BUSFIN 4211: 2.2 Alternative Decision Rules

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Recap: How do you decide whether to undertake an investment project? NPV Rule

Accept the project if Net Present Value is positive

Recap: NPV measures

your change in value from accepting the project.

Recap: If possible, take all projects with

NPV > 0

Recap: When choosing among mutually exclusive projects, take

the one with the highest NPV

There are alternative methods

• Some alternatives have the benefit of simple calculations

• Other alternatives have the intuitive appeal of rate of return

When the results of alternative methods differ from NPV

• This may mean that project go/no go decision is different

• Or that the priority rank of projects is different

Any method producing results that differ from NPV is to

be taken with great care!

The NPV rule always leads to the correct decision

• Alternative rules often agree with NPV, but they sometimes disagree

• We want to understand when and why alternative rules lead to bad decisions

Internal Rate of Return (IRR)

Def: Discount rate that forces a project’s NPV to equal zero.

the most popular alternative method.

It is intuitive and usually gives right result

the interest rate that sets the NPV of the cash flows equal to 0

In other words, it is the return on investment (ROI) of the project

rate of return – how much this project yields every period

IRR Decision Rule:

Undertake project if IRR > hurdle rate, where the hurdle rate is

the cost of capital (risk-adjusted discount rate) r for that project

If your return is higher than the hurdle rate, invest

Hurdle Rate

• your opportunity cost, i.e., discount rate

Calculation: Taking discount rate r as

given, calculate the NPV

Decision: Accept project if NPV >

hurdle (zero)

Calculation: Taking the NPV as given

(zero), calculate IRR

Decision: Accept project if IRR >

hurdle (r)

rules are equivalent most of the time, but

not always!

Higher NPV, higher IRR –

more likely to accept the project