A division head proposes a $10M plant expansion projecting positive cash flows for eight years. Two analysts agree the project is "good," yet rank it differently against a competing automation project. The ranking flip comes from method choice, not the numbers. Capital investment analysis exists to make that choice deliberate.
Net present value sums every project cash flow, discounted at the firm's cost of capital, and subtracts the initial investment. A positive NPV means the project earns more than the capital it consumes, increasing shareholder wealth by exactly that dollar amount.
The discount rate r is the weighted average cost of capital (WACC) or a risk-adjusted hurdle rate. NPV is measured in dollars, so it carries scale information that ratio-based methods strip away.
KEY: Decision rule. Accept if NPV > 0, reject if NPV < 0, indifferent at NPV = 0. For mutually exclusive projects, pick the highest NPV.
Internal rate of return is the discount rate that drives NPV to exactly zero. You solve for r in the NPV equation set equal to zero, typically by financial calculator...
Common mistakes
- Picking the higher IRR on mutually exclusive projects. Scale and timing can flip the right answer. When NPV and IRR disagree, NPV wins because it measures dollar wealth created.
- Forgetting the multiple IRR trap. Non-conventional cash flows with more than one sign change can yield two IRRs or none. The exam loves a mining or environmental-cleanup setup. Default to NPV.
- Using payback as the accept rule. Payback is a screen, not an accept criterion. A 1.5-year payback with zero year-3-plus cash flows destroys value relative to a 3-year payback with strong tail cash flows.
Bottom line
- NPV discounts all project cash flows at the cost of capital and accepts projects where NPV > 0. The decision criterion that maximizes shareholder wealth.
- IRR solves for the discount rate that makes NPV = 0 and accepts projects where IRR > cost of capital (hurdle rate). IRR is scale-blind and timing-sensitive.
- Independent projects: accept all with NPV > 0 (or IRR > hurdle). Mutually exclusive: pick the highest NPV, ignore IRR rank.
- NPV reinvests intermediate cash flows at the cost of capital; IRR reinvests at the IRR, which drives most ranking conflicts.
Exam shortcut
When NPV and IRR conflict on mutually exclusive projects, the answer is always NPV. The conflict comes from scale or timing differences, and IRR's reinvestment assumption is the flaw. When the cash-flow stream changes sign more than once (initial outlay, positive operating flows, then a large terminal outflow for reclamation or shutdown), suspect the multiple IRR problem and pick the NPV-based choice.
The full lesson (about 1,964 words, 13 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- 2E2
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