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NPV Versus IRR W.L. Silber I. Our favorite project A has the following cash flows !

"### # # " # ( $%## % $&## ) $'## *

We +now that if the cost of capital is ", percent we reject the project because the net present value is negative NPV

We also +now that at a cost of capital of ,- we accept the project because the net present value is positive NPV

II. .hus/ so0ewhere between ,- an1 ",- we change our evaluation of project A fro0 rejecting it 2when NPV is negative3 to accepting it 2when NPV is positive3. We can calculate the point at which NPV shifts fro0 negative to positive b4 searching for the value of r/ calle1 the internal rate of return 2IRR3 in the following e5uation/ which 0a+es the NPV6#.

7ore generall4/ if 89i is the cash flow in perio1 i/ the IRR is that rate/ r/ such that

In our case/ 89# 6 !"###/ 89% 6 %##/ 89) 6 &## an1 89* 6 '##. All the other 89i 6 #.

III. .he IRR can/ in general/ onl4 be 1erive1 b4 trial an1 error. Putting our values for the 89i into a calculator 2ver4 carefull43 we fin1 the IRR6 ").&&,-. We can chec+ this result as follows

.he su0 is not e:actl4 ;ero because of roun1ing. IV. We can now for0ulate an alternative rule to accepting the project if NPV < # an1 rejecting it if NPV = #. In particular/ we can reco00en1 rejecting a project if the cost of capital is greater than the IRR 2").&&,- in this case3 an1 we can reco00en1 accepting a project if the cost of capital is less than the IRR. .hese two rules are e5uall4 acceptable in this case for 1eter0ining whether project A will increase the value of the fir0. V. .here are circu0stances/ however/ where the IRR rule an1 the NPV rule provi1e conflicting a1vice. In particular/ IRR an1 NPV 0a4 1iffer where there are two 0utuall4 exclusive projects that must be ranked according to which one is best and where these two projects have very different timing of cash flows. Whenever there is a conflict between NPV and I the correct answer is provided by NPV. !et"s see why.

VI. #uppose we want to compare project $ with project %. &he cash flows are described below' with $"s cash flows e(ually distributed over time' while %"s cash flow )as we saw* are delayed.

We have already solved for the I of project %' i.e.' I % + ,-.../0. #olving for the I of project $ produces' I $ + ,/.120. &hus' the I rule ranks project $ better than %. !et"s see whether that is also true for the NPV rule' i.e.' let"s see if NPV$ is always greater than NPV%. &o implement the NPV rule we must calculate the NPV of % and $ for alternative values of the cost of capital. &his is done in table ,3 &able , 4ost of 4apital 510 ,60 ,10 /0 60 NPV% 7,86 7,5 9,:95:, 9-6/ NPV$ 7-2 982 95,2 9588 92/6

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