NPV AND IRR RULES

A B C D E F G H I
1 NPV RULE FOR CAPITAL BUDGETING
2
3
4 Choose a project if it costs less than the PV of its cash flows. More generally:
5 take a project if its Net Present Value is positive.
6
7 EXAMPLE
8
9 Interest rate 10%
10
11 Year 0 1 2 3
12
13 Cash flow (600) 200 200 500
14 PV factor 100% 91% 83% 75%
15 PV of cash flow (600) 182 165 376
16 Cumulative PV (600) (418) (253) 123
17 Net Present Value 123
18
19 Investors would have to invest 123 more (a total of 723) to get the cash flows of 200, 200,
20 and 500 at an interest rate of 10%. Therefore the project has a value of 123 for investors.
21 The interest rate is called the cost of capital, because it is the opportunity cost of funds - the
22 rate investors can earn on alternative investments.

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 NPV AND IRR RULES

A B C D E F G
1 IRR RULE
2
3
4 For a standard project, NPV > 0 if and only if IRR > Cost of Capital
5
6 IRR Rule: Choose a project if and only if IRR > Cost of Capital
7
8 Standard means
9 - cash outflows occur in early years and cash inflows in later years.
10 - the alternative to the project is the status quo.

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 NPV AND IRR RULES

A B C D E F G H
1 NONSTANDARD PROJECTS MAY HAVE MORE THAN ONE INTERNAL RATE OF RETURN
2
3
4 Cost of capital 12%
5
6
7 Year 0 1 2
8
9 Net cash flow (400,000) 960,000 (572,000)
10 PV factor 100% 89% 80%
11 PV of net cash flow (400,000) 857,143 (455,995)
12 Cumulative PV (400,000) 457,143 1,148
13 Net present value 1,148
14
15 IRR (Internal Rate of Return) 10%
16
17 For this project, varying the initial guess in the IRR function can cause the IRR to change.
18 This is a good project (positive NPV), but you can't tell it from the IRR function. The following
19 chart shows that there are two break-even costs of capital or IRR's. The NPV is positive at the
20 actual cost of capital (12%), so it is a good project.

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 NPV AND IRR RULES

A B C D E F G H
1 Year 0 1 2
2 Net cash flow (400,000) 960,000 (572,000)
3
4 Discount Rate NPV
5
6 2% (8,612)
7 4% (5,769) 4,000
8 6% (3,418)
2,000
9 8% (1,509)
10 10% - -

Net Present Value

11 12% 1,148 0% 5% 10% 15% 20% 25% 30% 35% 40% 45%
12 14% 1,970 (2,000)

13 16% 2,497
(4,000)
14 18% 2,758
15 20% 2,778 (6,000)
16 22% 2,580
(8,000)
17 24% 2,185
18 26% 1,612 (10,000)
19 28% 879 Discount Rate
20 30% -
21 32% (1,010)
22 34% (2,139)
23 36% (3,374)
24 38% (4,705)
25 40% (6,122)

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 NPV AND IRR RULES

A B C D E
1 AN EXAMPLE OF MUTUALLY EXCLUSIVE PROJECTS
2
3 Cost of capital 10%
4
5 Year 0 1
6
7 Project A Cash flow (10,000) 20,000
8 PV factor 100% 91%
9 PV of cash flow (10,000) 18,182
10 NPV 8,182
11 IRR 100%
12
13 Project B Cash flow (20,000) 35,000
14 PV factor 100% 91%
15 PV of cash flow (20,000) 31,818
16 NPV 11,818
17 IRR 75%
18
19 Project B is best, even though its IRR is lower.

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 NPV AND IRR RULES

A B C D E F G H
1 PROJECTS CAN BE VALUED ON AN INCREMENTAL BASIS
2
3
4 Cost of capital 10%
5
6 Year 0 1
7
8 Project A Cash flow (10,000) 20,000
9 PV factor 100% 91%
10 PV of cash flow (10,000) 18,182
11 NPV 8,182
12
13 Project B-A Cash flow (10,000) 15,000
14 PV factor 100% 91%
15 PV of cash flow (10,000) 13,636
16 NPV 3,636
17
18 Project B has a positive NPV relative to A (on an incremental basis) so should be taken.

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