Net Present Value
Using the company's cost of capital, the net present value (NPV) is the sum of the discounted cash flows minus the original investment.

Formula 11.11

Look Out!
Projects with NPV > 0 increase stockholders return
Projects with NPV < 0 decrease stockholders return

Example: Net Present Value
Using the cash flows in the previous examples, calculate the NPV for each machine and decide which project Newco should accept. As calculated previously, Newco's cost of capital is 8.4%.

NPVA = -5,000 + 500 + 1,000 +  1,000 + 1,500   + 2,500 + 1,000   = $469
                        (1.084)1 (1.084)2 (1.084)3 (1.084)4 (1.084)5 (1.084)6

NPVB = -2,000 + 5001,500 +  1,500 + 1,500   + 1,500   + 1,500 = $3,929
                        (1.084)1 (1.084)2 (1.084)3 (1.084)4 (1.084)5 (1.084)6

Given that both machines have NPV > 0, both projects are acceptable. However, for mutually exclusive projects, the decision rule is to choose the project with the greatest NPV. Since the NPVB > NPVA, Newco should choose the project for Machine B.

Internal Rate of Return
The internal rate of return (IRR) on a project is the rate of return at which the projects NPV equals zero. At this point, a project's cash flows are equal to the project's costs. Similar to how management must establish a maximum payback period, management must also set what is known as a "hurdle rate", the minimum rate of return a company will accept for a project.

When a project is reviewed with a hurdle rate in mind, the greater the IRR is above the hurdle rate, the greater the NPV, and conversely, the further the IRR is below the hurdle rate, the lower the NPV.

Look Out!
For the IRR, the decision rules are as follows:
If IRR > hurdle rate, accept the project
If IRR< hurdle rate, reject the project

For a project to be accepted, the IRR must be greater than or equal to the hurdle rate. If a company is deciding between two projects, the project with the highest IRR is the project to be accepted.

Formula 11.12

The IRR formula is quite difficult to calculate without the use of a financial calculator. Thus, a financial calculator is highly recommended to solve for a project's IRR. Otherwise trial and error must be used.

The NPV Profile

Related Articles
  1. Investing

    Return on Investment (ROI) Vs. Internal Rate of Return (IRR)

    Read about the similarities and differences between an investment's internal rate of return (IRR) and its return on investment (ROI).
  2. Small Business

    Calculating the Internal Rate of Return Using Excel

    The internal rate of return on investments is explained and illustrated in different investment scenarios.
  3. Small Business

    Capital Budgeting: Which is Better, IRR or NPV?

    Using internal rate of return and net present value for capital budgeting evaluations often end in the same result. But there are times when using NPV to discount cash flows makes more sense.
  4. Financial Advisor

    Understanding Internal Rate Of Return

    Internal rate of return, or IRR, is one of the most popular methods of evaluating potential projects. Learn more about this important metric.
  5. Financial Advisor

    How to Compare Permanent Life Insurance Policies

    How you can use the internal rate of return to compare and purchase a permanent life insurance policy.
  6. Small Business

    Modified Internal Rate of Return (MIRR)

    Modified internal rate of return (MIRR) is a variant of the more traditional internal rate of return calculation.
  7. Financial Advisor

    A Guide on the Risk-Adjusted Discount Rate

    When a project or investment faces higher amounts of risk or uncertainty, it may be appropriate to utilize the risk-adjusted discount rate.
  8. Personal Finance

    Project Manager: Job Description & Average Salary

    Discover more about the specific tasks that project managers are responsible for and the average salary that can be expected in such a position.
Frequently Asked Questions
  1. What are Common Examples of Monopolistic Markets?

    Discover what causes real instances of market monopoly, how it persists and where monopoly privilege is most common in the ...
  2. What is the gold standard?

    The gold standard is a monetary system where a country's currency or paper money has a value directly linked to gold, but ...
  3. What's the most expensive stock of all time?

    The most expensive publicly traded stock of all time is Warren Buffett’s Berkshire Hathaway.
  4. What is a "socially responsible" mutual fund?

    As the name suggests, socially responsible mutual funds invest exclusively in socially responsible investments.
Trading Center