Talk:Capital budgeting

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[edit] Discussion

capital budgeting

While describing IRR you say "Nevertheless, for mutually exclusive projects, the decision rule of taking the project with the highest IRR - which is often used - may select a project with a lower NPV". I dont understand how is this possible .Can you give some example?

'example with mutually exclusive projects, k=8%

time 0 1 2 3 4 5

CFA -2000 300 300 300 300 2300

CFB -1000 200 200 200 200 1200

NPV A = $558.98, IRR = 15%

NPV B = -1000 + 200{P/A 8%,5} + 1000{P/F 8%,5}

= $479.13 < $558.98. ==> accept project A but IRR B = 20% > 15% !

Why the difference in the 2 methods? Mainly the effect of the size of investment here. It can be better to invest 2000 at 15% than 1000 at 20%. What do you do with the extra 1000? That's the key hidden assumption of the 2 methods. If you invest it at 8% (implied by NPV's assumptions) then A is better. But if you invest it at 20% (implied by IRR's assumptions) then B is better. Most people think that an 8% re-investment rate is more realistic.

Smallbones 15:03, 27 February 2007 (UTC)

I think this should cover the payback method as well. The payback method may seem trivial, but for small projects, particularly IT projects, where the system developed may become obsolete within four years, it may be the most appropriate method.