Capital budgeting analysis with net present value and internal rate of return

Capital Budgeting

If the discount rate is 0%, the project's NPV is $670,000. If the discount rate is 2%, the project's NPV is $614,353.50. If the discount rate is 6%, the project's NPV is $514,815.60. If the discount rate is 11%, the project's NPV is $408,997.50. The project's modified internal rate of return is 39%. The chart will show that the net present value is zero will at 46%, as this is where the NPV intersects the y axis. This implies that when the discount rate is 28%, the project will have a zero NPV. This number should be equal to the internal rate of return, but of course the modified internal rate of return (MIRR) and the internal rate of return (IRR) are different numbers, because of the impacts of compounding.

For the second equation, if the discount rate is 1%, the NPV of the project is $65,358.36. If the discount rate is 4%, then the NPV of the project is $7,593.31. If the discount rate is 10%, the NPV will be -$91,776.90. If the discount rate is 18%, then NPV will be -$197,892. The MIRR for the project will be 3%. When the line is drawn, the NPV intersects with the y-axis at around 4.5%. This means that at around that point, the project's NPV will be zero. If the discount rate is higher, the project should not be undertaken. If the discount rate is lower, the project can at that point be undertaken.

To determine the NPV of this project, multiply the initial investment by the profitability index. In this case, .2 * 0.94 = $188,000. This means that while the project pays back the initial investment, it does not do so twice. It is up to management to decide the implications of this.

I believe that net present value is a superior means of making a capital budgeting decision compared with internal rate of return. While the two are based on the same numbers and math, the NPV calculation simply provides more information. It provides information that can help to understand the payback characteristics of the project -- for example taking a cumulative NPV helps to provide a sensitivity analysis for the payback.

In addition, the net present value allows the manager to make a determination about a project based on the total value of the project. This is especially useful in situations where management must determine between mutually exclusive options. The projects, however, may have very different payback characteristics in terms of the flows, the timing of the flows and the certainty of the flows. As a result, the IRR does not provide enough information -- the project is profitable, but is it is a long-term or short-term project? The NPV calculation allows for better analysis, beyond the bottom-line number.