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Learning Objectives

4. Appraise the use of the cost of capital as the discount rate in capital budgeting analysis. (LO4)

5. Integrate the cash flows that result from an investment decision, including the after tax operating benefits and the tax shield benefits of capital cost allowance (amortization). (LO5)

6. Perform NPV analysis to assist in the decision-making process concerning long-run investments. (LO6)

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Table 12-5Internal rate of return and net present value ($10,000 investment)

LO4

Investment A (11.16% IRR) Investment A

Year Cash Flow Year Cash Flow

1 $5,000 1 $5,000 10%

2 5,000 2 5,000 11%

3 2,000 Discounted at 11.16%

3 2,000 12% Discounted at various rates if desired

NPV = 0 NPV = $27

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Net Present Value Profile

– a graph of the NPV of a project at 3 different discount rates:

• a zero discount rate• the normal discount rate (or cost of capital)• the IRR for the investment

– allows an easy way to visualize whether or not an investment should be undertaken

LO4

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6,000

4,000

2,000

0

Net present value ($)

5% 10% 15% 20% 25%

IRRB = 14.33%

IRRA = 11.16%

Discount rate (percent)

Investment B

Investment A

Figure 12-2Net Present Value Profile

B

B

A

A

LO4

Investment A Investment B

Discount Rate NPV

Discount Rate NPV

0 % $2,000 0 % $6,000

5 1,025 5 3,433

10 180 10 1,414

11.16 0 14.33 0

15 -556 15 -195

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6,000

4,000

2,000

0

Net present value ($)

5% 10% 15% 20% 25%

IRRC = 22.49%

IRRB = 14.33%

Discount rate (percent)Crossover point

Investment C

Investment B

Investment C

Investment B

Figure 12-3Net Present Value Profile With Crossover

B

B

C

C

LO4

Investment C

Discount Rate NPV

0 % $3,200

5 2,381

10 1,563

15 1,002

20 417

22.49 0

25 -1128.7%