A controller is asked to choose between two equipment purchases. Project A costs $2,000,000 and produces $600,000 of after-tax cash flow per year for five years. Project B costs $3,500,000 and produces $900,000 per year for the same period. The CFO mentions a hurdle rate of 10%. The exam question is not whether you can compute one number, it is whether you know which model answers which question, and what to do when two models disagree.
HIGH-FREQUENCY: NPV is the present value of all expected cash flows minus the initial investment. Accept any project whose NPV is positive; among mutually exclusive projects, choose the highest NPV. The discount rate is the cost of capital, usually WACC.
NPV measures the dollar value added to the firm. A project with NPV of $240,000 is expected to make shareholders $240,000 wealthier in present-value terms. That is why NPV is the primary criterion: it is denominated in dollars, not percentages, and it is consistent with the goal of maximizing firm value.
Common mistakes
- Treating IRR as the primary decision rule. IRR is intuitive, but it suffers from reinvestment bias, scale problems, and multiple-IRR pitfalls with non-conventional flows. The exam will offer an answer choice that "picks the higher IRR." That is wrong when IRR and NPV conflict on mutually exclusive projects. NPV is the primary rule.
- Ignoring the depreciation tax shield. Depreciation is non-cash, but it reduces taxable income and therefore reduces taxes paid. The shield equals depreciation times the tax rate. A common trap question gives revenue, cash expenses, depreciation, and tax rate, and the wrong answer omits the depreciation add-back from operating cash flow.
- Using payback as the primary decision rule. Payback ignores time value and ignores all cash flows beyond the cutoff. A project that pays back in two years and then dies is identical to one that pays back in two years and then produces $50 million.
Bottom line
- Net present value discounts each cash flow at the cost of capital and subtracts the initial investment; accept if NPV is positive. This is the primary criterion.
- Internal rate of return is the discount rate where NPV equals zero; accept if IRR exceeds the hurdle rate, but watch for multiple-IRR pitfalls when sign changes occur in the cash flow stream.
- Profitability index equals PV of inflows divided by initial investment; rank projects by PI when capital is rationed.
- Payback and discounted payback answer when you get your money back; payback ignores the time value of money and all flows after the cutoff, while discounted payback fixes time value but still ignores later flows.
Exam shortcut
When a question presents NPV and IRR ranking mutually exclusive projects differently, pick the project with the higher NPV. NPV wins. The exam reliably tests this by setting up a scale or timing conflict and offering the "higher IRR" answer as a distractor.
The full lesson (about 2,739 words, 18 min read) adds 1 worked example, all 5 common mistakes, a self-check, free in the app.
Learning objectives
- I.B3
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