Subject 1. NPV and IRR
A company should choose those capital investment processes that maximize shareholder wealth.
The net present value (NPV) of an investment is the present value of its cash inflows minus the present value of its cash outflows. The internal rate of return (IRR) is the discount rate that makes net present value equal to 0.
According to the NPV rule, a company should accept projects where the NPV is positive and reject those in which the NPV is negative. A positive NPV suggests that cash inflows outweigh cash outflows on a present value basis. That is, the positive cash flows are sufficient to repay the initial investment along with the capital costs (opportunity cost) associated with the project. If the company must choose between two, mutually-exclusive projects, the one with the higher NPV should be chosen.
According to the IRR Rule, a company should accept projects where the IRR is greater than the discount rate used (WACC) and reject those in which the IRR is less than the discount rate. An IRR greater than the WACC suggests that the project will more than repay the capital costs (opportunity costs) incurred.
There are three problems associated with IRR as a decision rule.
Study notes from a previous year's CFA exam:
a. calculate and interpret the net present value (NPV) and the internal rate of return (IRR) of an investment;
b. contrast the NPV rule to the IRR rule, and identify problems associated with the IRR rule;