In this chapter, we covered different investment decision rules. We evaluated the most popular alternatives to the NPV: the payback period, the discounted payback period, the accounting rate of return, the internal rate of return, and the profitability index. In doing so we learned more about the NPV.
While we found that the alternatives have some redeeming qualities, when all is said and done, they are not the NPV rule; for those of us in finance, that makes them decidedly second-rate.
Of the competitors to NPV, IRR must be ranked above both payback and accounting rate of return. In fact, IRR always reaches the same decision as NPV in the normal case where the initial outflows of an independent investment project are followed only by a series of inflows.
We classified the flaws of IRR into two types. First, we considered the general case applying to both independent and mutually exclusive projects. There appeared to be two problems here:
Some projects have cash inflows followed by one or more outflows. The IRR rule is inverted here: One should accept when the IRR is below the discount rate.
Some projects have a number of changes of sign in their cash flows. Here, there are likely to be multiple internal rates of return. The practitioner must use either NPV or modified internal rate of return here.
Next, we considered the specific problems with the NPV for mutually exclusive projects. We showed that, due to differences in either size or timing, the project with the highest IRR need not have the highest NPV. Hence, the IRR rule should not be applied. (Of course, NPV can still be applied.)
However, we then calculated incremental cash flows. For ease of calculation, we suggested subtracting the cash flows of the smaller project from the cash flows of the larger project. In that way the incremental initial cash flow is negative. One can always reach a correct decision by accepting the larger project if the incremental IRR is greater than the discount rate.
We described capital rationing as the case where funds are limited to a fixed dollar amount. With capital rationing the profitability index is a useful method of adjusting the NPV.
