Investment Decision Criteria: NPV, IRR, and More | CFA Level I Corporate Issuers

Today, we’ll dive into the investment decision criteria analysts use to evaluate capital investments. We’ll start with the two most common methods – Net Present Value (NPV) and Internal Rate of Return (IRR). We’ll also discuss the effect of project NPV on share price, Return on Invested Capital (ROIC), and its impact on a company’s stocks.

Net Present Value (NPV) and Internal Rate of Return (IRR)

The Net Present Value (NPV) is the sum of the present values of all the expected incremental cash flows if a project is undertaken. The discount rate used is the firm’s cost of capital, adjusted for the risk level of the project.

For a normal project, with an initial cash outflow followed by a series of expected after-tax cash inflows, the NPV is the present value of the expected inflows minus the initial cost of the project.

The NPV is the sum of all these present values minus $500, giving us a figure of $215.

So, what is the significance of this? The NPV can be viewed as the expected effect on shareholder wealth, so when it’s positive, shareholder wealth is expected to increase. In this case, an NPV of $215 means that the firm value will increase by this amount in today’s dollar if the cash flows pan out as expected. Do note that this is based on the assumption that the firm finances this investment at a cost of 5%.

Now, let’s change this required rate of return to 25%. Using this discount rate, we find that the NPV drops to -$15. For a firm whose cost is 25%, the NPV for the same project is -$15. It should not invest in this project as the effect on shareholder wealth is negative.

That brings us to Internal Rate of Return (IRR). The IRR is the discount rate for which the NPV of the project is equal to zero. This implies that for firms which can raise capital at a rate lower than the IRR, the NPV will be positive, and the firm should accept the project. For firms whose cost of capital is higher than the project’s IRR, the NPV is negative, and the firm should reject the project.

To calculate the IRR, simply equate the NPV to zero and solve for the IRR. It might not be so simple in practice, but in the exam, you have 3 choices, so you could use trial-and-error and work out which one gives you an NPV of zero.

Calculating NPV and IRR with a Financial Calculator

Financial calculators can greatly simplify the process of calculating NPV and IRR. Let’s walk through the steps of using the Texas Instrument BA II Plus calculator to find the NPV and IRR for:

Comparing NPV and IRR

Both NPV and IRR have their advantages and disadvantages. One problem with IRR is the possibility of multiple IRRs or no IRR, making it hard to determine if a project is profitable. With the NPV method, however, you can always calculate an NPV, and it is quite clear that a project is profitable when NPV is positive, and unprofitable when NPV is negative.

The main weakness of NPV is that it doesn’t consider the size of the project. For example, an NPV of $1000 is great for a project costing $2000, but not so great for a project costing $100,000.

IRR, on the other hand, doesn’t have this weakness as it measures profitability as a percentage. This allows us to understand the relative profitability of different projects.

Besides, the IRR provides information on the margin of safety. For example, if a firm’s cost of capital is 3% and a project’s IRR is 3.1%, there’s only a safety margin of 0.1%. If the actual return on the project is lower by just 0.1 percentage points, the project would be unprofitable for the company.

One disadvantage of both methods is the possibility of producing conflicting project rankings. For example, for a firm with 7% cost of capital, NPV method may rank project X as the most profitable, while the IRR method ranks project Y as the most profitable. This wouldn’t be an issue if the projects are not mutually exclusive, but if they are, only one of them can be accepted.

When projects are mutually exclusive, accept the project with the highest NPV if it’s greater than zero. If projects are not mutually exclusive, accept all projects that are profitable, in which either method will give the same outcome.

Impact of NPV on Share Price

A project’s NPV can be viewed as the amount that will be added to shareholder’s wealth when the project is undertaken and the cash flows are received as expected. A project with positive NPV will increase the value of the firm to the shareholders, and it should be accepted.

In theory, a positive NPV project should cause a proportionate increase in a company’s stock price. In reality, the actual impact is more complicated. A company’s stock price is more a function of its expected future investments, and the profitability of its future projects. If a company announces a new project with positive NPV, but the expected profitability of the project falls short of expectations, the share price may decline.

Return on Invested Capital (ROIC)

Another measure of profitability that affects a firm’s stock price is the Return on Invested Capital (ROIC). The ROIC is a measure of the profitability of a company relative to the amount of capital invested by equity and debt holders. The ratio is calculated by dividing the after-tax net profit by the average book value of invested capital, which includes debt, preferred stock, and common stock.

ROIC = After-tax Net Profit / Average book value of invested capital

The ROIC measure is often compared with the associated cost of capital of the company. If the ROIC is higher than the Cost of Capital (COC), the company is generating a higher return for investors than what is required, thereby increasing the firm’s value for shareholders. The inverse is true if the ROIC is lower than the COC.

Conclusion

That concludes our lesson on investment decision criteria. We’ve explored the basics of NPV, IRR, their comparative advantages, and the impact of a project’s NPV on a firm’s share price. In our next lesson, we’ll learn about real options and their role in capital investment decisions.