Introduction to Finance

DISCUSSION QUESTION 2
The book describes why NPV is the best technique to evaluate capital budgeting projects. 
Besides NPV, which technique do you think is “best”? Explain why.
payback period method 
determines the time in years it will 
take to recover, or pay back, the 
initial investment in fi xed assets
13
Christina Duff , “Discount Retailers Get No Quick Fix from Remodeling Stores, Study Says,” 
The Wall Street 
Journal
, (March 27, 1995), p. A15C.

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C H A PT E R 1 7 Capital Budgeting Analysis
17.8
Conflicts Between Discounted Cash 
Flow Techniques
NPV, IRR, MIRR, and PI will 
always
agree on whether a project should be accepted or rejec-
ted. So, if the fi rm is considering only independent projects, it makes little practical diff erence 
which method is used. All of them always give consistent indicators as to whether a given 
project would increase or decrease shareholder wealth. 
When mutually exclusive projects are ranked from most attractive to least attractive, NPV 
may rate them diff erently from the other techniques. The main reason for this is that NPV 
measures one aspect of the project, whereas IRR and PI measure another. NPV measures 
the dollar change in shareholder wealth that arises from undertaking the project. As relative 
measures of project attractiveness, IRR and PI indicate the rate of profi tability a project adds 
to shareholder wealth but not the dollar amount. A project with a lower IRR or PI may add 
more to shareholder value than another mutually exclusive project if the projects have diff erent 
cash fl ow patterns, time horizons, or sizes.
Diff erent Cash Flow Patterns
Projects that provide larger cash fl ows in their early stages can seem to provide more funds 
than a project with more even cash fl ows. If the IRR exceeds the fi rm’s required rate of return, 
the eff ects of compounding larger cash fl ows at a rate exceeding the required return may result 
in the project receiving a higher ranking by the IRR method than by the NPV method. Thus, 
projects with larger earlier cash fl ows may have higher IRR rankings than those with larger 
later cash fl ows.
Diff erent Time Horizons
A shorter project may free up invested funds sooner and, consequently, off er a higher IRR. 
A long-term project’s cash fl ows will remain internally invested in the project for a longer 
period. Unless those future cash fl ows are large, the discounting process may reduce their 
perceived present value, eroding the IRR of the longer-term project. The IRR of a desirable 
project must exceed the project’s required return; the NPV formula uses a lower discount rate, 
so it values later cash fl ows more favorably than does the IRR calculation.
Suppose projects Short and Long each require an initial investment of $100. In two years, 
project Short returns a lump sum of $200. Project Long lasts ten times longer and returns ten 
times more than Short; that is, Long will return a lump sum of $2,000 in 20 years. A quick 
calculation will confi rm that Short has an IRR of 41.42 percent; Long has an IRR of 16.16 
percent, but, at a 10 percent cost of capital, Long’s NPV of $197.29 exceeds the $65.29 NPV 
of Short.