Introduction to Corporate Finance

9: Capital Budgeting Process and Decision Criteria

As an example, consider a project with the following stream of cash flows:

Admittedly, this project has a rather strange sequence of alternating net cash inflows and outflows,

but it is not hard to think of real-world investments that generate cash flow streams that flip back

and forth like this. Consider, for example, high-technology products. A

new product costs money to develop. It generates plenty of cash for a

year or two, but it quickly becomes obsolete. Obsolescence necessitates

more spending to develop an upgraded version of the product, which

then generates cash again. The cycle continues indefinitely. The iPhone

provides an example of this – each time Apple launches a new model,

previous models earn much lower marginal revenues. Notice that Apple

launches intermediate product releases that involve software upgrades,

rather than full hardware upgrades. (For these intermediate releases,

development costs are lower, compared to the full upgrades.)

Figure 9.7 presents the NPV profile for a project with the cash flows just described at various

discount rates. Notice that there are four points on the graph at which the project’s NPV equals

zero. In other words, there are several IRRs for this project, including 0%, 10%, 20% and 30%. How

does one apply the IRR decision rule in a situation such as this? Suppose that the hurdle rate for this

project is 15%. Two of the four IRRs on this project exceed the hurdle rate, and two fall below the

hurdle rate. Should the company invest or not? The only way to know for sure is to check the NPV.

On the graph, we see that at a discount rate of 15%, the project’s NPV is positive, so the company

should invest.

FIGURE 9.6 LENDING VERSUS BORROWING

The green line is the NPV profile for project 1, which is a loan made by the company; it shows that as the IRR exceeds
the hurdle rate, the loan’s NPV is positive. The orange line is the NPV profile for project 2, which involves the company
borrowing money; it shows that the higher the rate at which the loan payments are discounted, the higher the NPV.

Project 1

Project 1

NPV

Project 2

Project 2

Discount

rate (%)

IRR > Hurdle rate IRR < Hurdle rate

50%

$0

IRR

$

$

Year CF ($ in millions)

0 +100

1 –460

2 +791

3 –602.6

4 +171.6