chapter 8

Chapter 8: Investment Decision Rules

8.1 NPV and Stand-Alone Projects

  • Investment Scenario: Saskatchewan Fertilizer Corporation (SFC) proposes a project costing $250 million with expected annual cash flows of $35 million, starting from the end of the first year and lasting indefinitely.

  • NPV Calculation:

    • NPV calculation formula: The NPV of a project is based on the present value of future cash flows and is sensitive to the choice of discount rate.

8.2 The Internal Rate of Return Rule

  • IRR Definition:

    • The Internal Rate of Return (IRR) is defined as the discount rate that makes the NPV of the project equal to zero.

  • Investment Rule Based on IRR:

    • Accept projects where IRR exceeds the cost of capital; reject projects where IRR is less than the cost of capital.
    • Example: For SFC’s project:
    • With a cost of capital at 10%, the IRR is calculated at 14%.
    • Since IRR > cost of capital, the project is justifiable.

  • Sensitivity of IRR:

    • If cost of capital estimates exceed 14%, then NPV becomes negative, indicating the project becomes unattractive.

  • Comparison with NPV:

    • When IRR and NPV rules conflict, always follow the NPV decision rule as it is a more reliable indicator of profitability.

  • Conflicts with IRR Rule:

    • Unconventional Cash Flows: Project cash flows that don’t follow typical patterns can yield multiple IRRs or no IRR at all.
    • Example Interpretations:
    • If cash inflows precede outflows, traditional IRR assessment may yield flawed conclusions.

Examples of IRR Applications

  • Book Deal Example:

    • Publisher’s offer: $1 million upfront; opportunity cost of $500,000 per year over three years.
    • Calculated IRR at 23.38%, exceeding the 10% opportunity cost; however, NPV might still be negative indicating rejection.

  • Challenges with Multiple IRRs:

    • Scenarios with multiple IRRs due to fluctuating cash flows and their implications on the investment decision-making process.

8.3 The Payback Rule

  • Definition: Payback period is the duration taken to recover the initial investment.
  • Application: If the period is less than a defined threshold (often five years), the project is accepted; otherwise, it is rejected.
    • Shortcomings include:
    • Ignoring time value of money.
    • Neglecting cash flows post-payback period.
    • Being overly simplistic in evaluation.

8.4 Choosing Between Projects

  • Mutually Exclusive Projects: Projects that cannot coexist in selection often require careful evaluation.

    • Choose the project with the highest NPV, despite conflicting IRR comparisons.

  • Example of NPV Calculation for Mutually Exclusive Projects:

    • A breakdown of cash flows and costs for various student-oriented businesses around a university can lead to a derived net present value.

8.5 Project Selection with Resource Constraints

  • Understanding Profitability Index: A tool to rank projects based on NPV over resource requirements, assisting in resource allocation decisions.
    • Example: Choosing between projects that need varying warehouse space or budget constraints; prioritize the combination that maximizes NPV.

Shortcomings of Decision Rules

  • Profitability Index Limitations:
    • Scenarios where PI does not yield accurate prioritizations, particularly with limited resources.
    • Issues arise in complex resource constraint situations.

Review Questions

  • Explain the NPV rules for stand-alone projects.
  • Discuss the IRR rule vs NPV rule in conflict cases.
  • Analyze decision-making for mutually exclusive projects.
  • Explore profitability rankings in resource-constrained environments.
  • Propose methodologies for selecting attractive projects during capital rationing.