should:
– Accept positive-NPV projects; accepting them is
equivalent to receiving their NPV in cash today, and
– Reject negative-NPV projects; accepting them would
reduce the value of the firm, whereas rejecting them
has no cost (NPV = 0)
8.2 Using the NPV Rule (1 of 6)
• Organizing the Cash Flows and Computing the NPV:
– A take-it-or-leave-it decision
– A fertilizer company can create a new environmentally
friendly fertilizer at a large savings over the company’s
existing fertilizer
– The fertilizer will require a new factory that can be built
at a cost of $81.6 million. Estimated return on the new
fertilizer will be $28 million after the first year, and will
last for four years
8.2 Using the NPV Rule (2 of 6)
• Organizing Cash Flows and Computing NPV
– The following timeline shows the estimated cash flows:
8.2 Using the NPV Rule (3 of 6)
• Given a discount rate r, the NPV is:
28 28 28 28
NPV  81.6    
1  r (1  r )2 (1  r )3 (1  r )4 (Eq. 8.2)

• We can also use the annuity formula:

28  1 
NPV  81.6   1   (Eq. 8.3)
r  (1  r )4 
8.2 Using the NPV Rule (4 of 6)
• Organizing Cash Flows and Computing NPV
– If the company’s cost of capital is 10%, the NPV is $7.2
million and they should undertake the investment
8.2 Using the NPV Rule (5 of 6)
• The NPV Profile
– The NPV depends on cost of capital
– NPV profile graphs the NPV over a range of discount
rates
– Based on this data the NPV is positive only when the
discount rates are less than 14%
Figure 8.1 NPV of Fredrick’s New Project

Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.
 8.2 Using the NPV Rule (6 of 6)
• Measuring the Sensitivity with IRR
– If you are unsure of your cost of capital estimate, it is important to determine
how sensitive your analysis is to errors in this estimate
– The IRR can provide this information
• Alternative Rules Versus the NPV Rule
– When evaluating alternative rules for project selection, understand that
alternative investment rules may or may not give the same answer as the
NPV rule
– When the rules conflict, always base your decision on the NPV rule
8.3 Alternative Decision Rules (1 of 11)
• The Payback Rule
– Based on the notion that an opportunity that pays back
the initial investment quickly is qood idea
 Calculate the amount of time it takes to pay back the
initial investment, called the payback period
 Accept the project if the payback period is less than a
prespecified length of time
 Reject the project if the payback period is greater than
that prespecified length of time
Example 8.2 Using the Payback Rule (1 of 4)
Problem:
• Assume Fredrick’s requires all projects to have a payback
period of two years or less. Would the firm undertake the
fertilizer project under this rule?
Year Project A Expected Net Cash Project B Expected Net Cash
Flow Flow
0 -$10,000 -$10,000
1 $1,000 $5,000
2 $1,000 $5,000
3 $8,000 $5,000
4 $1,000,000 $5,000
Example 8.2 Using the Payback Rule (2 of 4)
Solution:
Plan:
• In order to implement the payback rule, we need to know
whether the sum of the inflows from the project will exceed
the initial investment before the end of two years. The
project has inflows of $28 million per year and an initial
investment of $81.6 million.
Example 8.2 Using the Payback Rule (3 of 4)
Execute:
• The sum of the cash flows for years 1 and 2 is $28 × 2 = $56
million, which will not cover the initial investment of $81.6
million. In fact, it will not be until year 3 that the cash inflows
exceed the initial investment 1$28 × 3 = $84 million2.
Because the payback period for this project exceeds two
years, Fredrick’s will reject the project.
Example 8.2 Using the Payback Rule (4 of 4)
Evaluate:
• While simple to compute, the payback rule requires us to
use an arbitrary cutoff period in summing the cash flows.
• Furthermore, note that the payback rule does not discount
future cash flows.
• Instead, it simply sums the cash flows and compares them
to a cash outflow in the present. In this case, Fredrick’s
would have rejected a project that would have increased
the value of the firm.
Example 8.2a Using the Payback Rule (1 of 5)
Problem:
• When choosing between two projects, assume a company
chooses the one with the lowest payback period. Which of the
following two projects would the firm undertake the project under
this rule?
Year Project A Expected Net Cash Project B Expected Net Cash
Flow Flow
0 -$10,000 -$10,000
1 $1,000 $5,000
2 $1,000 $5,000
3 $8,000 $5,000
4 $1,000,000 $5,000
Example 8.2a Using the Payback Rule (2 of 5)
Solution:
Plan:
• In order to implement the payback rule, we need to know
when the sum of the inflows from the project will equal the
initial investment.
• Project A has inflows of $1,000 for two years, an inflow of
$8,000 in year 3, and an inflow of $1,000,000 in year four.
Initial investment is $10,000.
• Project B has inflows of $5,000 for four years with an initial
investment of $10,000.
Example 8.2a Using the Payback Rule (3 of 5)
Execute:
• For Project A:
– The sum of the cash flows from years 1 to 3 is $10,000.
– This will cover the initial investment of $10,000 at the end of
year 3.
• For Project B:
– The sum of the cash flows from years 1 and 2 is $10,000.
– This will cover the initial investment of $10,000 at the end of
year 2.
Example 8.2a Using the Payback Rule (4 of 5)
Execute:
• Because the payback for Project B is faster than for
Project A, Project B will be chosen, even though the 4th
cash flow for Project A is very high!
Example 8.2a Using the Payback Rule (5 of 5)
Evaluate:
• While simple to compute, the payback rule requires us to
use an arbitrary cutoff period in summing the cash flows. It
ignores any cash flow after this cutoff – in this case, the
firm would make a huge mistake!
• Further, also note that the payback rule does not discount
future cash flows
• Instead it simply sums the cash flows and compares them
to a cash outflow in the present.
8.3 Alternative Decision Rules (2 of 11)
• Weakness of the Payback Rule
– Ignores the time value of money
– Ignores cash-flows after the payback period
– Lacks a decision criterion grounded in economics
8.3 Alternative Decision Rules (3 of 11)
• The Internal Rate of Return Rule
– Take any investment opportunity where IRR exceeds
the opportunity cost of capital
8.3 Alternative Decision Rules (4 of 11)
• Weakness in IRR
– In most cases IRR rule agrees with NPV for stand-
alone projects if all negative cash flows precede
positive cash flows
– In other cases the IRR may disagree with NPV
Figure 8.2 The Most Popular Decision Rules Used by
CFOs

Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.
Summary of NPV, IRR, and Payback for
Fredrick’s New Project
Table 8.1 Summary of NPV, IRR, and Payback for Fredrick’s New
Project

NPV at 10% $7.2 million Accept ($7.2 million > 0)

Payback Period 3 years Reject (3 years > 2 year required payback)
IRR 14% Accept (14% > 10% cost of capital)
8.3 Alternative Decision Rules (5 of 11)
• Delayed Investments
– Two competing endorsements:
 Offer A: single payment of $1million upfront
 Offer B: $500,000 per year at the end of the next three
years
 Estimated cost of capital is 10%
– Opportunity timeline:
8.3 Alternative Decision Rules (6 of 11)
• The NPV is:

500,000 500,000 500,000

NPV  1,000,000   
1 r (1  r )2
(1  r )3

• Set NPV to zero and solve for r to get IRR.

8.3 Alternative Decision Rules (7 of 11)
• 23.38% > the 10% opportunity cost of capital, so
according to IRR, Option A best
• However, NPV shows that Option B is best

500,000 500,000 500,000

NPV  1,000,000   2
 3
 $243,426
1.1 1.1 1.1

• To resolve the conflict we can show a NPV Profile

Figure 8.3 NPV of Evan Cole’s $1 Million QuenchIt Deal
• For most investments
expenses are upfront
and cash is received in
the future
• In these cases a low
rate is best
• When cash is upfront a
high interest rate is
best
8.3 Alternative Decision Rules (8 of 11)
• Multiple IRRs
– Suppose the cash flows in the previous example
change
– The company has agreed to make an additional
payment of $600,000 in 10 years
8.3 Alternative Decision Rules (9 of 11)
• The new timeline:

• The NPV of the new investment opportunity is:

500,000 500,000 500,000 600,000

NPV  1,000,000    
(1  r) (1  r) 2
(1  r) 3
(1  r)10

• If we plot the NPV profile, we see that it has two IRRs!

Figure 8.4 NPV of Evan’s Sports Drink Deal with
Additional Deferred Payments

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8.3 Alternative Decision Rules (10 of 11)
• Modified Internal Rate of Return (MIRR)
– Used to overcome problem of multiple IRRs
– Computes the discount rate that sets the NPV of modified cash flows to
zero
– Possible modifications
 Bring all negative cash flows to the present and incorporate into the initial cash
outflow, leave the positive cash flows alone
 Leave the initial cash flow alone and compound all of the remaining cash flows
to the final period of the project
Figure 8.5 NPV Profile for a Project with Multiple IRRs

Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.
Figure 8.6 NPV Profile of Modified Cash Flows for the Multiple-
IRR Project from Figure 8.5

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8.3 Alternative Decision Rules (11 of 11)
• MIRR: A Final Word
– Is it advisable to modify the cash flows?
– It is not really an internal rate of return?
– It does not solve some of the problems of IRR when choosing among
projects
8.4 Choosing Among Projects (1 of 8)
• Mutually Exclusive Projects.
– Can’t just pick the project with a positive NPV
– The projects must be ranked and the best one chosen
– Pick the project with the highest NPV
Example 8.3 NPV and Mutually Exclusive Projects (1 of 5)

Problem:
• You own a small piece of commercial land near a university. You are
considering what to do with it. You have been approached with an offer to buy it
for $220,000. You are also considering three alternative uses yourself: a bar, a
coffee shop, and an apparel store. You assume that you would operate your
choice indefinitely, eventually leaving the business to your children.
Example 8.3 NPV and Mutually Exclusive Projects (2 of 5)

Problem:
• You have collected the following information about the
uses. What should you do?

Blank Initial Cash flow in the Growth Cost of

Investment First Year (CF1) rate (g) capital (r)
Bar $400,000 $60,000 3.5% 12%
Coffee Shop $200,000 $40,000 3% 10%
Apparel Store $500,000 $75,000 3% 13%
Example 8.3 NPV and Mutually Exclusive Projects (3 of 5)

Solution:
Plan:
• Since you can develop only one project (you only have one
piece of land), these are mutually exclusive projects. In order to
decide which project is most valuable, you need to rank them by
NPV. Each of these projects (except for selling the land) has
cash flows that can be valued as a growing perpetuity, so from
Chapter 4, the present value of the inflows is CF1
.
r g
• The NPV of each investment will be
CF1
 Initial Investment
r g
Example 8.3 NPV and Mutually Exclusive Projects (4 of 5)
Execute:
$60,000
• The NPVs are: Bar:  $400,000  $305,882
0.12  0.035
$40,000
Coffee Shop:  $200,000  $371,429
0.10  0.03
$75,000
Apparel Store:  $500,000  $250,000
0.13  0.03
Alternative NPV
Coffee Shop $371,429
Bar $305,882
Apparel Store $250,000
Sell the Land $220,000

• You should choose the coffee shop.

Example 8.3 NPV and Mutually Exclusive Projects (5 of 5)

Evaluate:
• All the alternatives have positive NPVs, but you can take only one of them, so
you should choose the one that creates the most value.
• Even though the coffee shop has the lowest cash flows, its lower start-up cost
coupled with its lower cost of capital (it is less risky) make it the best choice.
Example 8.3a NPV and Mutually Exclusive Projects (1 of 5)

Problem:
• You own a small piece of commercial land near a university. You are
considering what to do with it. You have been approached recently with an offer
to buy it for $600,000. You are also considering three alternative uses of the
land for yourself: a laundromat, a bakery, and a bike shop. You assume that
you would operate your choice indefinitely, eventually leaving the business to
your children.
Example 8.3a NPV and Mutually Exclusive Projects (2 of 5)

Problem:
• You have collected the following information about the
uses. What should you do?

Blank Initial Cash flow in the Growth Cost of

Investment First Year rate capital
Laundromat $200,000 $35,000 2.0% 7.0%
Bakery $750,000 $45,000 3.5% 6.5%
Bike Shop $800,000 $40,000 4.5% 7.0%
Example 8.3a NPV and Mutually Exclusive Projects (3 of 5)
Solution:
Plan:
• Since you can only do one project (you only have one
piece of land), these are mutually exclusive projects. In
order to decide which project is most valuable, you need to
rank them by NPV. Each of these projects (except for
selling the land) has cash flows that can be valued as a
growing perpetuity, the present value of the inflows is CF
1
.
• The NPV of each investment will be r g

CF1
 Initial Investment
r g
Example 8.3a NPV and Mutually Exclusive Projects (4 of 5)

Execute:
$35,000
• The NPVs are: Laundromat: -$200,000  $500,000
0.07-0.02
$45,000
Bakery: -$750,000  $750,000
0.065-0.035
$40,000
Bike Shop: -$800,000  $800,000
0.07-0.045
Alternative NPV
Laundromat $500,000
Bakery $750,000
Bike Shop $800,000
Sell the Land $600,000
• Based on the rankings the bike shop should be chosen.
Example 8.3a NPV and Mutually Exclusive Projects (5 of 5)

Evaluate:
• All of the alternatives have positive NPVs, but you can only take one of them,
so you should choose the one that creates the most value.
• Even though the Laundromat has the lowest start-up costs, the higher cash
flows of the bike shop, along with its higher growth rate, makes it the best
choice.
8.4 Choosing Among Projects (2 of 8)
• Differences in Scale
– A 10% IRR can have very different value implications for an initial
investment of $1 million vs. an initial investment of $100 million
8.4 Choosing Among Projects (3 of 8)
• Identical Scale
‒ NPV of Maria’s investment in her boyfriend’s business:

6000 6000 6000

NPV  10,000     $4,411
1.12 1.12 1.12
2 3

‒ NPV of Maria’s investment in the delivery business:

5000 5000 5000

NPV  10,000     $2,009
1.12 1.12 1.12
2 3
8.4 Choosing Among Projects (4 of 8)
• Identical Scale
– IRR of her boyfriend’s business:
Figure 8.7 NPV of Maria’s Investment Opportunities with Two-
Drone Delivery Service
8.4 Choosing Between Projects (5 of 8)
• Change in Scale:
– Maria realizes she can just as easily invest in 10
drones for the delivery business.
– Setup costs would be $50,000 and annual cash flows
would be $25,000

25,000 25,000 25,000

NPV  50,000   2
 3
 $10,046
1.12 1.12 1.12
8.4 Choosing Between Projects (6 of 8)
• Change in Scale
– IRR is unaffected by scale
– IRR of boyfriend’s business is the same
Figure 8.8 NPV of Maria’s Investment Opportunities with the
Ten-Drone Delivery Service
Example 8.4 Computing the Crossover Point (1 of 5)
Problem:
• Solve for the crossover point for Maria from Figure 8.8.
Example 8.4 Computing the Crossover Point (2 of 5)

Solution:
Plan:
• The crossover point is the discount rate that makes the NPV of the two
alternatives equal.
• We can find the discount rate by setting the equations for the NPV of each project
equal to each other and solving for the discount rate.
• In general, we can always compute the effect of choosing the delivery service
over her boyfriend’s business as the difference of the NPVs. At the crossover
point the difference is 0.
Example 8.4 Computing the Crossover Point (3 of 5)
Execute:
• Setting the difference equal to 0:
25,000 25,000 25,000  6000 6000 6000 
NPV  50,000      10,000    3 
0
1 r (1  r )2
(1  r ) 
3
1  r (1  r ) (1  r ) 
2

• combining terms, we have

19,000 19,000 19,000
NPV  40,000    0
1 r (1  r ) 2
(1  r )3

• As you can see, solving for the crossover point is just like
solving for the IRR, so we will need to use a financial
calculator or spreadsheet:
Example 8.4 Computing the Crossover Point (4 of 5)
Execute:
• And we find that the crossover occurs at a discount rate of
20.04%.
Example 8.4 Computing the Crossover Point (5 of 5)
Evaluate:
• Just as the NPV of a project tells us the value impact of
taking the project, so the difference of the NPVs of two
alternatives tells us the incremental impact of choosing
one project over another. The crossover point is the
discount rate at which we would be indifferent between the
two projects because the incremental value of choosing
one over the other would be zero.
Example 8.4a Computing the Crossover Point (1 of 5)
Problem:
• Solve for the crossover point for the following two projects.

Blank Expected Net Cash Flow Blank

Year Project A Project B
0 −$12,000 −$10,000
1 $5,000 $4,100
2 $5,000 $4,100
3 $5,000 $4,100
Example 8.4a Computing the Crossover Point (2 of 5)
Solution:
Plan:
• The crossover point is the discount rate that makes the
NPV of the two alternatives equal.
• We can find the discount rate by setting the equations for
the NPV of each project equal to each other and solving
for the discount rate.
• In general, we can always compute the effect of choosing
Project A over Project B as the difference of the NPVs. At
the crossover point the difference is 0.
Example 8.4a Computing the Crossover Point (3 of 5)
Execute:
• Setting the difference equal to 0:
$5,000 $5,000 $5,000  $4,100 $4,100 $4,100 
NPV  $12,000      $10,000    0
1 r (1  r )2 (1  r )3  1 r (1  r )2 (1  r )3 
• Combining terms yields:
$900 $900 $900
NPV  $2,000    0
1  r (1  r ) (1  r )
2 3

• As you can see, solving for the crossover point is just like
solving for the IRR, so we will need to use a financial
calculator or spreadsheet:
Example 8.4a Computing the Crossover Point (4 of 5)
Execute:
• And we find that the crossover occurs at a discount rate of
16.65%.
Example 8.4a Computing the Crossover Point (5 of 5)
Evaluate:
• Just as the NPV of a project tells us the value impact of
taking the project, so the difference of the NPVs of two
alternatives tells us the incremental impact of choosing
one project over another.
• The crossover point is the discount rate at which we would
be indifferent between the two projects because the
incremental value of choosing one over the other would be
zero.
8.4 Choosing Among Projects (7 of 8)
• Timing of the Cash Flows
– Suppose Javier could sell the Internet café business at
the end of the first year for $40,000
– Should he plan to sell it?
Figure 8.9 NPV With and Without Selling
8.4 Choosing Among Projects (8 of 8)
• The Bottom Line on IRR
– Picking the investment opportunity with the largest IRR
can lead to a mistake
– In general, it is dangerous to use the IRR in choosing
between projects
– Always rely on NPV
8.5 Evaluating Projects with Different Lives (1 of 2)
• Often, a company will need to choose between two solutions to the same problem

Table 8.2 Cash Flows ($ Thousands) for Network Server Options

Year PV at 10% 0 1 2 3
A −12.49 −10 −1 −1 −1
B −10.47 −7 −2 −2 Blank

Table 8.3 Cash Flows ($ Thousands) for Network Server Options,

Expressed as Equivalent Annual Annuities
Year PV at 10% 0 1 2 3
A −12.49 0 −5.02 −5.02 −5.02
B −10.47 0 −6.03 −6.03 Blank
Example 8.5 Computing an Equivalent Annual
Annuity (1 of 4)
Problem:
• You are about to sign the contract for server A from Table
8.2 when a third vendor approaches you with another
option that lasts for four years. The cash flows for server C
are given below.
• Should you choose the new option or stick with server A?
Example 8.5 Computing an Equivalent
Annual Annuity (2 of 4)
Solution:
Plan:

• In order to compare this new option to server A, we need to put

server C on an equal footing by computing its annual cost. We
can do this by:
1. Computing its NPV at the 10% discount rate we used above.
2. Computing the equivalent four-year annuity with the same present
value.
Example 8.5 Computing an Equivalent
Annual Annuity (3 of 4)
Execute:
 1  1 
PV  14  1.2   1  4
 17.80
 0.10   (1.10) 
PV 17.80
Cash Flow    5.62
1 1  1  1 
1 1
r  (1  r )  0.10  (1.10)4 
 N  

• Server C’s annual cost of $5620 is greater than the annual

cost of server A ($5020), so we should still choose server A.
Example 8.5 Computing an Equivalent
Annual Annuity (4 of 4)
Evaluate:
• In this case, the additional cost associated with purchasing
and maintaining server C is not worth the extra year we get
from choosing it. By putting all of these costs into an
equivalent annuity, the EAA tool allows us to see that.
Example 8.5a Computing an Equivalent
Annual Annuity (1 of 5)
Problem:
• You are considering a maintenance contract from two
vendors. Vendor Y charges $100,000 upfront and then
$12,000 per year for the three-year life of the contract.
Vendor Z charges $75,000 upfront and then $35,000 per
year for the two-year life of the contract.
• Compute the NPV and EAA for each vendor assuming an
8% cost of capital.
 Example 8.5a Computing an Equivalent
Annual Annuity (2 of 5)
Solution: 0 1 2 3
Plan:
Vendor Y
-$100,000 -$12,000 -$12,000 -$12,000
0 1 2

Vendor Z
-$75,000 -$35,000 -$35,000

• In order to compare the two options, we need to put both on an equal

footing by computing its annual cost. We can do this
1. Computing its NPV at the 8% discount rate we used above
2. Computing the equivalent annual annuity with the same present value.
Example 8.5a Computing an Equivalent
Annual Annuity (3 of 5)
Execute:

 1 1 
NPVY  $100,000  $12,000   3
 $130,925
 0.08 0.08(1.08) 
PVY $130,925
Cash Flow Y    $50,803
 1 1   1 1 
 0.08  0.08(1.08)3   0.08  0.08(1.08)3 
   
Example 8.5a Computing an Equivalent
Annual Annuity (4 of 5)
Execute:
 1 1 
NPVZ  $75,000  $35,000   2
 $137,414
 0.08 0.08(1.08) 
PVZ $137,414
Cash Flow Z    $77,058
 1 1   1 1 
 
 0.08 0.08(1.08)2   0.08 0.08(1.08)2 
   

• The annual cost of Vendor Z is greater than the annual

cost of Vendor Y, so we should choose Vendor Y.
Example 8.5a Computing an Equivalent
Annual Annuity (5 of 5)
Evaluate:
• In this case, the higher upfront cost associated with Vendor
Y is worth the extra year we get from choosing it. By
putting all of these costs into an equivalent annuity, the
EAA tool allows us to see that.
8.5 Evaluating Projects with Different Lives (2 of 2)
• Important Considerations When Using the Equivalent
Annual Annuity
– Required Life
– Replacement Cost
8.6 Choosing Among Projects when
Resources are Limited (1 of 3)
• Evaluating Projects with Different Resource
Requirements
– Sometimes different investment opportunities demand
different amounts of a particular resource
– If there is a fixed supply of the resource so that you
cannot undertake all possible opportunities, simply
picking the highest-NPV opportunity might not lead to
the best decision
Possible Projects for $200 Million Budget
Table 8.4 Possible Projects for $200 Million Budget
Project NPV ($ millions) Initial Investment NPV/Initial Investment
($ millions)
A 100 200 0.500
B 75 120 0.625
C 70 80 0.875
8.6 Choosing Among Projects when Resources
are Limited (2 of 3)
• Evaluating Projects with Different Resource
Requirements
– Profitability Index
Value Created NPV
Profitability Index  
Resource Consumed Resource Consumed

(Eq. 8.4)
Example 8.6 Profitability Index with a
Budget/Money Constraint (1 of 6)
Problem:
• Your division at NetIt, a large networking company, has put
together a project proposal to develop a new home
networking router. The expected NPV of the project is
$17.7 million, and the project will require 50 software
engineers. NetIt has 190 engineers available, and is
unable to hire additional qualified engineers in the short
run. Therefore, the router project must compete with the
following other projects for these engineers:
 Example 8.6 Profitability Index with a
Budget/Money Constraint (2 of 6)
Problem:
Project NPV($ Millions) Engineering Headcount (EHC)
Router 17.7 50
Project A 22.7 47
Project B 8.1 44
Project C 14.0 40
Project D 11.5 61
Project E 20.6 58
Project F 12.9 32
Total 107.5 332

• How should NetIt prioritize these projects?

Example 8.6 Profitability Index with a
Budget/Money Constraint (3 of 6)
Solution:
Plan:
• The goal is to maximize the total NPV that we can create
with 190 engineers (at most). We can use Equation 8.4 to
determine the profitability index for each project. In this
case, since engineers are our limited resource, we will use
Engineering Headcount in the denominator. Once we have
the profitability index for each project, we can sort them
based on the index.
 Example 8.6 Profitability Index with a
Budget/Money Constraint (4 of 6)
Execute:
Engineering Profitability
Headcount Index Cumulative
Project NPV($ Millions) (EHC) (NPV per EHC) EHC Required
Project A 22.7 47 0.483 47
Project F 12.9 32 0.403 79(47 + 32)
Project E 20.6 58 0.355 137(79 + 58)
Router 17.7 50 0.354 187(137 + 50)
Project C 14.0 40 0.350 Blank
Project D 11.5 61 0.189 Blank
Project B 8.1 44 0.184 Blank
Example 8.6 Profitability Index with a
Budget/Money Constraint (5 of 6)
Execute:
• As shown in the table above, we assigned the resource to
the projects in descending order according to the
profitability index. The final column shows the cumulative
use of the resource as each project is taken on until the
resource is used up. To maximize NPV within the
constraint of 190 engineers, NetIt should choose the first
four projects on the list.
 Example 8.6 Profitability Index with a
Budget/Money Constraint (6 of 6)
Evaluate:
• By ranking projects in terms of their NPV per engineer, we find the most value we
can create, given our 190 engineers.
• There is no other combination of projects that will create more value without using
more engineers than we have.
• This ranking also shows us exactly what the engineering constraint costs us—this
resource constraint forces NetIt to forgo three otherwise valuable projects (C, D,
and B) with a total NPV of $33.6 million.
 Example 8.6a Profitability Index with a
Budget/Money Constraint (1 of 6)
Problem:
• AaronCo is considering several projects to undertake. All of the projects currently
under consideration have a positive NPV, but AaronCo has a fixed capital budget
of $300 million. The company does not believe they will be able to raise any
additional funds.
• How should AaronCo prioritize the projects (listed on the following slide)?
Example 8.6a Profitability Index with a
Budget/Money Constraint (2 of 6)
Problem:
Project NPV($ Millions) Initial Cost ($ Millions)
A $15 $25
B $25 $75
C $110 $200
D $60 $150
E $25 $50
F $20 $35
G $35 $40
Total $290 $575
Example 8.6a Profitability Index with a
Budget/Money Constraint (3 of 6)
Solution:
Plan:
• The goal is to maximize the total NPV we can create with
$300 million (at most). We can use Equation 8.3 to
determine the profitability index for each project. In this
case, since money is our limited resource, we will use
Initial Cost in the denominator. Once we have the
profitability index for each project, we can sort them based
on the index.
Example 8.6a Profitability Index with a
Budget/Money Constraint (4 of 6)
Execute:
Initial Cost Cumulative Initial Cost
Project NPV($ Millions) ($ Millions) PI ($ Millions)
G $35 $40 0.88 $40
A $15 $25 0.60 $65
F $20 $35 0.57 $100
C $110 $200 0.55 $300
E $25 $50 0.50 $350
D $60 $15 0.40 $500
B $25 $75 0.33 $575
Example 8.6a Profitability Index with a
Budget/Money Constraint (5 of 6)
Execute:
• We now assign the resource to the projects in descending
order according to the profitability index. The final column
shows the cumulative use of the resource as each project
is taken on until the resource is used up. To maximize NPV
within the constraint of $300 million, AaronCo should
choose the first four projects on the list.
 Example 8.6a Profitability Index with a
Budget/Money Constraint (6 of 6)
Evaluate:
• By ranking projects in terms of their NPV per engineer, we find the most value
we can create, given our $300 million budget.
• There is no other combination of projects that will create more value without
using more money than we have.
• This ranking also shows us exactly what the budget constraint costs us—this
resource constraint forces AaronCo to forgo three otherwise valuable projects (B,
D, and E) with a total NPV of $110 million.
 8.6 Choosing Among Projects when
Resources are Limited (3 of 3)
• Evaluating Projects with Different Resource Requirements
– Shortcomings of the Profitability Index
 In some situations it does not give an accurate answer if some resources are not
fully utilized
 Often beneficial to focus increasing the binding resource constraint
 With multiple resource constraints, the usefulness of the profitability index
breaks down
8.7 Putting It All Together (1 of 4)
Table 8.5 Summary of Decision Rules

NPV Blank
Definition • The difference between the present value of an
investment’s benefits and the present value of its costs
Rule • Take any investment opportunity where the NPV is
positive; turn down any opportunity where it is negative
Advantages • Corresponds directly to the impact of the project on the
firm’s value
• Direct application of the Valuation Principle
Disadvantages • Relies on an accurate estimate of the discount rate
• Can be time-consuming to compute
8.7 Putting It All Together (2 of 4)
[Table 8.5 continued]
IRR Blank
Definition • The interest rate that sets the net present value of the
cash flows equal to zero; the average return of the
investment
Rule • Take any investment opportunity where its IRR exceeds
the opportunity cost of capital; turn down any opportunity
where its IRR is less than the opportunity cost of capital
Advantages • Related to the NPV rule and usually yields the same
(correct) decision
Disadvantages • Hard to compute
• Multiple IRRs lead to ambiguity
• Cannot be used to choose among projects
• Can be misleading if inflows come before outflows
8.7 Putting It All Together (3 of 4)
[Table 8.5 continued]
Payback Period Blank
Definition • The amount of time it takes to pay back the initial
investment
Rule • Accept the project if the payback period is less than a
prespecified length of time—usually a few years;
otherwise, turn it down
Advantages • Simple to compute
• Favors liquidity
Disadvantages • No guidance as to correct payback cutoff
• Ignores cash flows after the cutoff completely
• Not necessarily consistent with maximizing shareholder
wealth
8.7 Putting It All Together (4 of 4)
[Table 8.5 continued]
Profitability Blank
Index
Definition • NPV/Resource Consumed
Rule • Rank projects according to their PI based on the
constrained resource and move down the list accepting
value-creating projects until the resource is exhausted
Advantages • Uses the NPV to measure the benefit
• Allows projects to be ranked on value created per unit of
resource consumed
Disadvantages • Breaks down when there is more than one constraint
• Requires careful attention to make sure the constrained
resource is completely utilized
Chapter Quiz
1. Explain the NPV rule for stand-alone projects.
2. Under what conditions will the IRR rule lead to the
same decision as the NPV rule?
3. What is the most reliable way to choose between
mutually exclusive projects?
4. Explain why choosing the option with the highest
NPV is not always correct when the options have
different lives.
5. What does the profitability index tell you?