Page 87 - CFA - Day 1 & 2 Course Notes

LOS 7.b: Contrast the NPV rule to the
IRR rule, and identify problems Session Unit 2: Discounted Cash Flow Applications
associated with the IRR rule..

NPV decision rule: The basic idea behind NPV analysis is that if a project has a positive NPV,

this amount goes to the firm’s shareholders. As such, if a firm undertakes a project with a

positive NPV, shareholder wealth is increased. The NPV decision rules are summarized:

• Accept projects with a positive NPV. Positive NPV projects will increase shareholder wealth.

• Reject projects with a negative NPV. Negative NPV projects will decrease shareholder wealth.

• When two projects are mutually exclusive (only one can be accepted), the project with the

higher positive NPV should be accepted.

IRR decision rule: Analyzing an investment (project) using the IRR method provides the analyst with a

result in terms of a rate of return. The following are decision rules of IRR analysis:

• Accept projects with an IRR that is greater than the firm’s (investor’s) required rate of return.

• Reject projects with an IRR that is less than the firm’s (investor’s) required rate of return.

Note that for a single project, the IRR and NPV rules lead to exactly the same accept/reject

decision. If the IRR is greater than the required rate of return, the NPV is positive, and if the
IRR is less than the required rate of return, the NPV is negative.