Why use NPV?
• NPV approach is considered the best one for
evaluating capital budgeting.
• NPV is easy to interpret and understand:
– Positive NPV projects are accepted, negative NPV
projects are rejected
– Accepting positive NPV projects benefits the
stockholders.
• Three key attributes:
– NPV uses cash flows
– NPV uses all the cash flows of the project
– NPV discounts the cash flows properly
NPV is used as a benchmark for evaluating other
alternative approaches to capital budgeting.
Managerial perspective - PBP
• Payback rule is often used by large companies when
making relatively small investment decisions.
• Used for decisions made by lower-level
management.
• Its simple to use and allows upper management to
delegate responsibility.
• Important in terms of management control (short term
verification of manager’s assessment of cash flows).
• For bigger investment decisions, the payback rule is
seldom used (when questions of controlling and
evaluating the manager become less important than
making the right investment decision).
Internal rate of return (IRR)
• The IRR is very similar to the NPV approach.
• Basic rationale: it tries to find a single number
that summarizes the merits of a project.
• That number does not depend on the interest
rate that prevails in the capital market.
• The number is internal or intrinsic to the
project and does not depend on anything
except the cash flows of the project.
IRR
• IRR rules:
– The firm should accept the project if the
discount rate is below 10% (IRR > discount
rate).
– The firms should reject the project if the
discount rate is above 10% (IRR < discount
rate).
Advantages of the IRR
• Rule that summarizes the information about a
project in a single rate of return.
• Simple way of discussing a project.
• However, in order to apply the IRR, you must
compare it with r. So, the discount rate is
needed for making a decision under both
approaches.