NPV AND IRR RULES

A B C D E F G H
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 Rs. 722.76
14 PV factor 100% 91% 83% 75% Rs. 122.76
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.
23 IRR 20%

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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.

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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 11%
5
6
7 Year 0 1 2
8
9 Net cash flow (400,000) 960,000 (572,000)
10 PV factor 100% 90% 81%
11 PV of net cash flow (400,000) 864,865 (464,248)
12 Cumulative PV (400,000) 464,865 617
13 Net present value 617
14 Rs. 400,616.83 Rs. 616.83
15 IRR (Internal Rate of Return) 10%

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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%

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 NPV AND IRR RULES

A B C D E F
1
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 18,182 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 13,636 3,636
17
18 100% 50%

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Rate 10%

Period Cash Flow

0 10000.00
1 2000
2 3000
3 4000
4 5000
5 1000

NPV Rs. 11,338.77 Rs. 1,338.77

IRR 15%