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Net Present Value and Other Investment Criteria

If you are going to persuade your company to use the net present value rule, you must be prepared to explain why other rules may not lead to correct decisions. That is why we have examined three alternative investment criteria in this chapter.

Some firms look at the book rate of return on the project. In this case the company decides which cash payments are capital expenditures and picks the appropriate rate to depreciate these expenditures. It then calculates the ratio of book income to the book value of the investment. Few companies nowadays base their investment decision simply on the book rate of return, but shareholders pay attention to book measures of firm profitability and some managers therefore look with a jaundiced eye on projects that would damage the company's book rate of return.

Some companies use the payback method to make investment decisions. In other words, they accept only those projects that recover their initial investment within some specified period. Payback is an ad hoc rule. It ignores the timing of cash flows within the payback period, and it ignores subsequent cash flows entirely. It therefore takes no account of the opportunity cost of capital.

The internal rate of return (IRR) is defined as the rate of discount at which a project would have zero NPV. It is a handy measure and widely used in finance; you should therefore know how to calculate it. The IRR rule states that companies should accept any investment offering an IRR in excess of the opportunity cost of capital. The IRR rule is, like net present value, a technique based on discounted cash flows. It will therefore give the correct answer if properly used. The problem is that it is easily misapplied. There are four things to look out for:

  1. Lending or borrowing? If a project offers positive cash flows followed by negative flows, NPV can rise as the discount rate is increased. You should accept such projects if their IRR is less than the opportunity cost of capital.
  2. Multiple rates of return. If there is more than one change in the sign of the cash flows, the project may have several IRRs or no IRR at all.
  3. Mutually exclusive projects. The IRR rule may give the wrong ranking of mutually exclusive projects that differ in economic life or in scale of required investment. If you insist on using IRR to rank mutually exclusive projects, you must examine the IRR on each incremental investment.
  4. The cost of capital for near-term cash flows may be different from the cost for distant cash flows. The IRR rule requires you to compare the project's IRR with the opportunity cost of capital. But sometimes there is an opportunity cost of capital for one-year cash flows, a different cost of capital for two-year cash flows, and so on. In these cases there is no simple yardstick for evaluating the IRR of a project.

In developing the NPV rule, we assumed that the company can maximize shareholder wealth by accepting every project that is worth more than it costs. But, if capital is strictly limited, then it may not be possible to take every project with a positive NPV. If capital is rationed in only one period, then the firm should follow a simple rule: Calculate each project's profitability index, which is the project's net present value per dollar of investment. Then pick the projects with the highest profitability indexes until you run out of capital. Unfortunately, this procedure fails when capital is rationed in more than one period or when there are other constraints on project choice. The only general solution is linear programming.

Hard capital rationing always reflects a market imperfection—a barrier between the firm and capital markets. If that barrier also implies that the firm's shareholders lack free access to a well-functioning capital market, the very foundations of net present value crumble. Fortunately, hard rationing is rare for corporations in the United States. Many firms do use soft capital rationing, however. That is, they set up self-imposed limits as a means of financial planning and control.

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