Introduction to Corporate Finance

9: Capital Budgeting Process and Decision Criteria

Even though both projects require the same initial investment and both last for five years, the

marketing campaign generates more cash flow in the early years than the product development proposal.

Therefore, in a relative sense, the payoff from product development occurs later than the payoff from

marketing. We know from our discussion of interest-rate risk in Chapter 4 that when interest rates

change, long-term bond prices move more than do short-term bond prices. The same phenomenon is at

work here. Figure 9.8 plots the NPV profiles for the two projects on the same set of axes. Notice the

line plotting NPVs for the product development idea is much steeper than the other. In simple terms,

this means the NPV of that investment is much more sensitive to the discount rate than is the NPV of

the marketing campaign.

Each investment’s IRR appears in Figure 9.8 where the NPV lines cross the x-axis. Figure 9.8

shows that both IRRs exceed the hurdle rate of 10% and that the marketing campaign has the higher

IRR. The two lines intersect at a discount rate of 12.5%. At that discount rate, the NPVs of the

projects are equal. At discount rates below 12.5%, product development, which has a longer-term

payoff, has the higher NPV. At discount rates above 12.5%, the investment in the marketing campaign

offers a larger NPV. Given that the required rate of return on investments for this particular company

is 10%, the company should choose to spend the $1 billion on product development. However, if

the company bases its investment decision solely on achieving the highest IRR, it will choose the

marketing campaign instead.

In summary, when the timing of cash flows is very different from one project to another, the project

with the highest IRR may or may not have the highest NPV. As in the case of the scale problem, the

timing problem can lead companies to reject investments that they should accept. We want to emphasise

FIGURE 9.8 NPV PROFILES DEMONSTRATING THE TIMING PROBLEM

The timing problem can lead to NPVs and IRRs that yield different investment recommendations. At any discount rate below
12.5%, product development is preferred because of its higher NPV, although the marketing campaign has a higher IRR.

10% 12.5%

Product development

IRR = 14.1%

Marketing

campaign

IRR = 15.9%

–$

$0

+$

Discount rate (%)

NPV