Introduction to Corporate Finance

9: Capital Budgeting Process and Decision Criteria

example

Suppose that Global Untethered requires its analysts to calculate the IRR of all proposed investments. The
company agrees to undertake only those investments which offer an IRR exceeding 18%, a rate that Global
Untethered believes to be an industry standard. Figures 9.5a and 9.5b present time lines depicting the IRR
calculations for Global Untethered’s two projects. To obtain the IRR for each project under consideration, just
solve these two equations:

$0 $250

$35

1r

$80

1r

$130

1r

$160

1r

$175

1r

+ 12345

()()()()()

=−

+

+

+

+

+

+

+

+

WE WE WE WE +WE

$0 $50

$18

1r

$22

1r

$25

1r

$30

1r

$32

SE SE SE SE 1rSE

12345

( ) ((()))( )

=− +

+

+

+

+

+

+

+

+

+

Here, rWE is the IRR for the Western Europe project, and rSE is the IRR for the South-eastern Australia
project. Solving these expressions yields the following:^6

rWE = 27.8%

rSE = 36.7%

Because both investments exceed the hurdle rate of 18%, Global Untethered would like to undertake both
projects. But what if it can invest in only one project or the other? Should the company invest in the South-
eastern Australia project because it offers the higher IRR, or should it invest in the Western Europe project
because it has a higher NPV? In this case, the NPV and IRR methods provide conflicting project rankings.

FIGURE 9.5A IRR OF GLOBAL UNTETHERED’S PROJECTS ($ MILLIONS): WESTERN EUROPE PROJECT

The internal rate of return (IRR) for Global Untethered’s Western Europe project is 27.8%, which is the discount rate
that causes the project’s cash flows to have an NPV of $0. The project is acceptable because its NPV is greater than the
company’s 18% hurdle rate.

0 1 2 3 4 5

End of year

NPV = $0

IRR = 27.8%

–$250 $35 $80 $130 $160 $175

IRR?

IRR?

IRR?

IRR?

IRR?

250

Calculator

Input Function

2nd CLR TVM

CLR WORK

CF

2nd

35 ENTER

–250 ENTER

80 ENTER Solution 27.8

130 ENTER

(^160) ENTER
(^175) ENTER
IRR
CPT
Formula B7:
IRR(BI:B6)
IRR 27.8%
Cash flow 2
–250
35
80
Cash flow 1
Cash flow 0
Row
Column
Spreadsheet
1
2
3
4 Cash flow 3 130
(^5) Cash flow 4 160
6 Cash flow 5 175
7
8
A B

6 Of course, you can make this calculation using a financial calculator or Excel, as shown in the time lines in Figure 9.5a.