Financial Management

Investment Analysis:
Investment Criteria
Prof. Carolina Salva

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Goals and Outline
• What are the tools or techniques that we can use to evaluate
investments?

• Project selection techniques:

˗ Net Present Value (NPV)

˗ Internal Rate of Return (IRR)

˗ The Payback Period

˗ Profitability Index

˗ Average Accounting Rate of Return

Investment analysis - some precisions

• What is an investment ?
Make a cash outflow today… (= initial investment outlay)
to receive future benefits / reduced costs / new revenues ….
( = future cash inflows)

• What is the goal of the investment? legal or social obligations, cost

reduction, replacement, expansion, strategic investment, …

• What is a good investment decision?

– One that raises the current market value of the firm’s equity, thereby
creating value for the firm owners
• What do we do when we analyse an investment?
– Involves comparing the amount of cash spent on an investment
today with the cash inflows expected from it in the future

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Assumptions to keep in mind

• Assumptions

– Separation of investment and financing decisions:

♦ If a project is judged to be profitable, it will be profitable regardless of
how it is financed.

– Efficient markets
♦ Evaluate investment opportunities as if there is plenty of cash
♦ Securities can be sold at a fair price

– Perfect capital markets

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Example

• Suppose you are given the following project:

You invest today 1000 and you estimate that you will get 1200 in 1
year. You can borrow from your local bank the 1000 for 1 year at a
rate of 8%. Should you take the project?

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Net Present value (NPV)

• NPV evaluates whether the present value of cash inflows is greater than
the present value of cash outflows:

NPV= PV(inflows) – PV(outflows)= PV (cash flows)

• Formally,

T T T
CFt CFt CFt
NPV    CF0     I0 
t 0 (1  r ) t
t 1 (1  r ) t
t 1 (1  r ) t

• r: the discount rate also called the opportunity rate of return. The
opportunity rate of return reflects how much could investors earn in
alternative comparable investments

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NPV and decision making

• Minimum acceptance criteria: Accept the project if NPV > 0

• NPV > 0 means the investment creates value and the return of
the investment is higher than the opportunity rate of return (or
required return by investors)
A B C D E F

1 0 1 2 3 4
2
3 Cash flows -100 50 40 40 30
4 Discount rate 15%
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6 NPV 17,18
7 =NPV(rate;value1;value2;…)
NPV (0,15 ; C3:F3) + B3

present value factor (tables) 1 0,8696 0,7561 0,6575 0,5718

NPV 17,18 -100 43,48 30,24 26,30 17,15

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NPV and decision making
• If you can take all projects, how much value do you generate?
• If projects are mutually exclusive, which do you take?
• If you have only 1’000 to invest, which projects do you take?

Comparing projects of unequal size

0 1 2 0 1 2

Project A -1000 800 500 Project A -1000 850 500

Project B -500 200 510 Project B -500 200 510
Project C -500 100 700 Project C -500 100 700

Discount rate 10% Discount rate 10%

NPV A 140.5 NPV A 186.0

NPV B 103.3 NPV B 103.3
NPV C 169.4 NPV C 169.4

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NPV and value creation

• Suppose the market value of Luminax is CHF 1.1 mio. This includes
CHF 1 mio in assets and CHF 0.1 mio in Cash. There are 10,000
shares and the price per share is 110.

• There is an investment opportunity that consists on investing CHF

100,000 to get future cash flows with present value of CHF 300,000.

• What should the firm do? If the firm undertakes the project, will the
market value of the firm change? What will happen to the price of the
share?

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Why NPV is a good investment rule?

• Properties:
– Focus on cash flows

– Accounts for time and risk

– Allows ranking projects from best to worst

– Measures value creation

♦ the NPV represents the immediate change in the shareholder wealth if
the project is accepted
♦ If positive, the project creates value for the firm’s owners; if negative, it
destroys value

– Additivity of NPV:
♦ NPV(A) + NPV(B) = Total NPV

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NPV and time

• Cash Flows for two investments with CF0 = $ -1 million and r = 10%

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NPV and risk

• Cash Flows for two investments with CF0 = $ -1 million and

r =12% r=15%

NPV(C) ? NPV(D)

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NPV limitations

• Not always easy to apply

• It ignores the opportunities to make changes to projects as time passes

Ex. Suppose two identical project A and B. A allows to recover ½ of the investment if
things turn out wrong

• It does not consider alternative investments that may be available

tomorrow

• It assumes cash flows are reinvested at the opportunity rate

• It focuses on quantitative aspects, BUT qualitative considerations (i.e. of

strategic or legal nature) may sometimes overrule financial
considerations.

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Internal Rate of Return (IRR)

• The IRR is the discount rate that sets the NPV of a project equal to zero

T
CFt
0   I0  
t 1 (1  IRR ) t

• The IRR is the rate of return earned by the project

• Computation: trial and error, calculator, excel (=IRR() function)

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IRR and decision making

• Minimum acceptance criteria: Accept if the IRR exceeds the opportunity

rate (required return by investors)

• If IRR > opportunity rate, it means that the investment creates value and
the NPV > 0

A B C D E
1 0 1 2 3
2
3 Cash flows -200 50 100 150
4 Discount rate 15%

IRR 19.44% =IRR(values: [guess])

=IRR (B3:E3 ; 0,15) If no cash flow in t, you need to put a zero!

50 100 150
NPV  0   200   
(1  IRR ) (1  IRR ) 2 (1  IRR ) 3

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NPV vs. IRR for the previous example

If we graph NPV (y-axis) and discount rate (x-axis), we can see the IRR as
the x-axis intercept.
0 1 2 3

Cash flows -200 50 100 150

Discount rate 15%
Discount rate NPV
0% 100.00
4% 73.88
8% 51.11
12% 31.13
16% 13.52
20% ‐2.08 IRR = 19.44%
24% ‐15.97
28% ‐28.38
32% ‐39.51
36% ‐49.54
40% ‐58.6

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IRR and decision making

• In general, IRR and NPV lead to the same conclusion

• Limitations of IRR, should we select the project with the highest IRR?:

1. The scale problem

2. Mutually exclusive projects of equal scale (e.g. acquiring an
accounting software)
3. The existence of several IRRs
4. Investing or borrowing?

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Limitation 1: The scale problem

• Which project do you choose? Would you rather make 100% or 50% on
your investments?

Mutually exclusive - different scale

0 1

Projet A -1 2
Projet B -1000 1500
discount rate 5%
NPV A 1
NPV B 429
IRR A 100%
IRR B 50%

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Limitation 2: Mutually exclusive projects of equal scale

Mutually exclusive - same scale

0 1 2 3
Proj A -10,000 10,000 1,000 1,000
Proj B -10,000 1,000 1,000 12,000
Discount rate 10%

NPV A 669
NPV B 751
IRR A 16%
IRR B 13%

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Limitation 2: Mutually exclusive projects of equal scale

NPV
2000
10.55% = cross-over rate or
Fisher intersection
1000

0
Discount rate
0% 5% 10% 15% 20% 25% 30% 35% 40%
-1000
Proj A
-2000

12.94% = IRRB 16.04% = IRRA

-3000

-4000

-5000 Proj B

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Limitation 2: Computing the crossover rate

To find the cross-over rate, compute the IRR for either project “A-B”
or “B-A”
Year Project A Project B Project A-B Project B-A
0 ($10,000) ($10,000) $0 $0
1 $10,000 $1,000 $9,000 ($9,000)
2 $1,000 $1,000 $0 $0
3 $1,000 $12,000 ($11,000) $11,000

1,500.00 10.55% = Crossover rate

1,000.00
500.00
0.00
NPV

(500.00) 0% 3% 6% 9% 12% 15% 18%

(1,000.00) A-B
(1,500.00)
(2,000.00)
(2,500.00) Discount rate

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Limitation 3: The existence of several IRRs
• When cash flows change sign more than once, we may find several
IRRs or none.

Examples 0 1 2 NPV IRR

Proj A, Cash Flow -1.000 2.450 -1.470 12,40 5% 40%
Proj B, Cash Flow -4.000 25.000 -25.000 -1.934 25% 400%
Proj C, Cash Flow 1.000 -3.000 2.500 339 ?
discount rate 10%

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Limitation 4: Investing or borrowing?
• When investment is delayed, evaluate whether the project is really an
investment project. According to IRR, should we invest in project A and B?

+$120
Proj. A Investing
0 1 2 3 IRR=20%
-$100 r=10%
NPV=9.09
-$120
Proj. B Borrowing
0 1 2 3
IRR=20%
+$100 r=10%
NPV<0

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IRR: properties and limitations

• Properties: • Limitations:
– Focus on cash flows – Some times is not an optimal
– Accounts for time and risk selection method
– Easy to understand and – A note: assumes CF are
communicate reinvested at the IRR
– For independent projects with
“normal cash flow patterns”
IRR and NPV give the same
conclusion

Recommendation:
Compute both NPV and IRR. If they give the same
conclusion, use the one you prefer. If they give conflicting
outcomes use the NPV.

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Example

CF0 CF1 CF2 CF3

ProjA -1000 90 90 1090 IRR=9% r=4%
ProjB -1000 0 0 1295 IRR=9% r=4%

• Based on the IRR method, which project would you choose?

• What if the intermediate flows are reinvested at 4%?
• If the intermediate cash flows are reinvested at 4%, what is the
corrected IRR*?

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The payback period

• How long does it take the project to “pay back” the initial investment?
• Payback Period = number of years to recover initial costs

• Example:
0 1 2 3 4
Cash Flows -10.000 5.000 3.000 2.000 1.000
Accum Cash Flows -5.000 -2.000 0 1.000

• Payback is 3 years: Is that good or bad?

• Minimum acceptance criteria: set by management. Accept the project if

the payback is smaller than a cut off period

• Frequently used as a check on NPV analysis or by small firms or for

small decisions

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The payback period: example

Time Payback NPV(10%)

0 1 2 3
Projet A -2’000 0 2’000 5’000 2 3409,5
Projet B -2’000 1’000 1’000 10 2 -256,9

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The payback period
• Advantages: • Limitations:

– Easy to understand – Ignores time value and risk

– Biased towards liquidity. Useful if  Discounted payback
liquidity is critical – Ignores cash flows beyond the cut
– Simple and useful for small projects or off period
when it is hard / expensive to estimate – Requires an arbitrary cut off period
cash flows or discount rates
– Biased towards ST projects. We
– If you accept a project according to may give up profitable investments,
payback, most likely the project has a i.e. R&D
NPV>0
– A project accepted based on the
– Useful as a complementary measure:
payback criteria may not have a
Suppose you have two projects with positive NPV
the same NPV but different payback:
which one to choose? – It tells you something about a
project’s liquidity, but not about its
profitability

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Discounted payback period

0 1 2 3 4
Cash Flows -10.000 5.000 3.000 2.000 1.000
Accum Cash Flows -5.000 -2.000 0 1.000
Payback 3
Discount rate 10%
Discount factor 1 0,9091 0,8264 0,7513 0,6830
Discounted Cash Flows -10.000 4.545 2.479 1.503 683
Accum Discounted CF -5.455 -2.975 -1.473 -790
Discounted Payback >4

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Project selection with resource constraints
• If unrestricted, firms should take all positive NPV investments available
• However, often there are limitations on the number of projects a firm can
take due to resource constraints (limited budget, production capacity,
space, people, etc.)
• Example: Often managers work with a budget constraint. Their goal is to
maximize total NPV while staying on the budget. Given the projects
below, what would you choose:
a) If there is no budget constrain
b) If your budget is $100 mio

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Profitability index

• Useful when resources are limited to identify the optimal combination of

projects to take

• Profitability Index (PI) = NPV / Units of ressource

• Profitability Index (PI) = NPV / Initial Investment

• Minimum acceptance criteria: Accept if PI > 0

• Ranking criteria: Select the project with the highest PI

• Advantages:
• It is a good substitute for NPV that is easy to communicate
• Correct decision when evaluating independent projects
• Disadvantages:
• Problems with mutually exclusive investments of different size

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Profitability index with a human resource constraint

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Profitability index with a human resource constraint

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The Average Accounting Return (AAR)

• It is defined as:
Average earnings / Average book value of investments

0 1 2 3 4 5
earnings 100 80 60 40 20
initial investment -1000
book value 1000 800 600 400 200 0

Average earnings 60
Average book value 500
AAR 0,12

• AAR decision rule: Accept if the project return is larger than the target
return
• AAR= Accounting Earnings/ Average Book Value of Investments

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The Average Accounting Return (AAR)

• There are serious shortcomings with this rule

˗ It does not focus on cash flows
˗ It does not consider the time value of money
˗ It does not account properly for risk (ad hoc selection of the target
return)

• … but 11% of surveyed CFOs use this rule, why?

˗ Simple given pro forma statements
˗ Compensation systems are often based on accounting figures so it
is normal that managers still want to check accounting returns
when deciding

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What practitioners do

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Wrap up

• An investment decision rule should take into account

– Time
– Cash flows: It should account for all incremental cash flows
attributable to the project
– Risk: It should adjust for the risk inherent in the project through the
opportunity cost of capital

• The recommended rule is the NPV

• If other rules give different outcomes, then rely on the NPV

– Take all projects with positive NPV
– If you need to select among projects, take the one with highest NPV

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Exercise I

Compute the IRR, NPV, PI, and payback period for the following two
projects. Assume the required return is 10%.

Year Project A Project B

0 -$200 -$150
1 $200 $50
2 $800 $100
3 -$800 $150

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Comparing projects with different life spans

Comparing projects of unequal life spans

0 1 2 3 4
Machine A -80.000 -4.000 -4.000
Machine B -120.000 -3.000 -3.000 -3.000 -3.000
r 10%

Both generate identical cash inflows

So, the machine with the lower present value of annual costs should be preferred

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Comparing projects with different life spans

OPTION 1
0 1 2 3 4
Machine A -80.000 -4.000 -84.000 -4.000 -4.000
Machine B -120.000 -3.000 -3.000 -3.000 -3.000
r 10%

npv A -158.795
npv B -129.510
Thus B is preferred

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Comparing projects with different life spans

OPTION 2: equivalent annual annuity approach

0 1 2 3 4
Machine A -80.000 -4.000 -4.000
Machine B -120.000 -3.000 -3.000 -3.000 -3.000
r 10%

npv A -86.942
npv B -129.510

What annual constant payments does each option imply?

PMT A -86.942 -XXX -XXX

PMT B -129.510 -YYY -YYY -YYY -YYY

-XXX 50.095
-YYY 40.856

So option B is better.

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