CP

rows above our cash flow line, starting with expected sales, then deducting various

costs and taxes, and ending up with the cash flows shown on Row 4. Moreover, once

a spreadsheet has been set up, it is easy to change input values to see what would

happen under different conditions. For example, we could see what would happen if

lower sales caused all cash flows to decline by $15, or i fthe cost o fcapital rose to

10.5 percent. UsingExcel, it is easy to make such changes and then see the effects

on NPV.

Rationale for the NPV Method

The rationale for the NPV method is straightforward. An NPV of zero signifies that

the project’s cash flows are exactly sufficient to repay the invested capital and to pro-

vide the required rate of return on that capital. If a project has a positive NPV, then it

is generating more cash than is needed to service the debt and to provide the required

return to shareholders, and this excess cash accrues solely to the firm’s stockholders.

Therefore, if a firm takes on a project with a positive NPV, the wealth of the stock-

holders increases. In our example, shareholders’ wealth would increase by $78.82 if

the firm takes on Project S, but by only $49.18 if it takes on Project L. Viewed in this

manner, it is easy to see why S is preferred to L, and it is also easy to see the logic of

the NPV approach.^5

There is also a direct relationship between NPV and EVA (economic value added,

as discussed in Chapter 9)—NPV is equal to the present value of the project’s future

EVAs. Therefore, accepting positive NPV projects should result in a positive EVA and

a positive MVA (market value added, or the excess of the firm’s market value over its

book value). So, a reward system that compensates managers for producing positive

EVA will lead to the use of NPV for making capital budgeting decisions.

Internal Rate of Return (IRR)

In Chapter 4 we presented procedures for finding the yield to maturity, or rate of re-

turn, on a bond—i fyou invest in a bond, hold it to maturity, and receive all o fthe

promised cash flows, you will earn the YTM on the money you invested. Exactly the

same concepts are employed in capital budgeting when theinternal rate of return

(IRR) methodis used. TheIRRis defined as the discount rate that equates the pres-

ent value o fa project’s expected cash inflows to the present value o fthe project’s

costs:

or, equivalently, the IRR is the rate that forces the NPV to equal zero:

(7-2)

NPV a

n

t 0

CFt

(1IRR)t

0.

CF 0 

CF 1

(1IRR)^1



CF 2

(1IRR)^2

.^.^ .

CFn

(1IRR)n

 0

PV(Inflows)PV(Investment costs),

Capital Budgeting Decision Rules 267

(^5) This description of the process is somewhat oversimplified. Both analysts and investors anticipate that
firms will identify and accept positive NPV projects, and current stock prices reflect these expectations.
Thus, stock prices react to announcements of new capital projects only to the extent that such projects were
not already expected.
See Ch 07 Tool Kit.xls.

The Basics of Capital Budgeting: Evaluating Cash Flows 265