NPV AND IRR RULES

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NPV RULE FOR CAPITAL BUDGETING

www.exinfm.com/excel%20files/npv_irr.xls

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

200
91%
182
(418)

200
83%
165
(253)

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

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IRR RULE

For a standard project,

IRR Rule:

NPV > 0

Choose a project

if and only if

IRR > Cost of Capital

if and only if

IRR > Cost of Capital

Standard means
- cash outflows occur in early years and cash inflows in later years.
- the alternative to the project is the status quo.

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NPV AND IRR RULES

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NONSTANDARD PROJECTS MAY HAVE MORE THAN ONE INTERNAL RATE OF RETURN

Cost of capital

Year
Net cash flow
PV factor
PV of net cash flow
Cumulative PV
Net present value
IRR (Internal Rate of Return)

12%

0
(400,000)
100%
(400,000)
(400,000)
1,148

960,000 (572,000)
89%
80%
857,143 (455,995)
457,143
1,148

10%

For this project, varying the initial guess in the IRR function can cause the IRR to change.
This is a good project (positive NPV), but you can't tell it from the IRR function. The following
chart shows that there are two break-even costs of capital or IRR's. The NPV is positive at the
actual cost of capital (12%), so it is a good project.

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NPV AND IRR RULES

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(400,000)

Discount Rate

NPV

2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
22%
24%
26%
28%
30%
32%
34%
36%
38%
40%

(8,612)
(5,769)
(3,418)
(1,509)
1,148
1,970
2,497
2,758
2,778
2,580
2,185
1,612
879
(1,010)
(2,139)
(3,374)
(4,705)
(6,122)

D
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960,000 (572,000)

Net Pres e nt Value

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A
Year
Net cash flow

4,000
2,000
0% 5% 10% 15% 20% 25% 30% 35% 40% 45%
(2,000)
(4,000)
(6,000)
(8,000)
(10,000)

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Discount Rate

NPV AND IRR RULES

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AN EXAMPLE OF MUTUALLY EXCLUSIVE PROJECTS
Cost of capital

10%
Year

Project A

Cash flow
PV factor
PV of cash flow
NPV
IRR

(10,000)
100%
(10,000)
8,182
100%

20,000
91%
18,182

Project B

Cash flow
PV factor
PV of cash flow
NPV
IRR

(20,000)
100%
(20,000)
11,818
75%

35,000
91%
31,818

Project B is best, even though its IRR is lower.

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NPV AND IRR RULES

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PROJECTS CAN BE VALUED ON AN INCREMENTAL BASIS

Cost of capital

10%
Year

Project A

Cash flow
PV factor
PV of cash flow
NPV

(10,000)
100%
(10,000)
8,182

20,000
91%
18,182

Project B-A

Cash flow
PV factor
PV of cash flow
NPV

(10,000)
100%
(10,000)
3,636

15,000
91%
13,636

Project B has a positive NPV relative to A (on an incremental basis) so should be taken.

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