Investment Decision Rules

This section focuses on evaluating investment decisions such as new products, equipment purchases, and marketing campaigns.
Introduces the NPV rule, which maximizes firm value.
Explains alternative techniques, including:
- Payback rule
- Internal Rate of Return (IRR) rule
Compares alternative techniques with NPV rule and illustrates potential drawbacks of using these alternatives.

Net Present Value (NPV): The difference between the present value of an investment's benefits and the present value of its costs.
Formula:
NPV = PV(Benefits) - PV(Costs)

Present value (PV) integrates the concept of discounting future cash flows to present terms.
Corporations prefer values defined in present terms to make sound financial decisions.

The NPV investment rule is derived from the Valuation Principle, which states that:
- Projects should be assessed based on their present value to make solid investment decisions.
By applying NPV, companies can discern profitable investment opportunities.

Consider an investment requiring an initial outlay and providing returns:
- Initial investment of $500 provides a return of $550 in one year with an interest rate of 8%.
- Calculation:
- PV(Benefits) = 550 / 1.08 = 509.26 (this is the present value of $550 in one year)
- NPV = 509.26 - 500 = 9.26 (positive NPV indicates to undertake the investment)
Should a manager not possess the entire initial investment, they may borrow the amount needed; hence:
- Today's cash flow: Loan amount ($509.26) minus investment ($500) provides $9.26.
- Future cash flow: Project return ($550) minus loan repayment ($509.26 x 1.08) yields zero obligation.

The positive NPV illustrates cash surplus today, which indicates a beneficial investment decision, irrespective of current cash availability.

NPV Decision Rule: Invest in alternatives with the highest NPV.
- Accept projects with a positive NPV; this decision increases firm wealth.
- Reject projects with negative NPV; this would decrease firm value.
- Neutral NPV (0) results in no gain or loss from undertaking the project.

Acceptance of positive-NPV projects equates to receiving their respective NPVs in cash.
Negative-NPV projects equate to losses, which should be avoided in decision-making.
Zero-NPV projects neither gain nor lose value and should be approached with caution.

Investors benefit from projects with positive NPVs, enhancing their wealth.
The NPV rule simplifies wealth-enhancing decisions, eliminating the need to consider individual preferences.

Evaluation of a single, stand-alone project through NPV criteria involves:
- Comparing project's NPV against zero.
- Decision rule suggests acceptance if NPV is positive.

Fredrick's Feed and Farm: Develops a new fertilizer requiring immediate capital.
- Outflow of $81.6 million and inflow of $28 million for four years:
- Cash flow analysis yields:
  - Year 0: -$81.6 million
  - Years 1-4: +$28 million (each year)
- Formula application for NPV:
  NPV = -81.6 + rac{28}{(1 + r)} + rac{28}{(1 + r)^2} + rac{28}{(1 + r)^3} + rac{28}{(1 + r)^4}
Adoption of the project's estimated cost of capital of 10% yields a positive NPV of $7.2 million, supporting project embarkation.

An NPV Profile: A graphical representation of project NPV across different discount rates.
Construction of an NPV profile assists in visualizing project sensitivity to changing capital cost estimates.
- This is done efficiently through Excel.
- Key data establishes the IRR, where NPV transitions from positive to negative, providing critical decision insights.

Internal Rate of Return (IRR): The discount rate that sets NPV to zero.
The example with Fredrick's illustrates IRR of 14% based on established cash flows.
The IRR provides sensitivity measurements regarding cost of capital estimates; deviations beyond the determined threshold influence project attractiveness.

A study revealed 77% of firms utilize the NPV rule as an investment decision tool, indicating a significant increase in adoption from past standards.
Alternative rules exist but should be employed judiciously, supplementing, rather than supplanting, NPV guidance for financial prudence.

The NPV is favored for its accuracy and reliability, as it presents a comprehensive understanding of investment impacts.
Firms should always prioritize NPV in decision-making processes, especially when facing conflicting alternative rules, ensuring decisions align with wealth maximization principles.