In general, the difference between the cost of capital and the IRR is the

maximum amount of estimation error in the cost of capital estimate

that can exist without altering the original decision.

DO NPV + PAYBACK RULE BECAUSE PAYBACK RULE GIVES U INFO ON WHEN YOU
GET YOUR MONEY BACK
FOR EXAMPLE SURE UR NPV IS POSTIIVE OVER THE LIFE OF THE PROJECT, BUT
HOW LONG DOES IT TAKE? PAYBACK RULE WILL TELL YOU THAT.
3) Profitability index: if PI>1, accept.
Internal Rate of Return (IRR) Investment Rule
Take any investment where the IRR exceeds the cost of capital. Turn down any

Figure 6.2
investment whose IRR is less than the cost of capital.
Use if projects negative cash flows precede its positive cash flows (unconventional

When the benefits of an investment occur before the costs, the NPV is a
increasing function of the discount rate.
cash flows if not)
Can have Multiple IRRS which is complicated

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6-16

 IRR Versus the IRR Rule

While the IRR rule has shortcomings for making investment decisions, the IRR
itself remains useful. IRR measures the average return of the investment and the
sensitivity of the NPV to any estimation error in the cost of capital.
Mutually Exclusive Projects
When you must choose only one project among several possible projects, the
choice is mutually exclusive.
NPV Rule
Select the project with the highest NPV.
IRR Rule
Selecting the project with the highest IRR may lead
to mistakes.
When projects differ in their scale of investment, the timing of
their cash flows, or their riskiness, then their IRRs cannot be
meaningfully compared.
If a projects size is doubled, its NPV will double. This is not the case with IRR
because IRR measure average return of the investment. Thus, the IRR rule cannot be
used to compare projects of different scales.

Shortcomings of the Incremental IRR Rule

You must ensure that the incremental cash flows are initially negative and then
become positive.
The incremental IRR may not exist.
Multiple incremental IRRs could exist.
The fact that the IRR exceeds the cost of capital for both projects does not imply
that both projects have a positive NPV.
The incremental IRR rule assumes that the riskiness of the two projects is the
same.
The profitability index can be used to identify the optimal combination of
projects to undertake.
From Table 6.1, we can see it is better to take projects B & C together and forego
project A.