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Summary NPV analysis
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This explains the NPV and IRR method of calculating value of projects
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ACF 214 ReadingInvestment Decision Rules
NPV and Stand-Alone Projects
NPV Investment Rule: when making an investment decision, take the alternative
with the highest NPV. Choosing this alternative is equivalent to receiving its NPV in
cash today.
in the case of stand-alone project, we must choose between accepting or
rejecting the project.
the NPV rule says to compare the project’s NPV to zero and accept the project
if its NPV is positive.
The NPV Profile and IRR
The NPV of the project depends on the appropriate cost of capital.
the NPV profile is a graph of the project’s NPV over a range of discount rates.
The IRR of an investment is the discount rate that sets the NPV of the project’s cash
flow equal to zero.
the IRR of a project provides useful information regarding the sensitivity of the
project’s NPV to errors in the estimate of its cost of capital.
Internal Rate of Return Rule (IRR)
IRR is the average return earned by taking on the investment opportunity.
IRR rule is based on this idea: if the average return on the investment opportunity is
greater than the return on other alternatives in the market with equivalent risk and
maturity.
IRR Investment rule: take any investment opportunity where the IRR exceeds
the opportunity cost of capital.
Turn down any opportunity whose IRR is less than the opportunity cost of
capital.
ACF 214 Reading 1
, Applying the IRR Rule
Like the NPV rule, the internal rate of return investment rule is applied to single, stand-
alone projects within the firm.
the IRR rule is only guaranteed to work for a stand-alone project if all of the project’s
negative cash flows precede its positive cash flows.
The Payback Rule
The payback investment rule states you should only accept a project if its cash
flows pay back its initial investment within a prespecified period.
to apply the payback rule, you first calculate the amount of time it takes to pay
back the initial investment (payback period).
you accept the project if the payback period is less than a prespecified length
time, otherwise reject the project.
The payback rule is not reliable as the NPV rule because it (1) ignores the project’s
cost of capital and the time value of money, (2) ignores cash flows after the payback
period, and (3) relies on an ad hoc decision criterion.
Choosing Between Projects
A firm must choose just one project from several possible projects, that is, the choices
are mutually exclusive.
NPV Rule and Mutually Exclusive Investments
when a project are mutually exclusive, we need to determine which projects have
positive NPV and then rank the projects to identify the best one.
IRR Rule and Mutually Exclusive Investments
when projects differ in their scale of investment, the timing of their cash flows, or
their riskiness, then their IRRs cannot be meaningfully compared.
differences in scale: if a project has a positive NPV, then if we can double its
size, its NPV will double.
doubling the cash flows of an investment opportunity must make it worth twice
as much (Law of One Price).
ACF 214 Reading 2
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