1. Chapter 6
Capital Budgeting
Techniques

2. 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.

3. If NPV > 0, accept the project If NPV < 0, reject the project
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

4. Net Present Value (NPV)

5. Net Present Value (NPV)
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

6. Net Present Value (NPV)

7. Internal Rate of Return (IRR)
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.

8. Capital Budgeting (NPV)
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

9. If IRR > k, accept the project If IRR < k, reject the project
Internal Rate of Return (IRR)
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

10. The Internal Rate of Return (IRR)

11. Capital Budgeting (IRR)
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

12. NPV versus IRR
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

13. Net Present Value Profiles

14. IRR and 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

15. Example With Mutually Exclusive Projects
Period
Project A
Project B
-500
-400 1
325 2
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?

16. NPV profiles

17. Conflicts Between NPV and IRR
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