959 Words4 Pages

NPV Versus IRR W.L. Silber

I.

Our favorite project A has the following cash flows:

-1000 0

0 1

0 2

+300 3

+600 4

+900 5

We know that if the cost of capital is 18 percent we reject the project because the net present value is negative:

- 1000 + 300 600 900 + + = NPV 3 4 (1.18) (1.18) (1.18)5

- 1000 + 182.59 + 309.47 + 393.40 = -114.54

We also know that at a cost of capital of 8% we accept the project because the net present value is positive:

- 1000 +

300 600 900 + + = NPV 3 4 (1.08 ) (1.08 ) (1.08 )5

- 1000 + 238.15 + 441 .02 + 612 .52 = 291.69

II.

Thus, somewhere between 8% and 18% we change our evaluation of project A

from rejecting it (when NPV is negative) to accepting it (when NPV is*…show more content…*

Indeed, the low cost of capital makes those “large but delayed” cash flows quite valuable.

VIII.

One way to understand the preference of NPV over IRR, more generally, is to

recognize that NPV uses the “correct” rate, i.e., the cost of capital, to discount the cash flows, rather than an “arbitrary” rate, i.e., the IRR, that makes NPV =0. Another way to understand the superiority of the NPV rule is that the discounting process inherent in both the IRR and NPV techniques implicitly assumes the reinvestment of the cash flows at whatever discount rate is used, either IRR or the cost of capital. When the IRR is very high relative to the cost of capital it is unrealistic to assume reinvestment at that high rate. This is especially damaging when comparing

two investments with very different timing of cash flows. We will revisit this reinvestment assumption later, under our discussion of yield to maturity on coupon bonds, where its meaning will become

I.

Our favorite project A has the following cash flows:

-1000 0

0 1

0 2

+300 3

+600 4

+900 5

We know that if the cost of capital is 18 percent we reject the project because the net present value is negative:

- 1000 + 300 600 900 + + = NPV 3 4 (1.18) (1.18) (1.18)5

- 1000 + 182.59 + 309.47 + 393.40 = -114.54

We also know that at a cost of capital of 8% we accept the project because the net present value is positive:

- 1000 +

300 600 900 + + = NPV 3 4 (1.08 ) (1.08 ) (1.08 )5

- 1000 + 238.15 + 441 .02 + 612 .52 = 291.69

II.

Thus, somewhere between 8% and 18% we change our evaluation of project A

from rejecting it (when NPV is negative) to accepting it (when NPV is

Indeed, the low cost of capital makes those “large but delayed” cash flows quite valuable.

VIII.

One way to understand the preference of NPV over IRR, more generally, is to

recognize that NPV uses the “correct” rate, i.e., the cost of capital, to discount the cash flows, rather than an “arbitrary” rate, i.e., the IRR, that makes NPV =0. Another way to understand the superiority of the NPV rule is that the discounting process inherent in both the IRR and NPV techniques implicitly assumes the reinvestment of the cash flows at whatever discount rate is used, either IRR or the cost of capital. When the IRR is very high relative to the cost of capital it is unrealistic to assume reinvestment at that high rate. This is especially damaging when comparing

two investments with very different timing of cash flows. We will revisit this reinvestment assumption later, under our discussion of yield to maturity on coupon bonds, where its meaning will become

Related

## Ibjectages And Disadvantages And Disadvantages Of Investment Appraisals

1547 Words | 7 PagesIt requires a rough estimate rate of return that has to be decided by the firm and IRR is not complete based on the required rate of return. If the calculated IRR is far off from the estimated required rate of return, firms can safely make decisions on either side to keep a room for estimation errors. Disadvantages of IRR One main disadvantages of IRR is that the method ignores the actual dollar value of benefits. If two investments have different lifespan, for example

## The Value Of The Cash Flow

1324 Words | 6 PagesPart: B Net Present Value (NPV) calculates the present value of the cash flow which is based on the opportunity cost of capital and comes up with a value that is added to the wealth of the shareholders if that project is accepted. Apart from Net present Value (NPV) there are a couple of more methods for investment appraisal such as internal rate of return (IRR), Payback period (PBP) and Profitability Index (PI). Net Present Value (NPV) vs. Payback Period (PBP): Payback period calculates the period

## Essay on Capital 20Budget 20Analysis 20Group 20P

1648 Words | 7 Pagesthe Net Present Value (NPV) is performed on the salvage values before and after sales tax values along with the different sale ranges. Keywords: NPV, NPV Profile, NPV, IRR, multiple IRRs, ranking conflict of NPV vs. IRR, payback period, profitability index, discount rate, cost of capital concept, cash flow analysis, cash flow timeline,

## Capital Structure

1960 Words | 8 PagesJaffe et al. (2002:146) argues that IRR is the "most important alternative to the NPV approach", because it is independent of the prevailing capital market interest rate in its attempt to resolve an internal (or intrinsic) rate that is dependent only on the cash flows from the project. Internal Rate of Return (IRR) Importantly, IRR is a method for determining value that does not depend on the determination of a discount rate. This

## Essay about Laurentian Bakeries

1379 Words | 6 Pagesthe NPV approach to investment appraisal and compare the strengths and weaknesses of the NPV approach to two other commonly used approaches. (30 marks) This first section of this paper will provide a brief explanation on theoretical rationale for the net present value (NPV) method of investment appraisal and then compare its strengths and weaknesses to two alternative methods of investment appraisal, those of internal rate of return (IRR) and pay-back. Theoretical rationale for the NPV approach

## Revlon Inc. 2007 by M.Jill Austin

2423 Words | 10 PagesHere are our decision rules: If the NPV is: | Benefits vs. Costs | Should we expect to earn at least our minimum rate of return? | Accept the investment? | Positive | Benefits > Costs | Yes, more than | Accept | Zero | Benefits = Costs | Exactly equal to | Indifferent | Negative | Benefits <

## Capital Structure Approach

1558 Words | 6 PagesRecommend a capital structure approach that maximizes shareholder return. Capital Structure: "Capital structure is the manner in which a firm's assets are financed; that is, the right-hand side of the balance sheet. Capital structure is normally expressed as the percentage of each type of capital used by the firm debt, preferred stock, and common equity." (Capital Structure Decision, 2002) Capital structure is a mix of debt, preferred stock, and common stock to which Competitive Bikes will

## Capital Budgeting

3643 Words | 15 PagesReport on Capital Budgeting Abstract This report deals with • The nature of capital investment appraisal • The techniques available for evaluating capital investments • The limitations of these techniques • The capital budgeting practices in select countries Introduction: Some of the major responsibilities of top management are in the area of long range planning. Allocating resources to competing uses is one of the most important decisions a manager has to make. Executives are constantly

## Return on Investment

2291 Words | 10 PagesReturn On investment CONTENTS INTRODUCTION 6 The ROI Concept 6 Simple ROI for Cash Flow and Investment Analysis 7 Competing Investments: ROI From Cash Flow Streams 7 ROI vs. NPV, IRR, and Payback Period 10 Other ROI Metrics 11 LIST OF TABLES Table 1 6 Table 2 7 Table 3 8 Table 4 8 Table 5 8 Table 6 ………………………………....................... 9 Table 7 ………………………………...................... 10 Return on Investment: What is ROI analysis? Return on Investment (ROI) analysis

## Premier Paper Co

2019 Words | 9 PagesReturn (IRR) is most easily defined as the return that leads to a project NPV equal to zero. Another way to define the IRR is to consider it as the discount rate that at which the NPV of cash outflows equals the NPV of cash inflows. In other words, it’s the most discounted rate at which a project can possibly break even. In theory, if a project has an IRR greater than the company’s required return rate, then the project will be profitable and the company should proceed with project. The IRR is generally

### Ibjectages And Disadvantages And Disadvantages Of Investment Appraisals

1547 Words | 7 Pages### The Value Of The Cash Flow

1324 Words | 6 Pages### Essay on Capital 20Budget 20Analysis 20Group 20P

1648 Words | 7 Pages### Capital Structure

1960 Words | 8 Pages### Essay about Laurentian Bakeries

1379 Words | 6 Pages### Revlon Inc. 2007 by M.Jill Austin

2423 Words | 10 Pages### Capital Structure Approach

1558 Words | 6 Pages### Capital Budgeting

3643 Words | 15 Pages### Return on Investment

2291 Words | 10 Pages### Premier Paper Co

2019 Words | 9 Pages