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 8%
10
11 Year 0 1 2
12
13 Cash flow #NAME? #NAME? #NAME?
14 PV factor 100% 93% 86%
15 PV of cash flow #NAME? #NAME? #NAME?
16 Cumulative PV #NAME? #NAME? #NAME?
17 Net Present Value -
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.

Page 1
 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.

Page 2
 NPV AND IRR RULES

A B C D E F G
1 NONSTANDARD PROJECTS MAY HAVE MORE THAN ONE INTERNAL RATE OF RETURN
2
3
4 Cost of capital / Market intrest rate 12%
5
6
7 Year 0 1 2
8
9 Net cash flow #NAME? #NAME? #NAME?
10 PV factor 100% 89% 80%
11 PV of net cash flow #NAME? #NAME? #NAME?
12 Cumulative PV #NAME? #NAME? #NAME?
13 Net present value #NAME?
14
15 IRR (Internal Rate of Return) #NAME?
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.

Page 3
 NPV AND IRR RULES

A B C D E F G H I J K L
1 Year 0 1 2
2 Net cash flow #NAME? #NAME? #NAME?
3
4 Discount Rate NPV
5

Net Present Value

6 2% #NAME?
7 4% #NAME? 12
8 6% #NAME?
9 8% #NAME?
10
10 10% #NAME?
11 12% #NAME?
12 14% #NAME? 8

13 16% #NAME?
14 18% #NAME? 6
15 20% #NAME?
16 22% #NAME? 4
17 24% #NAME?
18 26% #NAME?
2
19 28% #NAME?
20 30% #NAME?
-
21 32% #NAME?
0% 5% 10% 15% Discount
20% 25% Rate30% 35% 40% 45%
22 34% #NAME?
23 36% #NAME?
24 38% #NAME?
25 40% #NAME?

Page 4
 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.

Page 5
 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.

Page 6