Introduction to Corporate Finance

PART 3: CAPITAL BUDGETING

Figure 9.4 is a net present value (NPV) profile, which plots a project’s NPV (on the y-axis) against various

discount rates (on the x-axis). The NPV profile illustrates the relationship between a typical project’s

NPV and its IRR. By ‘typical’, we mean a project with initial cash outflows followed by cash inflows. In

this case, the NPV declines as the discount rate used to calculate the NPV increases. Not all projects

have this feature, as we will soon see. The green line in Figure 9.4 shows that when the discount rate is

relatively low, the project has a positive NPV. When the discount rate is high, the project has a negative

NPV. At some discount rate, the NPV equals zero, and that rate is the project’s IRR.

net present value (NPV)
profile
A plot of a project’s NPV (on the
y-axis) against various discount
rates (on the x-axis). It is used
to illustrate the relationship
between the NPV and the IRR
for the typical project

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investment if it earns a return greater than 10%

(so 10% is your hurdle rate). You determine that

the costs of obtaining the degree, which include

tuition, books and lost wages you would have

earned from working during the next year, add

up to about $50,000 in present value terms. This

represents your initial outlay. However, once

you have the degree in hand, you estimate that

your starting salary will be $5,000 higher than

it otherwise would have been, and that the

difference between your earnings with the degree

and what you would have earned without the

degree will grow at 5% per year over the next 30

years. That is, the cash flows associated with this

decision are as follows:

Today –$50,000

Year 1 $5,000

Year 2 $5,250

Year 3 $5,512

......

Year 29 $19,601

Year 30 $20,581

Plugging these values into Equation 9.2 and

solving for the discount rate that results in a zero

present value, we find that the IRR associated with

the master’s degree program is 14.2%. Given that

this return exceeds the 10% hurdle rate, you decide

to enrol in the master’s program.

FIGURE 9.4 NPV PROFILE

The NPV is positive when the IRR is greater than the hurdle (discount) rate, and the NPV is negative when the IRR is less

than the hurdle rate.

Project NPV

IRR  hurdle rate

IRR

NPV  $0

NPV  $0

IRR  hurdle rate

Shareholder

wealth increases

Shareholder

wealth

decreases

$0

$

$

Hurdle rate = Discount rate, r (%)