Introduction to Finance

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17.8 Conflicts Between Discounted Cash Flow Techniques
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Diff erent Sizes
Projects with smaller initial investments may have higher PIs and IRRs, but their small size 
may appear to make them less attractive from an NPV perspective. For example, consider 
projects Small and Large:
Project
Initial Outlay
PV of Cash Flows
NPV
PI
Small
$100.00
$150.00
$50
1.5
Large
1,000.00
1,100.00
$100
1.1
The NPV method ranks project Large fi rst because of its larger NPV, but PI ranks project 
Small fi rst.
Thus, rankings among capital budgeting projects may diff er for the three reasons above. 
The discounted cash fl ow methods each provide a diff erent perspective on project attract-
iveness. Since the goal of the decision process is to maximize shareholder wealth, the NPV 
approach remains preferred among the others.
Diff erence Between Theory and Practice
Thus far, this chapter has presented the basic concepts and techniques of capital budgeting. 
The capital budgeting process wants to identify projects that will maximize shareholder 
value. Using the fi rm’s mission and objectives as a guide, managers seek to identify market or 
product segments in which the fi rm can build, maintain, or expand a competitive advantage. 
We have reviewed fi ve capital budgeting techniques: net present value (NPV), internal 
rate of return (IRR), modifi ed internal rate of return (MIRR), profi tability index (PI), and the 
payback method. The fi rst four each use discounted cash fl ows to incorporate the time value 
of money into the analysis. The fi nal method ignores time value considerations. Financial 
managers favor the use of discounted cash fl ow (DCF) techniques. 
Theory suggests analysts should evaluate capital budgeting projects using DCF tech-
niques that incorporate all relevant cash fl ows, base decisions on clear and objective criteria, 
and indicate projects’ impacts on shareholder wealth. The NPV method satisfi es these con-
ditions better than other methods. Surveys of practitioners fi nd, however, that while NPV is 
widely used, there is a surprising continued popularity of nondiscounted cash fl ow techniques 
as primary or secondary evaluation methods.
Over time, studies have found that use of DCF techniques have become more prevalent 
among practitioners. Surveys indicate IRR is the most favored capital budgeting analysis tech-
niques. The payback is especially popular as a secondary or supplementary method of ana-
lysis. One survey found that about 75 percent of chief fi nancial offi
cers (CFOs) use NPV, IRR, 
or both to evaluate capital budgeting projects. Surprisingly, over half of the fi rms computed 
the payback period, too, to evaluate projects.
14
A survey of techniques used by multinational 
fi rms confi rms these results.
15
Why might real-world decision makers favor IRR and payback over NPV? One reason 
could be ignorance. Over time, surveys have shown that the use of DCF techniques has 
become more prevalent, perhaps because business schools have taught students the virtues of 
time value of money and NPV. The apparent sustaining power of IRR and payback techniques, 
however, suggests the possibility of other reasons. Let’s examine several of them.