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NPV AND IRR AS

THE INVESTMENT
CRITERIA
Dian Indrawati, ST, MT

Net Present Value

Capital Budgeting Decision

Central to the success of any company is


the investment decision, also known as
the capital budgeting decision.
Assets acquired as a result of the capital
budgeting decision can determine the
success of the business for many years.
It is extremely important that we ensure
that the correct capital budgeting decision
is made!

Net Present Value

Capital Budgeting Decision

Suppose you had the opportunity to buy a


Tbill (Treasury Bill) which would be worth
$400,000 one year from today.
Interest

rates on Tbills are a risk free 7%.

What would you be willing to pay for this


investment?
PV today:
$400,000 / (1.07) =
$373,832

$400,00
0
1

Net Present Value

Capital Budgeting Decision

You would be willing to pay $373,382 for a risk


free $400,000 a year from today.
Suppose this were, instead, an opportunity to
construct a building, which you could sell in a
year for $400,000 with certainty (That means
the project is risk free.)
Since this investment has the same risk and
promises the same cash flows as the Tbill, it is
also worth the same amount to you:

$373,28
2

Net Present Value

Capital Budgeting Decision

Now, assume you could buy the land for


$50,000 and construct the building for
$300,000. Is this a good deal?
Sure! If you would be willing to pay
$373,382 for this investment and can
acquire it for only $350,000, you have
found a very good deal!
You are better off by:

$373,382 - $350,000 = $23,832

Net Present Value

Capital Budgeting Decision

We have just developed a way of


evaluating an investment decision which is
known as Net Present Value (NPV).
NPV is defined as the PV of the cash flows
from an investment minus the initial
investment.
NPV
= PV Required Investment (C0)
= [$400,000/(1+.07)] - $350,000
= $23,832

Net Present Value

Capital Budgeting Decision

This discount rate is known as the


opportunity cost of capital.
It

is called this because it is the return you give


up by investing in the project.
In this case, you give up the money you could
have used to buy a 7% tbill so that you can
construct a building.
But, a Tbill is risk free! A construction project is
not!
We should use a higher opportunity cost of
capital.

Net Present Value

Risk and Net Present Value

Suppose instead you believe the building project


is as risky as a stock which is yielding 12%.
Now your opportunity cost of capital would be
12% and the NPV of the project would be:
NPV = PV IC0
= [$400,000/(1+.12)] - $350,000
= $357,143 - $350,000 = $7,142.86
The project is significantly less attractive once you
take account of risk.
This leads to a basic financial principal: A risky
dollar is worth less than a safe one.
Semih Yildirim

ADMS 3530

7-9

Net Present Value

Valuing long lived projects

The NPV rule works for projects of any duration:


Simply discount the cash flows at the appropriate opportunity
cost of capital and then subtract the cost of the initial investment.

The critical problems in any NPV problem are to determine:

The amount and timing of the cash flows.


The appropriate discount rate.

Semih Yildirim

ADMS 3530

7-10

Net Present Value

Semih Yildirim

ADMS 3530

Other Investment Criteria

7-11

Net Present Value vs Other Criteria

Use of the NPV criterion for accepting or


rejecting investment projects will maximize
the value of a firms shares.
Other criteria are sometimes used by firms
when evaluating investment opportunities.
Some

of these criteria can give wrong answers!


Some of these criteria simply need to be used
with care if you are to get the right answer!

Semih Yildirim

ADMS 3530

7-12

Other Investment Criteria

Internal Rate of Return (IRR)

IRR is simply the discount rate at which the NPV of the


project equals zero.

You can calculate the rate of return on a project by:


1. Setting the NPV of the project to zero.
2. Solving for r.

Unless you have a financial calculator, this calculation


must be done by using trial and error!
Semih Yildirim

ADMS 3530

Other Investment Criteria

7-13

Internal Rate of Return (IRR)

To go back to our office example,


we discovered the following:
Discount Rate

NPV of Project

7%

$23,382

12%

$7,143

At what rate of return will the NPV


of this project be equal to zero?
Semih Yildirim

ADMS 3530

7-14

Other Investment Criteria

Internal Rate of Return (IRR)

If we solve for r in the equation below, we


find the IRR for this project is 14.29%:

IRR Decision Rule: Accept Projects with


IRR
r
which exceeds the opportunity cost of
capital
Semih Yildirim
ADMS 3530

Other Investment Criteria

7-15

Internal Rate of Return (IRR)

Another way of solving for IRR is to


graph the NPV at various discount
rates.
The point where this NPV profile
crosses the x axis will be the IRR
for the project.

Semih Yildirim

ADMS 3530

7-16

IRR BY GRAPH
NPV Profile for this Project

IRR = 14.3%

(occurs where NPV = 0)

NPV ($)

$60,000
$50,000
$40,000
$30,000
$20,000
$10,000
$0
($10,000)
($20,000)

5%

10%

15%

20%

Discount Rate
Semih Yildirim

ADMS 3530

Other Investment Criteria

7-17

Internal Rate of Return (IRR) vs NPV:

The NPV Rule states that you invest in any


project which has a positive NPV when its cash
flows are discounted at the opportunity cost of
capital.
The Rate of Return Rule states that you invest
in any project offering a rate of return which
exceeds the opportunity cost of capital.

i.e., if you can earn more on a project than it costs to


undertake, then you should accept it!

The NPV and IRR rules will give the same


accept/reject answer about a project as long as the
NPV of a project declines smoothly as the discount
rate increases.
Semih Yildirim
ADMS 3530
Do not confuse IRR and the opportunity cost of