NPV AND IRR RULES

A B C D E F
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 21%
10
11 Year 0 1 2
12
13 Cash flow (500,000,000,000) 366,350,000,000 412,515,850,000
14 PV factor 100% 83% 68%
15 PV of cash flow (500,000,000,000) 302,768,595,041 281,753,876,101
16 Cumulative PV (500,000,000,000) (197,231,404,959) 84,522,471,143
17 Net Present Value 84,522,471,143
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
1 NONSTANDARD PROJECTS MAY HAVE MORE THAN ONE INTERNAL RATE OF RETURN
2
3
4 Cost of capital 21%
5
6
7 Year 0 1 2
8
9 Net cash flow (500,000,000,000) 366,350,000,000 412,515,850,000
10 PV factor 100% 83% 68%
11 PV of net cash flow (500,000,000,000) 302,768,595,041 281,753,876,101
12 Cumulative PV (500,000,000,000) (197,231,404,959) 84,522,471,143
13 Net present value 84,522,471,143
14
15 IRR (Internal Rate of Return) 35%
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 (21%), so it is a good project.

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 NPV AND IRR RULES

A B C D E F G H I J
1 Year 0 1 2
2 Net cash flow (500,000,000,000) 366,350,000,000 412,515,850,000
3
4 Discount Rate NPV
5

Net Present Value

10 10% 173,967,644,628
200,000,000,000
11 12% 155,953,324,298
12 14% 138,777,200,677 150,000,000,000
13 16% 122,385,441,439
14 18% 106,728,562,195 100,000,000,000
15 20% 91,761,006,944
50,000,000,000
16 21% 84,522,471,143
17 22% 77,440,775,329
-
18 24% 63,729,090,791 0% 5% 10% 15% 20% 25% 30% 35% 40% 45%
19 26% 50,590,104,560 (50,000,000,000) Discount Rate
20 28% 37,990,631,104
21 30% 25,899,911,243
22 32% 14,289,399,679
23 34% 3,132,574,070
24 36% (7,595,236,808)
25 38% (17,917,007,982)
26 40% (27,854,158,163)

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 NPV AND IRR RULES

K L
1
2
3
4
5
6
300,000,000,000 7
8
250,000,000,000 9
10
200,000,000,000
11
150,000,000,000 12
13
100,000,000,000 14
15
50,000,000,000
16
17
-
0% 5% 10% 15% 20% 25% 30% 35% 18 40% 45%
(50,000,000,000) Discount Rate 19
20
21
22
23
24
25
26

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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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