This section applies the techniques and formulas first presented in the time value of money material toward realworld situations faced by financial analysts. Three topics are emphasized: (1) capital budgeting decisions, (2) performance measurement and (3)
Net Preset Value
NPV and IRR are two methods for making capitalbudget decisions, or choosing between alternate projects and investments when the goal is to increase the value of the enterprise and maximize shareholder wealth. Defining the NPV method is simple: the present value of cash inflows minus the present value of cash outflows, which arrives at a dollar amount that is the net benefit to the organization.
To compute NPV and apply the NPV rule, the authors of the reference textbook define a fivestep process to be used in solving problems:
1.Identify all cash inflows and cash outflows.
2.Determine an appropriate discount rate (r).
3.Use the discount rate to find the present value of all cash inflows and outflows.
4.Add together all present values. (From the section on cash flow additivity, we know that this action is appropriate since the cash flows have been indexed to t = 0.)
5.Make a decision on the project or investment using the NPV rule: Say yes to a project if the NPV is positive; say no if NPV is negative. As a tool for choosing among alternates, the NPV rule would prefer the investment with the higher positive NPV.
Companies often use the weighted average cost of capital, or WACC, as the appropriate discount rate for capital projects. The WACC is a function of a firm's capital structure (common and preferred stock and longterm debt) and the required rates of return for these securities. CFA exam problems will either give the discount rate, or they may give a WACC.
Example:
To illustrate, assume we are asked to use the NPV approach to choose between two projects, and our company's weighted average cost of capital (WACC) is 8%. Project A costs $7 million in upfront costs, and will generate $3 million in annual income starting three years from now and continuing for a fiveyear period (i.e. years 3 to 7). Project B costs $2.5 million upfront and $2 million in each of the next three years (years 1 to 3). It generates no annual income but will be sold six years from now for a sales price of $16 million.
For each project, find NPV = (PV inflows)  (PV outflows).
Project A: The present value of the outflows is equal to the current cost of $7 million. The inflows can be viewed as an annuity with the first payment in three years, or an ordinary annuity at t = 2 since ordinary annuities always start the first cash flow one period away.
PV annuity factor for r = .08, N = 5: (1  (1/(1 + r)^{N})/r = (1  (1/(1.08)^{5})/.08 = (1  (1/(1.469328)/.08 = (1  (1/(1.469328)/.08 = (0.319417)/.08 = 3.99271
Multiplying by the annuity payment of $3 million, the value of the inflows at t = 2 is ($3 million)*(3.99271) = $11.978 million.
Discounting back two periods, PV inflows = ($11.978)/(1.08)^{2} = $10.269 million.
NPV (Project A) = ($10.269 million)  ($7 million) = $3.269 million.
Project B: The inflow is the present value of a lump sum, the sales price in six years discounted to the present: $16 million/(1.08)^{6} = $10.083 million.
Cash outflow is the sum of the upfront cost and the discounted costs from years 1 to 3. We first solve for the costs in years 1 to 3, which fit the definition of an annuity.PV annuity factor for r = .08, N = 3: (1  (1/(1.08)^{3})/.08 = (1  (1/(1.259712)/.08 = (0.206168)/.08 = 2.577097. PV of the annuity = ($2 million)*(2.577097) = $5.154 million.
PV of outflows = ($2.5 million) + ($5.154 million) = $7.654 million.
NPV of Project B = ($10.083 million)  ($7.654 million) = $2.429 million.
Applying the NPV rule, we choose Project A, which has the larger NPV: $3.269 million versus $2.429 million.
Exam Tips and Tricks Problems on the CFA exam are frequently set up so that it is tempting to pick a choice that seems intuitively better (i.e. by people who are guessing), but this is wrong by NPV rules. In the case we used, Project B had lower costs upfront ($2.5 million versus $7 million) with a payoff of $16 million, which is more than the combined $15 million payoff of Project A. Don\'t rely on what feels better; use the process to make the decision! 
The Internal Rate of Return
The IRR, or internal rate of return, is defined as the discount rate that makes NPV = 0. Like the NPV process, it starts by identifying all cash inflows and outflows. However, instead of relying on external data (i.e. a discount rate), the IRR is purely a function of the inflows and outflows of that project. The IRR rule states that projects or investments are accepted when the project's IRR exceeds a hurdle rate. Depending on the application, the hurdle rate may be defined as the weighted average cost of capital.
Example:
Suppose that a project costs $10 million today, and will provide a $15 million payoff three years from now, we use the FV of a singlesum formula and solve for r to compute the IRR.
IRR = (FV/PV)^{1/N }1 = (15 million/10 million)^{1/3 } 1 = (1.5)^{ 1/3 } 1 = (1.1447)  1 = 0.1447, or 14.47%
In this case, as long as our hurdle rate is less than 14.47%, we green light the project.
NPV vs. IRR
Each of the two rules used for making capitalbudgeting decisions has its strengths and weaknesses. The NPV rule chooses a project in terms of net dollars or net financial impact on the company, so it can be easier to use when allocating capital.
However, it requires an assumed discount rate, and also assumes that this percentage rate will be stable over the life of the project, and that cash inflows can be reinvested at the same discount rate. In the real world, those assumptions can break down, particularly in periods when interest rates are fluctuating. The appeal of the IRR rule is that a discount rate need not be assumed, as the worthiness of the investment is purely a function of the internal inflows and outflows of that particular investment. However, IRR does not assess the financial impact on a firm; it only requires meeting a minimum return rate.
The NPV and IRR methods can rank two projects differently, depending on thesize of the investment. Consider the case presented below, with an NPV of 6%:
Project  Initial outflow  Payoff after one year  IRR  NPV 
A  $250,000  $280,000  12%  +$14,151 
B  $50,000  $60,000  20%  +6604 
By the NPV rule we choose Project A, and by the IRR rule we prefer B. How do we resolve the conflict if we must choose one or the other? The convention is to use the NPV rule when the two methods are inconsistent, as it better reflects our primary goal: to grow the financial wealth of the company.
Consequences of the IRR Method
In the previous section we demonstrated how smaller projects can have higher IRRs but will have less of a financial impact. Timing of cash flows also affects the IRR method. Consider the example below, on which initial investments are identical. Project A has a smaller payout and less of a financial impact (lower NPV), but since it is received sooner, it has a higher IRR. When inconsistencies arise, NPV is the preferred method. Assessing the financial impact is a more meaningful indicator for a capitalbudgeting decision.
Project  Investment  Income in future periods  IRR  NPV  
Â  Â  t_{1}  t_{2}  t_{3}  t_{4}  t_{5}  Â  Â 
A  $100k  $125k  $0  $0  $0  $0  25.0%  $17,925 
B  $100k  $0  $0  $0  $0  $200k  14.9%  $49,452 
Money Vs. TimeWeighted Return

Investing
Internal Rate Of Return: An Inside Look
Use this method to choose which project or investment is right for you. 
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. 
Investing
An Introduction To Capital Budgeting
We look at three widely used valuation methods and figure out how companies justify spending. 
Investing
Internal Rate of Return Formula for Excel
The internal rate of return, or IRR, is a popular metric businesses use to measure a projectâ€™s return on investment. 
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). 
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. 
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. 
Financial Advisor
A Guide on the RiskAdjusted Discount Rate
When a project or investment faces higher amounts of risk or uncertainty, it may be appropriate to utilize the riskadjusted discount rate. 
Managing Wealth
What's a Hurdle Rate?
Hurdle rate has two meanings. In the business world, a business typically makes a decision on a capital project based on the net present value approach. To determine the net present value, the ... 
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.