Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

IV. Capital Budgeting 9. Net Present Value and

Other Investment Criteria

© The McGraw−Hill^319

Companies, 2002

flow of $60 per year for two years, so it’s only slightly more complicated than our
single-period example. However, if you were asked for the return on this investment,
what would you say? There doesn’t seem to be any obvious answer (at least not to us).
However, based on what we now know, we can set the NPV equal to zero and solve for
the discount rate:

NPV 0 
$100 [60/(1 IRR)] [60/(1 IRR)^2 ]

Unfortunately, the only way to find the IRR in general is by trial and error, either by
hand or by calculator. This is precisely the same problem that came up in Chapter 5
when we found the unknown rate for an annuity and in Chapter 7 when we found the
yield to maturity on a bond. In fact, we now see that, in both of those cases, we were
finding an IRR.
In this particular case, the cash flows form a two-period, $60 annuity. To find the un-
known rate, we can try some different rates until we get the answer. If we were to start
with a 0 percent rate, the NPV would obviously be $120
100 $20. At a 10 percent
discount rate, we would have:

NPV
$100 (60/1.1) (60/1.1^2 ) $4.13

Now, we’re getting close. We can summarize these and some other possibilities as
shown in Table 9.5. From our calculations, the NPV appears to be zero with a discount
rate between 10 percent and 15 percent, so the IRR is somewhere in that range. With a
little more effort, we can find that the IRR is about 13.1 percent.^6 So, if our required re-
turn were less than 13.1 percent, we would take this investment. If our required return
exceeded 13.1 percent, we would reject it.
By now, you have probably noticed that the IRR rule and the NPV rule appear to be
quite similar. In fact, the IRR is sometimes simply called the discounted cash flow,or
DCF, return.The easiest way to illustrate the relationship between NPV and IRR is to
plot the numbers we calculated for Table 9.5. We put the different NPVs on the vertical
axis, or y-axis, and the discount rates on the horizontal axis, or x-axis. If we had a very
large number of points, the resulting picture would be a smooth curve called a net pres-
ent value profile. Figure 9.5 illustrates the NPV profile for this project. Beginning with
a 0 percent discount rate, we have $20 plotted directly on the y-axis. As the discount
rate increases, the NPV declines smoothly. Where will the curve cut through the x-axis?
This will occur where the NPV is just equal to zero, so it will happen right at the IRR of
13.1 percent.

CHAPTER 9 Net Present Value and Other Investment Criteria 289

(^6) With a lot more effort (or a personal computer), we can find that the IRR is approximately (to 9 decimal
places) 13.066238629 percent, not that anybody would ever want this many decimal places.

TABLE 9.5

NPV at Different

Discount Rates

Discount Rate NPV

0% $20.00

5% 11.56

10% 4.13

15% 
 2.46

20% 
 8.33

net present value profile

A graphical

representation of the

relationship between an

investment’s NPVs and

various discount rates.