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Chapter 6
Investment
Decision Rules
Investment Decisions
• Leave the latte, take the chocolate
• (Bloomberg, Sept 15, 2009) Kraft may be ready to give up
coffee and hot dogs in exchange for chocolate. The the
food giant might sell assets like Maxwell House and Oscar
Mayer in order to raise enough cash to finance an
acquisition of British candy company Cadbury.
• Kraft last week proposed making a $16.7 billion stock-andcash bid for Cadbury, and at the time said it would have
no problem financing the transaction. The company
planned to pay 60 percent of the price tag in stock and
raise about $8 billion in cash for the rest.
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Parallel Petroleum to be bought
by Apollo Global
• Sept 15 (Reuters) - Independent oil and gas company Parallel
Petroleum Corp (PLLL.O) said it agreed to be bought by investor Leon
Black's Apollo Global Management LLC for $132 million in cash.
• The $3.15 per share offer represents an 11 percent premium to
Parallel stock's close on Monday on Nasdaq, and the total deal value
is $483 million, including assumption of $351 million in debt.
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Graham and Harvey, 2002
“It is a major tenet of modern finance theory that
the value of an asset (or an entire company)
equals the discounted present value of its
expected future cash flows. Hence, companies
contemplating investments in capital projects
should use the net present value rule: that is,
take the project if the NPV is positive (or zero);
reject if NPV is negative.”
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Graham and Harvey, 2002
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NPV and Stand-Alone Projects
• Researchers at FFF face an investment decision.
The project requires $250 million to build a new
plant. The benefits will be $35 million per year,
starting at the end of the first year and lasting
forever. Should the firm take the project?
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NPV of FFF’s New Project
The graph shows the NPV as a function of the discount rate. The NPV is
positive only for discount rates that are less than 14%, the internal rate of
return (IRR). Given the cost of capital of 10%, the project has a positive
NPV of $100 million.
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Alternative Decision Rules
•
•
•
•
The Payback Rule
The Internal Rate of Return Rule
Economic Profit or EVA
Why Do Rules Other Than the NPV Rule Persist?
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Using the Payback Rule
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Merits of the Payback Rule
• Cons
–
–
–
–
Ignores timing and risk of cash flows (time-value-of-money)
Imposes an arbitrary payback threshold
Completely ignores the cash flows after the payback point
If the project generates both positive and negative cash flows
(other than the initial outlay) we can have multiple payback periods
and no clear interpretation
• Pros?
– Simplicity
– Accounts for the liquidity of the project
– Accounts for the uncertainty of the cash flows
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IRR
• Take a project if its IRR exceeds the opportunity
cost of capital
• The IRR is the rate at which the NPV is zero.
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Deviations between NPV and IRR
• John Star is offered $1 million to write a book. He
will forgo $500,000 a year for three years in
opportunity costs. Should he take the book deal?
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NPV of Star’s $1 million Book Deal
When the benefits of an investment occur before the costs,
the NPV is an increasing function of the discount rate.
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Non-existent IRR
• John Star is offered $1 million per year in each of
the next three years if he gave four lectures per
month. He will forgo $500,000 a year for three
years in opportunity costs. Should he take the
lecture deal?
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NPV of Lecture Contract
No IRR exists because the NPV is positive for all values of the discount
rate. Thus the IRR rule cannot be used.
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Multiple IRRs
• John Star is offered $1 million to write a book. He
will forgo $500,000 a year for three years in
opportunity costs. After the book is written (in
year 3), he will receive $20,000 per year in
royalties, forever. Should he take the book deal?
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NPV of Star’s Book Deal with Royalties
In this case, there is more than one IRR, invalidating the IRR
rule. If the opportunity cost of capital is either below 4.723% or
above 19.619%, Star should make the investment.
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Mutually Exclusive Investment
Opportunities
• Don is evaluating two investment opportunities:
1) Invest $1,000, get $1,100 in year 1, declining at
10% thereafter, forever.
2) Invest $1,000, get $400, declining at 20%
thereafter, forever.
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NPV of Don’s Investment Opportunities with the
Single-Machine Laundromat
The NPV of his girlfriend’s business is always larger than the NPV of the
single-machine laundromat. The same is true for the IRR; the IRR of his
girlfriend’s business is 100%, while the IRR for the laundromat is 20%.
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Project of Different Scale
• Suppose Don can install 20 laundromats instead
of 1?
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NPV of Don’s Investment Opportunities
with the 20-Machine Laundromat
As in Figure 6.5, the IRR
of his girlfriend’s
business is 100%, while
the IRR for the
laundromat is 20%. But
in this case, the NPV of
his girlfriend’s business
is larger than the NPV of
the 20-machine
laundromat only for
discount rates in excess
of 13.9%.
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Economic Value Added: EVA®
• EVA is a measure of performance developed
by the consulting company Stern Stewart. It
measures the value that your company (or
division within a company) creates through its
investment and financing decisions.
• EVA= Economic Profit = “Profit” – Capital
Charge
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• In general,
EVA = (Net Operating Profit After Tax ) - [(Cost of
Capital %) * (Total Capital)]
• where NOPAT = EBIT x (1 - T)
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Comparison between NPV and EVA
NPV = PV ( Future CF ) - Initial Outlay
EVA = NOPAT - Capital Charge = NOPAT - Cost of Capital x Level of Capital
NPV
EVA
Application
Projects or Investment Decision
Performance Evaluation of the Firm
or Division
Time
Project's Life
Any defined period
Base
Cash Flows
NOPAT
Capital Expenditure
Reduces CF
Increased Level of Capital
Depreciation
Added to NOPAT
Reduces Level of Capital
Working Capital
Affects CF
Affects Level of Capital
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