Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 17

Chapter Chapter 66

Capital Budgeting

Techniques

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Net Present Value (NPV)

• Net Present Value (NPV). Net Present Value is

found by subtracting the present value of the after-tax

outflows from the present value of the after-tax

inflows.

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Net Present Value (NPV)

• Net Present Value (NPV). Net Present Value is found

by subtracting the present value of the after-tax

outflows from the present value of the after-tax

inflows.

Decision Criteria

If NPV > 0, accept the project

If NPV < 0, reject the project

If NPV = 0, indifferent

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Net Present Value (NPV)

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Using the Bennett Company data from Table

9.1, assume the firm has a 10% cost of capital.

Based on the given cash flows and cost of

capital (required return), the NPV can be

calculated as shown in Figure 9.2

Net Present Value (NPV)

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Net Present Value (NPV)

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• The Internal Rate of Return (IRR) is the discount rate

that will equate the present value of the outflows with

the present value of the inflows.

• The IRR is the project’s intrinsic rate of return.

Internal Rate of Return (IRR)

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Advantages:• Cash flows rather than profits are analyzed• Recognizes the time value of money• Acceptance criterion is consistent with the goal of maximizing value

Disadvantage:• Detailed, accurate long-term forecasts are required to evaluate a project’s

acceptance

Capital Budgeting (NPV)

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• The Internal Rate of Return (IRR) is the discount rate

that will equate the present value of the outflows with

the present value of the inflows.

• The IRR is the project’s intrinsic rate of return.

Decision Criteria

If IRR > k, accept the project

If IRR < k, reject the project

If IRR = k, indifferent

Internal Rate of Return (IRR)

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The Internal Rate of Return (IRR)

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Advantages:

• Cash flows rather than profits are analyzed

• Recognizes the time value of money

• Acceptance criterion is consistent with the goal of maximizing value

Disadvantages:

• Detailed, accurate long-term forecasts are required to evaluate a project’s acceptance

• Difficult to solve for IRR without a financial calculator or spreadsheet

Capital Budgeting (IRR)

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• When NPV>0, a project is acceptable because the firm will earn a return greater than its required rate of return (k) if it invests in the project.

• When IRR>k, a project is acceptable because the firm will earn a return greater than its required rate of return (k) if it invests in the project.

• When NPV>0, IRR>k for a project—that is, if a project is acceptable using NPV, it is also acceptable using IRR

NPV versus IRR

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Net Present Value Profiles

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• Mutually exclusive projects– If you choose one, you can’t choose the other– Example: You can choose to attend graduate school next year at either

Harvard or Stanford, but not both• Intuitively you would use the following decision rules:

– NPV – choose the project with the higher NPV– IRR – choose the project with the higher IRR

IRR and Mutually Exclusive Projects

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Example With Mutually Exclusive Projects

Period Project A

Project B

0 -500 -400

1 325 325

2 325 200

IRR 19.43% 22.17%

NPV 64.05 60.74

The required return for both projects is 10%.

Which project should you accept and why?

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-40,00

-20,00

0,00

20,00

40,00

60,00

80,00

100,00

120,00

140,00

160,00

0 0,05 0,1 0,15 0,2 0,25 0,3

Discount Rate

NP

V AB

NPV profiles

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• NPV directly measures the increase in value to the firm• Whenever there is a conflict between NPV and another decision

rule, you should always use NPV• IRR is unreliable in the following situations

– Non-conventional cash flows– Mutually exclusive projects

Conflicts Between NPV and IRR