Principles of Managerial Finance

CHAPTER 9 Capital Budgeting Techniques 403

10924.40

 45000 CF 0

CF 1

N

I

NPV

CF 2

CF 3

28000

12000

10000

3

10

Solution

Input Function

Project B

internal rate of return (IRR)
A sophisticated capital
budgeting technique; the
discount rate that equates the
NPV of an investment opportunity
with $0 (because the present
value of cash inflows equals the
initial investment); it is the
compound annual rate of return
that the firm will earn if it invests
in the project and receives the
given cash inflows.

LG4

Review Questions

9–4 How is the net present value (NPV)calculated for a project with a conven-

tional cash flow pattern?

9–5 What are the acceptance criteria for NPV? How are they related to the

firm’s market value?

9.4 Internal Rate of Return (IRR)

The internal rate of return (IRR)is probably the most widely used sophisticated

capital budgeting technique.However, it is considerably more difficult than NPV

to calculate by hand. The internal rate of return (IRR)is the discount rate that

equates the NPV of an investment opportunity with $0 (because the present value

of cash inflows equals the initial investment). It is the compound annual rate of

return that the firm will earn if it invests in the project and receives the given cash

inflows. Mathematically, the IRR is the value of k in Equation 9.1 that causes

NPV to equal $0.

$0

n

t 1

CF 0 (9.2)



n

t 1

CF 0 (9.2a)

The Decision Criteria

When IRR is used to make accept–reject decisions, the decision criteria are as

follows:

• If the IRR is greater thanthe cost of capital, acceptthe project.


• If the IRR is less thanthe cost of capital, rejectthe project.

CFt

(1IRR)t

CFt

(1IRR)t