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NPV AND IRR RULES

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A B C NPV RULE FOR CAPITAL BUDGETING

D

E

F

G

H

Choose a project if it costs less than the PV of its cash flows. More generally: take a project if its Net Present Value is positive.
EXAMPLE

Interest rate Year Cash flow PV factor PV of cash flow Cumulative PV Net Present Value

10% 0 (600) 100% (600) (600) 123 1 200 91% 182 (418) 2 200 83% 165 (253) 3 500 75% 376 123

Investors would have to invest 123 more (a total of 723) to get the cash flows of 200, 200, and 500 at an interest rate of 10%. Therefore the project has a value of 123 for investors. The interest rate is called the cost of capital, because it is the opportunity cost of funds - the rate investors can earn on alternative investments.

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

000) 89% 80% 857. The following chart shows that there are two break-even costs of capital or IRR's.143 1.995) 457. This is a good project (positive NPV).000 (572. varying the initial guess in the IRR function can cause the IRR to change.000) 1. Page 3 .000) (400.148 10% 1 2 960.000) 100% (400.148 For this project. but you can't tell it from the IRR function. so it is a good project. The NPV is positive at the actual cost of capital (12%).NPV AND IRR RULES 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 A B C D E F G NONSTANDARD PROJECTS MAY HAVE MORE THAN ONE INTERNAL RATE OF RETURN Cost of capital 12% Year Net cash flow PV factor PV of net cash flow Cumulative PV Net present value IRR (Internal Rate of Return) 0 (400.143 (455.

374) 24 38% (4.497 14 18% 2.418) 9 8% (1.000) 3 4 Discount Rate NPV 5 6 2% (8.612) 7 4% (5.000) (10.000) Discount Rate 20% 40% 60% Page 4 .769) 8 6% (3.122) D 1 2 960.148 12 14% 1.612 19 28% 879 20 30% 21 32% (1.139) 23 36% (3.970 13 16% 2.580 17 24% 2.705) 25 40% (6.000) (8.509) 10 10% 11 12% 1.010) 22 34% (2.000 Net Present Value 0% (2.NPV AND IRR RULES A B 1 Year 0 2 Net cash flow (400.000 (572.185 18 26% 1.778 16 22% 2.000) (6.000 2.000) (4.758 15 20% 2.000) C E F G H 4.

818 75% E 1 20.NPV AND IRR RULES 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 A B C D AN EXAMPLE OF MUTUALLY EXCLUSIVE PROJECTS Cost of capital 10% Year Project A Cash flow PV factor PV of cash flow NPV IRR Cash flow PV factor PV of cash flow NPV IRR 0 (10.182 100% (20.000) 100% (10.000) 11.000 91% 31.000 91% 18. Page 5 . even though its IRR is lower.818 Project B is best.182 Project B 35.000) 100% (20.000) 8.

Page 6 .182 Project A Cash flow PV factor PV of cash flow NPV Cash flow PV factor PV of cash flow NPV Project B-A 15.000) 8.636 1 20.NPV AND IRR RULES 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 A B C D E PROJECTS CAN BE VALUED ON AN INCREMENTAL BASIS F G H Cost of capital 10% Year 0 (10.636 Project B has a positive NPV relative to A (on an incremental basis) so should be taken.182 (10.000) 3.000 91% 13.000) 100% (10.000) 100% (10.000 91% 18.