resent

e
t er Invest e
to be rleh rather lhan
in eveht
The difteranee

Instecd
eompnre the exeretod
wilh me retum thel shareholdrrrs rrould rram on
invectmrrnts in tha

shareholders

madrrrt Phe ecmpany aoerrpts thosrr

prcjects hal previdrr

pesitive NPV end

rrrtum thec sharaholdrrrs erruld

this rale 01 ratum rula

thrrmsatrec, If usod
shrruld

thal Inerrursa jjrm vrtua,

thrr net prrrsrrnt value

somrr other measures that 0"r'0n:,,,,,,,;;
investment deoisiuns, The flrst Tho
ol these

Its dook

rate uf retum,
rules
more aecurate when
financial manager
suhstantial

enprr with
situatinns whrrn thrr frm has
odo
ehonsa thnsrr

cal culata and

Hnw~

savrrrrt traps fnr me unwruy

dnl~

Invrrstrrd r bUI mnre rrlabnratrr

nrrrrdrrd
rl"",inninn

mere han a rule el thumh when

investment deelslen,

what? NPV,

NPV
105

One

Value

flews,

Net Present Vrr!ue rrnd

!mlrrstmrrnt

Valua

Proltablity miau:

Payl:ck:

60

I
80

FIGURE

whc

Suuxeyevltlent:e
hwestment projec!s.

particular technique

al Finance: Evidenee lrom the Fel," Jaumal ar Financlal Ecormmies 51 (ZIJOll,

measures do nnl have this

and

Book

slmph: h.;:;~rJ.nm'5 uf no,v onk

rtturn
cakulkJ anu of the differtnce
f1o\l,-'~ Rt:?o th,;;
if yOS)
tu refrtdl. yuur uncln-smlng nf thl'
5tH], do lhr

Net Present Value

500

10

+$2,624

shouk1

i:.%ktn

J(cunt in

One

Value

also
an inital
1 and 81,800 yca: 2, At

of 52,000
10%

~2,000

500
10

1,800

as thc

~2,000

Yoo

discuunted cash flows fcu our

1,800
.10

500

~$58

two

+$50

as illustrated

first

In"",,,,'I,,,""'ot

makes NPV

we
O,

the dscount

Gritera

Valu6

rate

~l

O.
the

NPV

Actual calcularan of IRR

of

the
NPV

~4,000

+ ---~

zero discmmt rote,

4,000

5 Dol zero but

be

~4,OOO

lJlOO

~$889

Present Value and Other Investment

.. FIGURE 5.3

duccs
$2,000
$4,000
intcma!
01
(IRR) is 213%, thc mtc

O~~~~~~~~~~~~~~~

SCOllrlt

01
NPV

rata, %

the discmmt rate

,000

whlch

One

The mine

mR and its

Note rhat [here are two

ments

NPV

.035
~30

~30

m
1.1954

10

3,

o + ..

+
+

o.

NPV

rates that

BEYOND

rrrrrrrrrr

follows:

... +

of

10

In otOer
internal

1111'\1, A$billons

iRriR%iR% +-t

wOm-t~+1+1iR%iR%1+1-11

lO

FIGURE 5iR

15

30

[WD

35

'" O whon

[)iSGount (ate, %

rato

Net Present Value and Other

mUD,,',rr,,~nr

15~

company
of rcturo

BEVOND
eeffH~

A mjsat wth nc IRR

lCompanks
unUl
femulns
hi,
L

00.1)'

urouad the pmbk-m of muhiplt rates of return

one changt ;n the sign nf 1he c.J.sn flh'S,
llw i\HRR calculated follow",
nO ull he subseqcenl
uow:
\GiU + lO/U' + IOiU'

PV lu

AJd o Ihe

!OIU' ~

now he presenl value al' subStquenl r<h nows:

+ P\/{gubsequttnt cllsh
in the sign uf tITe- cash

Siott there

lOIU37

lOiU3?'

t10'A'S}

= 10

io

;'66 = L.H

the fevlsEd
lOiLl37'

of captd (un he initid

valud al ihe roSl
nf coursr, il

tnen be cakuh.ted nn

has

uniqut fate of return, '/h1;:::h b

+ El/U}?'
flo\\'

neg;:!lve), the project has ,

and just cakubk project

when

Value

foHows:

" FIGURE

Projec! G
!Jiscount rata, %

o;YDU mar, DO\1cver,

tba1 ynu
jumpeJ
uf tnt' frying Km
the fn~> The
in sign, in his
Ihtf 2ft likdy bn ffiullip0 mR, nn
w!l be
lO
Ihe
fh often suggfst2-d 1hu! tht ChOlc(, bebt>fen lhe Dei presen v:due ruk and
intnnal rale of ftturn ruie snu1d De:pend On
J.bk
Ths 1vwng~ The prospective
on anthe( indeprndcnt lnvcs!nwnl should m'h'Tbe alkHvtQ to
Ihe

lnvoh'f

Net Present Value

Investment Criteria

!8

Value

on

4ln

for

nther

L.n:g+:rm c;}sh Hm<,.,

COmpilOj tn day und~rt;"l.kmg J

"d",'D,"_''W_ITHnn'V (pruject
'<d$~~n~th>mone( {prnj~ct

generJJly pa}';; to
ni II mJ.kes

Net

nnt

Other Investment

he Jtnomim!or "hould be lhe rrosen! value of hu nUllayu.

comptmt Jo
Tbe
58iJ Jonu
he buBer
value tu inHLd ouday, that b,
si m,,!}' ucid LO lO ueh prn[;hilty inciex,

120

ODa

12

;HHIHIIr~

Capital ratoning mojels

mnner
lm',,'er prnt1tablBty
\h~t

in he Aprend" lo Chrrptff

Dad w

the

ID

IRR: Internal

XIRR:The

But that

he too

---!

122

Pan One

Value

1s not rationed, other resources may be. The availabilit}' of management

or even other capital equipment often constitutes an important cOl1straint
011

should never cost the fi1'm

constraints
become tight
to hurt-in the sense that
with
NPVs are
passed up-then the firm raises more money and ooseos the constraint. But what if ir alll't
mise more money-what if it faces IUlrd
mean we have
Hard rationing implies market
to thmw away net present value as a crHerion fm
on the nature
of the imperfection.
t still has
Arizona Aquaculture, ne. (AA!), bormws as much as the banks willlend it,
good investment opportunities. This is not hard
so
as AAI can issue stock But
perhaps it can't. Perhaps the fouoder and majority shareholder vetoes the idea from fear
control of the frm. Perhaps a stock ssue would bring
red
or
This doe:; flot invalidate the NPV rule. AA!'s sJwrellOlders can borrow or
shares, or buy more. The}' have free access to security markets. The type
is independent of AA!'s finandng Ol" investment decisions. The
way AAI can
shareholders s to rpak,e them richer..Thus AAI should invest its available casI! in the pac:Kaj;;e
of projects having the largest aggregate net present valuc.
A barrier between the firm and capital markets does BOt ul1dermine net
value so
long as the barder is the oll/y market imperfection. The important
i5 that the firn
slwrellOlders have free acces:; to well-functioning capital markets.
The net present value rule is undermined when imperfections restrict shareholders'
folio choice. Suppose that Nevada Aquaculture, ne. (NA!), Is solely owned by its
Alexander Turhot Mr. Turbot ha5110 cash or credit remaining, but he is convinced that expansion of his operation is a high-NPV investment. He has tried to seH stock but has found that
investors, skeptical of prospects for [sh farming in the desert, offer him much less
than he thinks his [rm s worth. For Mr. Turbot capital markets hardly exist It makes Hule
seme fm him to discount prospective cash tlOW5 at a market opportunity cost of capital.

Hard

"A nllljorly ",,"oer "1,,, is "Iockd - ""d 11", nlllcJ pcrsmml wcal!h le.! up in AA! mal' be efic,tivc!r cut off [mm capital market5.
The NI'V ruk mol' nol mOKC sen" lo ,d, on OIVlle,. ""gil il \VII! n lile "Ihcr 'MrdwIJers.

SUMMARY

IfyOl! are gaing to persuade yuur campany to use the net

value
yau must be
to explain why other rules may lIal ead to correct decisions. That is
we have examined three
alternatve investment crteria in this chapter.
Some firms look at the book rate of return on the project In this case the company decides
whieh cash payments are capital expenditures and picks the appropriate cate to depreciate these
lt then calculates the ratio of book income to the book value of the investmcnt Few
"w~''''v< base their investment dedsion simply on the book rate of retum, but shareholders pay attention lO book measures of frm prontability and sorne managers therefore look with
a
that would
the company's book rate of return.
So me
method to make lnvestment decisions. In other words,
accept
that recover thei. initiai nvestment within sorne specified
Payback i5 ao ad hoc rule. It
of cash flows within the payback period,
and it ignores
cash flows
It therefore takes no account of the opportunity
cest of capital.
The internal rate of rcturn (IRR) i5 defined as the rate of discount at whieh a
would
have zera NPV. It is a handy measure and widely used in finan ce; you should therefore know how

Net Present

:mil

Other

!nVA<::,rm:>nt

DecisioflS,"

Criteria