NPV AND IRR RULES

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A B C NPV RULE FOR CAPITAL BUDGETING

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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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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. .cash outflows occur in early years and cash inflows in later years. 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 .the alternative to the project is the status quo. Page 2 .

143 (455.000) 100% (400.143 1.995) 457.148 10% 1 2 960.000) 1.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 H 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. so it is a good project. This is a good project (positive NPV).148 For this project.000 (572. The following chart shows that there are two break-even costs of capital or IRR's. varying the initial guess in the IRR function can cause the IRR to change. Page 3 . The NPV is positive at the actual cost of capital (12%).000) 89% 80% 857. but you can't tell it from the IRR function.000) (400.

000 (572.000 2.185 17 26% 1.122) 25 D 1 2 960.010) 21 34% (2.NPV AND IRR RULES A B 0 1 Year 2 Net cash flow (400.000) (8.148 11 14% 1.612 18 28% 879 19 30% 20 32% (1.612) 6 4% (5.000) 3 NPV 4 Discount Rate 5 2% (8.769) 7 6% (3.497 13 18% 2.970 12 16% 2.139) 22 36% (3.778 15 22% 2.374) 23 38% (4.509) 9 10% 10 12% 1.000) (10.000) (4.000) (6.000) 4.418) 8 8% (1.758 14 20% 2.705) 24 40% (6.000) 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% Discount Rate Page 4 .580 16 24% 2.000 - C E F G H Net Present Value (2.

182 Project B 35.000 91% 31.818 75% 1 20.000) 100% (10.000) 100% (20.000) 11.000) 8.182 100% (20. Page 5 .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 E 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 (10.000 91% 18.818 Project B is best. even though its IRR is lower.

000 91% 18.000) 100% (10.182 (10.000 91% 13.000) 3.000) 100% (10.636 1 20. Page 6 .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 (10.182 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 Project B has a positive NPV relative to A (on an incremental basis) so should be taken.

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