NPV vs. Alternative Investment Criteria

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NPV vs. Alternative Investment Criteria
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Business Investments

• Office building
• Manufacturing machinery
• CRM system
• New product line
• Merger
• Advertising
• RD

• Common element
• Capital committed
• over time in exchange
• for future benefits

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Investment Criteria

• We need a decision criterion that will properly
  weigh the benefits of the investment against the
  cost of committing the capital

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The NPV Criterion

• Criterion Invest if NPV gt 0
• NPV values project net benefits using
  shareholders required rate of return

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Implications of Positive NPV

• In an efficient market, stock price rises by
  amount of NPV per share
• Value of project benefits exceeds value of costs
• Market value exceeds book value

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Alternative 1 Payback Period

• Payback period of periods until cumulative
  project inflows initial outlay
• Criterion dont invest if payback period exceeds
  some specified standard

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Aspects of Payback

• Reasons for use
• Bias toward liquidity
• Guard against overly optimistic forecasts

• Problems
• Effectively discounts cash flows before payback
  threshold at 0, cash flows after that at ?
• Verdict

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Alternative 2 Average Accounting Return (AAR)

• Calculate an average rate of return on capital
  invested over project life
• Criterion invest if AAR gt some specified
  standard (cost of capital?)

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Aspects of AAR

• Reasons for use
• Apparent consistency with accounting statements

• Problems
• Income and cash flow are different (depreciation
  can be misleading)
• Doesnt consider time
• Verdict

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Alternative 3 Internal Rate of Return (IRR)

• Find the discount rate that sets NPV 0
• Criterion invest if IRR exceeds cost of capital

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Aspects of IRR

• Reasons for use
• Simple, intuitive
• Properly considers time value of money

• Problems
• Multiple IRRs
• Incorrect ranking for mutually exclusive projects
• Verdict
• Mixed
• OK for yes/no
• Dont use to rank

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Alternative 4 Profitability Index (PI)

• Compute a benefit-cost ratio
• Criterion Invest if PI gt 1

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Aspects of PI

• Reasons for use
• Intuitive (bang per buck)
• Properly considers time value of money

• Problems
• Doesnt rank projects properly
• Verdict
• Mixed
• OK for yes/no
• Dont use to rank