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NPV AND IRR RULES

A B C D E F G H I
1 NPV RULE FOR CAPITAL BUDGETING
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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.
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7 EXAMPLE
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9 Interest rate 10%
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11 Year 0 1 2 3
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13 Cash flow (600) 200 200 500
14 PV factor 100% 91% 83% 75%
15 PV of cash flow (600) 182 165 376
16 Cumulative PV (600) (418) (253) 123
17 Net Present Value 123
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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.

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NPV AND IRR RULES

A B C D E F G
1 IRR RULE
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4 For a standard project, NPV > 0 if and only if IRR > Cost of Capital
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6 IRR Rule: Choose a project if and only if IRR > Cost of Capital
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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.

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NPV AND IRR RULES

A B C D E F G H
1 NONSTANDARD PROJECTS MAY HAVE MORE THAN ONE INTERNAL RATE OF RETURN
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4 Cost of capital 12%
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7 Year 0 1 2
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9 Net cash flow (400,000) 960,000 (572,000)
10 PV factor 100% 89% 80%
11 PV of net cash flow (400,000) 857,143 (455,995)
12 Cumulative PV (400,000) 457,143 1,148
13 Net present value 1,148
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15 IRR (Internal Rate of Return) 10%
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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.

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NPV AND IRR RULES

A B C D E F G H
1 Year 0 1 2
2 Net cash flow (400,000) 960,000 (572,000)
3
4 Discount Rate NPV
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6 2% (8,612)
7 4% (5,769) 4,000
8 6% (3,418)
2,000
9 8% (1,509)
10 10% - -

Net Present Value


11 12% 1,148 0% 5% 10% 15% 20% 25% 30% 35% 40% 45%
12 14% 1,970 (2,000)

13 16% 2,497
(4,000)
14 18% 2,758
15 20% 2,778 (6,000)
16 22% 2,580
(8,000)
17 24% 2,185
18 26% 1,612 (10,000)
19 28% 879 Discount Rate
20 30% -
21 32% (1,010)
22 34% (2,139)
23 36% (3,374)
24 38% (4,705)
25 40% (6,122)

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NPV AND IRR RULES

A B C D E
1 AN EXAMPLE OF MUTUALLY EXCLUSIVE PROJECTS
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3 Cost of capital 10%
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5 Year 0 1
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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%
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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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19 Project B is best, even though its IRR is lower.

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NPV AND IRR RULES

A B C D E F G H
1 PROJECTS CAN BE VALUED ON AN INCREMENTAL BASIS
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4 Cost of capital 10%
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6 Year 0 1
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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
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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
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18 Project B has a positive NPV relative to A (on an incremental basis) so should be taken.

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