Decision Making

How should we make financial decisions? Simple! Simply undertake actions that create value i.e. actions in which the benefits exceed the costs.

What if the costs and benefits arrive at different times? Compare their present values! The discount rate R adjusts for both timing and risk of cash flows.

NPV Decision Rule

The NPV (Net Present Value) states that we must accept all projects with a positive NPV and reject all projects with a negative NPV.

$NPV = PV(Benefits)-PV(Costs)$

This rule quantifies the value implications of decisions. It is an optimal rule.

(Note that the above formula is actually computed using Free Cash Flows i.e. FCFs).

Other rules involve the use of payback period and internal rate of return (IRR). They have certain shortcomings.

IRR Rule

IRR of a project is the discount rate for which the NPV of the project's FCFs is zero.

The IRR rule states that we must accept all projects with IRR>R and reject all projects with IRR<R. (R is the hurdle rate/opportunity cost of capital/discount rate).

Note that the IRR rule leads to the same decisions – accept or reject – as the NPV rule if all negative cash flows precede all positive cash flows.

Also note that the interest rate and the yield-to-maturity are the same as IRR.

Shortcomings

IRR Rule can mislead decision making when cash flow signs are anything other than all negatives before all positives. Sometimes, it can mislead decision making when comparing projects even when cash flow signs are proper.

This is because the IRR does not account for differences in scale.

Payback Period Rule

The payback period (pp) of a project is the duration until the cumulative free cash flows turn positive.

The Payback Period Rule states that we must accept all projects with pp<threshold and reject all projects with pp>threshold.

Shortcomings

• Ignores time value of money and risk of cash flows

  To overcome this, compute the discounted payback period (dpp) i.e. the duration until the cumulative discounted free cash flows turn positive.

  This (dpp) also has some shortcomings:

  • Ignores cash flows after cutoff (i.e. after the cumulative sum becomes positive), which leads to myopic decision making

  • Does not provide value implications of our decision

  • Does not help in choosing between multiple projects that have similar payback periods