Definitions
Net Present Value (NPV) and Internal Rate of Return (IRR) are the two most common financial ranking methods for deciding on whether or not to accept a project.
Net Present Value examines the differences between the present value of benefits of a project and the present value costs of a project. Most projects have an initial cash outlay or start-up cost followed by positive cash inflows. Accepting positive NPV projects will increase shareholder value for the firm. The Internal Rate of Return can also be thought of as the investment yield or return on invested capital. The IRR finds the return that equates the present value costs of the project with the present value benefits. Accepting projects with an IRR greater than the cost of capital will add value to the firm.
Examples
After demonstrating your knowledge of cost behavior and break-even analysis, you have recently been promoted to a financial planning management position with the LJB Company.
Your first assignment in your new position is to make two capital budgeting decisions.
The first decision requires choosing which of the two money-losing mutually exclusive projects below to accept. One of the projects must be accepted to satisfy a new government regulation.
The second decision requires choosing whether or not to accept an independent project.
Decision #1
The LJB Company has $18,000 to invest. The company is trying to decide between two alternatives. The two alternatives are as follows:
Project A Project B
Investment required $18,000 $18,000
Annual cash inflows $3,000 $3,000
Project life 10 years 10 years
Cost of capital 14% 14%
You have 2 options:
1. Test your skills in Excel and try to solve this problem: Open Excel, input this data and solve the problem.
Net Present Value
Project A: ($2,351.65)
Project B: ($7,567.77)
Decision: Accept Project A because NPV is less of a loss.
Internal Rate of Return
Project A: 10.56%
Project B: 1.96%
Decision: Accept Project A because IPR is greater than Project B.
Conclusion
Accept Project A under both ranking methods.
Decision #2
The LJB Company is considering the purchase of a new machine that is expected to reduce cash outflows. The cost of this machine is $30,000. The cost of capital is still 14%. The annual reduction in cash outflows would be as follows: Year Amount($)
1 6,000
2 5,000
3 8,000
4 12,000
5 14,000
You have 2 options:
1. Test your skills in Excel and try to solve this problem: Open Excel, input this data and solve the problem.
Net Present Value: ($1,113.61)
Decision: Reject Project because NPV is less than zero.
Internal Rate of Return: 12.69%
Decision: Reject because Project’s IRR is less than the firm’s cost of capital. Conclusion
Reject project using both ranking methods.
Summary
In summary, you have learned how to calculate NPV and IRR that are the two most widely used measures for determining whether or not to accept a project. You have had the opportunity to analyze a mutually exclusive project and an independent project. One important thing to keep in mind is that these are financial ranking methods so projects with negative net present values or internal rates of return less than the cost of capital can be accepted to comply with government regulations or for strategic reasons.
Self-Check
Questions:
1. What decision should be made if the NPV is greater than 0?
2. Would we ever accept a project if the NPV is less than 0?
3. What variable do we compare the IRR against to make our project acceptance decision?
Answers:
1. Accept the project because it will add to shareholder value.
2. Yes, if required due to governmental regulation or for a strategic reason.
3. The cost of capital. If IPT is greater than the cost of capital, we would accept.