CAPITAL BUDGETING

Overview 159

7.1 The NPV Rule for Judging Investments and Projects 159

7.2 The IRR Rule for Judging Investments 161

7.3 NPV or IRR, Which to Use? 162

7.4 The “Yes–No” Criterion: When Do IRR and NPV Give the Same Answer? 163

7.5 Do NPV and IRR Produce the Same Project

Rankings? 164

7.6 Capital Budgeting Principle: Ignore Sunk Costs and

Consider Only Marginal Cash Flows 168

7.7 Capital Budgeting Principle: Don’t Forget the Effects of Taxes—Sally and Dave’s Condo Investment 169

7.8 Capital Budgeting and Salvage Values 176

7.9 Capital Budgeting Principle: Don’t Forget the Cost of Foregone Opportunities 180

7.10 In-House Copying or Outsourcing? A Mini-case

Illustrating Foregone Opportunity

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Recall from Chapter 5 that the IRR is defined as the discount rate for which the NPV equals zero. It is the compound rate of return that you get from a series of cash flows.

Here are the two decision rules for using the IRR in capital budgeting.

The IRR rule for deciding whether or not a specific investment is worthwhile: Suppose we are considering a project that has cash flows CF0, CF1, CF2, . . . , CFN . IRR is an interest rate such that

CF0 + CF1

(1 + IRR)

+ CF2

(1 + IRR)2

+ ·· ·+ CFN

(1 + IRR)N

= CF0 +

N

t=1

CFt

(1 + k)t

= 0

Rule: If the appropriate discount rate for a project is r, you should accept the project if its

IRR > r and reject it if its IRR < r.

EXCEL NOTE

EXCEL’S NPV FUNCTION VERSUS THE FINANCE

DEFINITION OF NPV

We reiterate our Excel note from Chapter 5 (p. 94): Excel’s NPV function computes the present value of future cash flows; this does not correspond to the finance notion of NPV, which includes the initial cash flow. To calculate the finance NPV concept in the spreadsheet, we have to include the initial cash flow. Hence, in cell B12, the NPV is calculated as

NPV($B$2,B6:B10)B5 and in cell C12 the calculation is NPV($B$2,C6:C10)C5.

Suppose we apply the NPV criterion to projects A and B:

1

2

3

4

5

6

7

8

9

10

11

12

A B C D

Discount rate 12%

Year Project A Project B

0 -1000 -800

1 500 420

2 500 420

3 500 420

4 500 420

5 500 420