¶ … discount rate at which the line intersects the curve is 18%. This tells us that if the discount rate for the project is higher than 18%, the project will not have a positive net present value. If the discount rate for the project is lower than 18%, the project will have a positive net present value.
The project's IRR is 9%.
The NPV at the following discount rates is:
$126,000
$64,642.69
$10,906.87
($36,414.90)
The discount rate at which the line intersects the horizontal axis is 9%.
Between NPV and IRR, the former is the best way to make capital budgeting decisions. Because the two methods are virtually identical -- and based on the same math -- there is little to choose between them. Both numbers are arrived at by discounting back future cash flows. The difference is lies in the way the number is rendered. Internal rate of return is focused on the rate of return, whereas net present value is focused on the total amount of the cash flows.
One of the main reasons for making capital budgeting decisions is so that management can make the best investments of the firm's money. Often, the decision will come from a set of alternatives in which there is at least some mutual exclusivity. Thus, the decision-making criteria need to take into account the size of the investment in addition to its payoff. The internal rate of return is useful in helping to identify those investment opportunities that have the highest percentage payoff, but if a small investment opportunity is mutually exclusive with a larger opportunity that is more lucrative in real dollars but less lucrative on a percentage basis, the company may choose the smaller alternative. Under this scenario, the profit of the company would not be maximized.
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