Net Present Value (NPV) and Other Investment Criteria

Investment decisions are at the heart of corporate finance. Businesses must determine which projects create real value for shareholders and which should be avoided.

Capital budgeting helps managers evaluate long-term investments by comparing cash inflows and outflows using measurable financial criteria.

The major investment appraisal methods include:

• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Payback and Discounted Payback
• Profitability Index (PI)

Each provides a different perspective on project desirability.

Net Present Value (NPV)

Definition

Net Present Value (NPV) is the difference between an investment’s market value and its cost.
It measures how much value a project adds to the firm.

Formula

$$NPV = \sum \frac{CF_t}{(1+r)^t} - C_0$$

Where:

• $CF_t$ = Cash flow at time $t$
• $r$ = Discount rate (required return)
• $C_0$ = Initial investment

Decision Rule

• Accept if NPV > 0 → project adds value.
• Reject if NPV < 0 → project destroys value.

A positive NPV means the project earns more than the required rate of return.

Steps to Compute NPV (on a financial calculator)

1. Press the CF button.
2. Enter initial investment as CF₀ (negative value).
3. Enter all projected inflows as CF₁, CF₂ … CFₙ (positive values).
4. Enter the discount rate (I).
5. Compute NPV.

Why NPV is Preferred

• Accounts for the time value of money (TVM).
• Considers all cash flows.
• Directly measures the increase in firm value.
• Rarely gives incorrect decisions unless projects are mutually exclusive.

The Payback Rule

Definition

The payback period is the time required for an investment to generate enough cash to recover its initial cost.

Decision Rule

• Accept if calculated payback < target cutoff.
• Reject if calculated payback > target cutoff.

Example

If a project costs ₹1,00,000 and generates ₹25,000 annually, the payback period is 4 years.

Advantages

• Simple and easy to understand.
• Useful when liquidity is critical.
• Adjusts for risk by preferring quicker recoveries.

Disadvantages

• Ignores time value of money.
• Ignores cash flows after cutoff.
• Requires an arbitrary cutoff point.
• Biased against long-term projects.

The Discounted Payback Rule

Definition

The discounted payback period measures how long it takes for an investment’s discounted cash inflows to equal its initial cost.

Unlike the regular payback method, it accounts for time value of money.

Decision Rule

• Accept if discounted payback < target period.
• Reject otherwise.

Advantages

• Considers the time value of money.
• Easy to compute and communicate.
• Rejects projects with negative NPVs.

Disadvantages

• Ignores cash flows after the cutoff.
• May reject profitable long-term projects.
• Requires a subjective cutoff period.

The Internal Rate of Return (IRR)

Definition

The Internal Rate of Return (IRR) is the discount rate that makes a project’s NPV equal to zero.
It represents the expected rate of return on the investment.

Decision Rule

• Accept if IRR > required return.
• Reject if IRR < required return.

How to Calculate IRR (on a financial calculator)

1. Press CF.
2. Enter CF₀ (negative value for investment).
3. Enter all inflows CF₁ … CFₙ as positives.
4. Press IRR.
5. Compute.

Relationship Between NPV and IRR

Both methods generally yield the same decision if:

• The project’s cash flows are conventional (one outflow followed by inflows).
• Projects are independent (accepting one doesn’t affect another).

Multiple IRRs

Some investments with non-conventional cash flows (e.g., alternating inflows and outflows) may produce more than one IRR.
This issue is called the multiple rates of return problem.

To avoid it, analysts often use:

Modified Internal Rate of Return (MIRR), which assumes reinvestment at the cost of capital.

Advantages of IRR

• Intuitive “percentage return” concept.
• Incorporates time value of money.
• Usually agrees with NPV when cash flows are conventional.

Disadvantages of IRR

• Can give multiple results.
• Misleading for mutually exclusive projects.
• Assumes cash flows are reinvested at IRR (not realistic).

The Profitability Index (PI)

Definition

The Profitability Index (PI) measures the present value of future cash flows divided by the initial investment.

$$PI = \frac{PV \ of \ future \ cash \ inflows}{Initial \ Investment}$$

Decision Rule

• Accept if PI > 1.
• Reject if PI < 1.

Advantages

• Closely related to NPV and generally yields identical decisions.
• Simple to compute and interpret.
• Useful when capital is limited (helps rank projects).

Disadvantages

• Can mislead when comparing mutually exclusive projects.
• Sensitive to estimation errors in future cash flows.

Comparing Investment Decision Rules

Criterion	Time Value of Money	Uses All Cash Flows	Primary Focus	Key Limitation
NPV	Yes	Yes	Value creation	None (most reliable)
IRR	Yes	Yes	Return (%)	Multiple IRRs possible
Payback	No	No	Liquidity	Ignores later cash flows
Discounted Payback	Yes	No	Risk + Liquidity	Cutoff still arbitrary
Profitability Index	Yes	Yes	Efficiency	Fails for exclusive projects

Mutually Exclusive Investments

Mutually exclusive decisions occur when selecting one project prevents undertaking another.
For example, choosing between two factory sites.

When comparing mutually exclusive projects:

• Prefer the one with the highest NPV.
• Avoid using IRR or PI alone, as they can be misleading.

Worked Example (Simplified)

Year	Cash Flow (₹)	PV Factor @10%	PV (₹)
0	–1,00,000	1.000	–1,00,000
1	+40,000	0.909	36,360
2	+40,000	0.826	33,040
3	+40,000	0.751	30,040

NPV = 99,440 – 1,00,000 = –560 (Reject)
If the discount rate were lower, the project could turn positive.

Summary

• NPV is the most reliable method; it measures actual value creation.
• IRR provides a rate-based interpretation but may be inconsistent for complex projects.
• Payback focuses on liquidity but ignores profitability.
• Discounted Payback adds the time value of money but still uses arbitrary cutoffs.
• Profitability Index helps rank projects when funds are limited.

In practice:

Financial managers often use several methods together — primarily NPV and IRR — to balance precision and practicality.

FAQs About NPV and Investment Criteria

1. What does NPV tell us?

NPV shows how much wealth a project adds to the company. Positive NPV = value creation.

2. What’s the difference between IRR and NPV?

NPV expresses value in currency; IRR expresses return as a percentage.

3. Why do we prefer NPV for mutually exclusive projects?

Because it measures absolute value, not relative efficiency.

4. What’s the main flaw of Payback and Discounted Payback?

They ignore cash flows beyond the cutoff period.

5. Can a project have multiple IRRs?

Yes, if cash flows change sign more than once.

6. What is MIRR?

Modified IRR — it assumes reinvestment at the cost of capital and avoids multiple IRRs.

7. When is the Profitability Index useful?

When investment funds are limited, as it shows value created per rupee invested.