[Anonymous]

If the IRR is higher than the minimum desired rate of return then the project can be accepted. At first glance this is confusing to me thinking that a higher desired return is a good thing bc I will be receiving more on the investment (maybe this reasoning is incorrect?). Also I read that when the IRR is higher then the NPV is positive and basiclly that is why we accept a project but still I am a bit confused with the concept. So can anyone explain in numbers or in simple words how can an IRR (rate when NPV outflows are = to inflows) higher than the desired rate is a good thing? How does that makes a NPV positive? I keep searching in the Chapter 3 of the Ninja book for examples that explain this but cannot find any. I feel that I keep asking dumb questions but this is the first time in my life going over the IRR and NPV concepts so this is all new to me, any help is appreceated!

[surfer4life949]

I'll give this a shot:

Think of it this way. Say your minimum required rate of return is 10%. Your company chose this rate of return because historically, this is what the company has (on average) been able to gain as a return on projects and investments that it has made. You (being a savvy CPA) invest in project X, and low and behold you get a 12% return on the project. This 12% rate is the IRR for your project. Good job, you just made your company some cash $$$ by accepting Project X.

Now, for the NPV (Net Present Value) it assumes that we're going to be discounting (i.e. finding the Present Value) of some future cash flows. Well, now that we've established that Project X is a good investment, let's see what the Present value of Project X's cash flow is. The present value for Project X is the net cash flow that will come in discounted by a certain rate of return. Which rate of return should we use? Traditional finance theory would say that we should discount the cash flows by the rate of return that we could get by using the capital in the next alternative investment. Since your company usually makes a 10% return on it's projects, it's safe to say that the next best investment to Project X would be any other project that your company would normally make. Hence, you would discount Project X's cash flows by 10% to find the NPV.

A final note, since the 12% IRR and cash flows of Project X is greater than what you're using to discount (10%) these cash flows, your NPV would be positive (your return is greater than the return on the next best investments).

I hope this all helps 🙂

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[monikernc]

hi cortes, i will try…

use an example with an initial investment = $10,000, and you think you will get $11,000 back in 1 year. this a 10% rate of return. the PV of the $11,000 cash flow in one year is $10,000, and the NPV = 10,000-10,000 = 0. so 10% is the internal rate of return that results in a NPV = 0, and it is great, if your discount rate or hurdle rate is 10%.

the IRR for the $10,000 initial investment, with an inflow of $11,000 in 1 year will always be 10%., it is the internal rate of return where NPV = 0, PV cash flow – initial investment = 0, and 10,000 – 10,000 will always = 0.

but what if your discount or hurdle rate is 5%, then the PV of the $11,000 cash flow in a year, is $10,476, and the NPV = 10,476-10,000 = 476. NPV is positive when the IRR of 10% > Discount or Hurdle Rate of 5%.

and if your discount or hurdle rate is 12%, then the PV of the $11,000 cash flow in a year is only $9,821, and the NPV = 9,821-10,000 = (179). the NPV is negative when the IRR of 10% < Discount or Hurdle Rate of 12%.

higher discount rates will always result in lower PV of cash flows. so if the discount rate is greater than the IRR, the NPV will be negative.

conversely, lower discount rate will always result in higher PV of cash flows. so if the discount rate is less than the IRR, the NPV will be positive.

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[monikernc]

miles does a decent job of going through capital busgeting in this video. it is long, though. a nice productive break from mcq's and the book.

You can skip the present value review to save time by advancing through the section at the beginning where he is wearing a blue shirt.

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[Anonymous]

Thank you so much guys, I think I get the whole picture now. I was viewing the desired minimum rate wrongly, anything above that rate is good bc that rate is the rate assumed for cost of capital in a reinvestment. Also a higher IRR making a positive NPV makes sense mathematically bc higher discount rate =lower pv of money. If the discount rate used for the BREAK EVEN point(IRR) is higher then the lower hurdle rate would yield a higher pv of money (as monikernc explained).

Also I get why NPV is a better financial measurement bc it uses as the discount rate the cost of capital for a reinvestment and it measures better the cash flows over time(since it applies different discount rates over time) and it measures the impact of the hole cash flows of the project not only the break even point.

I hope that is it…

[Author]

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