|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:
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.