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