Von Lester L.

Atienza
BEC 113 – BAE

Meaning of Marginal Efficiency of present value of the series of annuities

Capital (MEC):
MEC refers to the expected profitability
of a capital asset. It may be defined as
the highest rate of return over cost
expected from the marginal or additional
unit of a capital asset. First we must go
to the marginal unit of the capital asset
and secondly its cost has to be
deducted from its return.
Now the MEC in its turn, depends on
two factors: the prospective yield of the
capital asset and the supply price of the
capital asset. The MEC is the ratio of
these two factors. The prospective yield
of a capital asset is the total net return
from the asset over its life time.
The supply price of an asset is the cost
of producing a brand new asset of that
kind and not the supply price of an
existing asset. It is referred to as the
replacement cost. If the supply price of a
capital asset is Rs. 20,000 and its
annual yield is Rs. 2000, then the
marginal efficiency of this asset is
2000/20000 x 100 = 10 percent. Thus
the marginal efficiency of capital is the
percentage of profit expected from a
given investment on a capital asset.
given by the returns expected from the
capital asset during its life equal to its
supply price”. This may be put in the
form of an equation.
Where Sp is the supply price or the cost
of capital asset, R1,R2… Rn are the
prospective yields or the series of
expected annual returns from the capital
asset in the years 1,2…….. n, and i is
the rate of discount. This makes the
capital asset exactly equal to the
present value of the expected yield from
it. This can be explained with a
numerical example.
Let us assume that:
1. The life time of a capital asset (n) is 2
years.
2. The supply price of the capital asset
(Sp) is Rs. 3000.
3. The expected yield from the asset at
the end of one year (R1) is Rs. 1100.
4. The expected yield from the asset at
the end of 2 years (R2) is Rs. 2420.

Keynes relates the prospective yield of a

The MEC or the rate of discount
capital asset to its supply price and
which will equate the future yields of
defines MEC “as being equal to that rate
of discount which would make the
the asset with its supply price is 10%
as shown below:
In this way, discounted prospective
yields of capital asset can be brought
into equality with the current supply
price. Thus investment will take place
only if the net prospective yield of an
asset is greater than its supply price and
given the income flow the higher the
supply price of the capital asset, the
lower will be the rate of discount.
Factors of Marginal Efficiency of
Capital (MEC):
The various factors that bring about
shifts in MEC are short run or
endogenous factors and long rim or
exogenous factors.
The short run factors are:
1. Expected demand:
If the demand for the product is
expected to be high in future, the MEC
will be high and the investment will
increase. On the other hand if the
demand for the product is expected to
decline in future the MEC will be low
and investment will fall.
2. Costs and prices:
If the costs are expected to decline and
if the prices are expected to increase,
the expectation of the producer will go
up. On the other hand if the costs are
expected to go up and prices are to
decline the MEC will receive a set back
and the investment will be less.
3. Propensity to consume:
If the propensity to consume is more
than the volume of investment will be
more and vice versa.
4. Changes in income:
An increase in the level of income will
stimulate investment while a decrease in
the level of income will discourage
investment.
5. Current state of expectation:
Businessmen while making expectations
take into account the current state of
affairs regarding costs, prices, returns
etc. If they are high the MEC is bound to
be high for new projects of investment
6. Level of confidence:
During period of optimism the
businessmen over estimate and boost
the MEC of capital assets. During period
of pessimism they under estimate and
reduce the MEC of capital assets.
The long run factors which influence the
MEC are as follows:
1. Population growth:
A rapidly growing population means a
rapid increase in the demand for all
types of goods and hence investment
rises and conversely, a decline in
population will decrease the demand
investment.
2. Development of new areas:
When a new area is developed heavy
investments in all fields such as
agriculture, industries, electricity,
housing etc., are to be undertaken.
3. Technological factors:
New invention or new discovery may
necessitate the installation of new
machineries in the industrial enterprise
and encourage investment.
4. Productive capacity of the Industry:
If the existing capacity is fully utilised
then any further increase in demand will
be met with by making fresh investment
on new capital equipment.
5. Level of current investment:
If the existing level of investment is
already high there will be little scope for
further investment and vice versa.
Criticism of the Marginal Efficiency of
Capital:
Keynes used the term marginal
efficiency of capital in a vague manner.
Secondly, Keynes failed to recognize
that interest rates are also governed by
expectations like the marginal efficiency
of capital. He considered marginal
efficiency of capital in the field of
dynamic economics and rate of interest
in the field of static economics.
The rate of discount or yield i.e., r is
conventionally called the Marginal
Efficiency of Investment (MEI). Keynes
originally called it the ‘Marginal
Efficiency of Capital’. Brooman says that
it is preferable to use a term which
refers explicitly to investment (i.e., MEI).
The MEI (or MEC) ought to be
distinguished from the ‘Marginal product
of capital’ which refers to the increase in
current output resulting from the addition
of one more unit of capital.
It is clear that the marginal product of
capital is a physical quantity similar to
the marginal product of any other factor.
The MEI is a percentage rate, and not
the physical quantity. Again the marginal
product of capital does not involve
expectations about the yield from the The relationship between MEC and MEI
unit of capital during the remainder of its is illustrated in the figure 1.:
life. But the MEI is very much concerned
with such expectations about the yield.

Strictly speaking, however, there is a

difference between the MEC and the
MEI. The MEC is derived as the
relationship between i (rate of interest)
and the optimum level of capital stock.
The MEI is derived as the relationship
between i (rate of interest) and the
optimum change in capital stock. It can
be said by way of corollary that the MEC
and the MEI are interrelated.
MEI schedule indicates the rate of
investment spending per time period at
The MEI really indicates the decision to
each possible market rate of interest for
invest whereby there is change in the
different levels of the stock of capital.
capital stock. This relationship between
Part A shows the MEC schedule. When
investment as the change in capital
the rate of interest is 9% and capital
stock and the actual capital stock
stock is 400 billion dollars, the net
presents a difficulty in determining the
investment is zero. MEI schedule
MEI. If investment is change in capital
labeled MEIa shows that at point F,
stock, it can be assumed that the capital
when the rate of interest is 9%, the net
stock is fixed once investment is
investment is zero.
underway.

If rate of interest falls to 6%, net

Keynes recognized this difficulty and
investment will be 30 billion dollars. At
sought to overcome it by stating that he
G, the MEI is 8%, because the rise in
was interested in short period changes
net investment spending from zero to 15
in investment. In the short period
billion dollars has raised the prices of
change in investment would be
capital goods which has reduced the
insignificant relative to the entire capital
rate of interest to 8%. As this is higher
stock; therefore, the impact of
than MEI (6%) higher rate of net
investment on capital stock could be
investment is needed.
ignored.
At point H, MEI has fallen to 7 per cent
because higher rate of net investment
spending has pushed the prices of
capital goods to a higher level. The MEI
is still above 6 percent, so a still higher
rate of net investment spending is
wanted. At point J, MEI is 6 percent. It is
no higher or lower than the initial rate of
interest.
From the beginning to the end of this
first time period, with net investment of
30 billion dollars during the period, the
capital stock will have risen to 430 billion
dollars from its beginning level of 400
billion dollars. As shown in Part A, this
increase of 30 billion dollars reduces the
MEC about 8 per cent (actually 7.87)
from its previous level of 9. Because r is
still 6 per cent, further growth in the
capital stock is called for.
The amount by which it grows in the
second period, or the rate of net
investment spending in the second
period, depends on the MEI schedule.
With MEC now at 8 per cent, the new
MEI schedule, relating investment
expenditures to the interest rate, must
show zero net investment at an interest
rate of 8 per cent (point K).
Therefore, MEIb, the new schedule, lies
below MEIa because of the increase in
the stock of capital in the first time
period; the whole MEI schedule must fall
to a lower level with each movement to
a lower point on the given MEC
schedule, MEIb slopes down ward for
the same reason that MEIa sloped
downward—the rising supply price of
capital goods as the rate of output of
these goods is expanded in response to
investment spending.
The rate of net investment spending in
the second period is determined in the
same way as the rate in the first period
was. It will be the rate that reduces the
MEI to equality with r. Schedule MEIb
shows that net investment for the
second period will be 20 billion dollars
(point L). Note that this is below the 30
billion dollars of the first time period.
Given that the prices of capital goods
rise with their rate of output as soon as
net investment reaches the rate of 20
billion dollars per time period, the rise in
prices of capital goods reduces the MEI
from 8 to 6 per cent, or the equality with
r.
In the first period, only when net
investment reached the 30 billion dollars
the rate was the rise in prices of capital
goods sufficient to produce the greater
drop in MEI from 9 to 6 percent, or to
equality with r. In other words, the
greater spread between MEI and the r at
the beginning of the first period
permitted the higher rate of investment
spending in that period.
Net Investment spending of 20 billion schedule or by a change in the market
dollars during the second period raises rate of interest.
the stock of capital to 450 billion dollars
from its level of 430 billion dollars at the Full proof formulas to calculate the
beginning of the second period. The Marginal Efficiency of Capital (MEC).
increase in the capital stock reduces the
The marginal efficiency of capital along
MEC further to about 7 percent (actually
with rate of interest determines the
7.12) which produces the new, lower
amount of new investment, which in
MEI schedule, MEIc. The rate of net
turn, determines the volume of
investment spending in the third period
employment, given the propensity to
as given by this schedule is 10 billion
consume.
dollars.

In the fundamental equation Y = C + I,

This again raises the stock of capital
given by Keynes, we have seen that
now from 450 billion dollars to 460
income at a time depends upon
billion dollars. This in turn reduces the
consumption and investment,
MEC and creates the new, still lower
consumption being stable in the short-
MEI schedule, MEId. The rate of net
run and less than unity—a gap comes to
investment spending in the fourth period
exist which can be wiped off only by an
is then 5 billion dollars. With no shift in
increase in investment.
the MEC schedule and with no further
fall in r, net investment spending, lower
“Investment (in this way) is an essential
in each succeeding period, eventually
requirement for full employment and the
raises the stock of capital to 480 billion
key to prosperity in a capitalistic
dollars, at which level the MEC equals r.
economy.

The actual stock of capital is now the

This is so widely and generally
profit-maximizing stock for the interest
recognized by all economic schools and
rate of 6 per cent. With the capital stock
sects that it may be regarded as an
at 480 billion dollars, the relevant MEI
axiom of modern economics. Not only
schedule is MEIn, which shows net
net investment, but an increasing rate of
investment to be zero and gross
net investment is necessary to assure
investment equal to replacement
continued full employment.”
investment per time period. We have
reached a new equilibrium, which will be
upset only by a shift in the MEC
Marginal efficiency of capital refers to
the anticipated rate of profitability of a
new capital asset. It is the expected rate
of return over cost from the employment
of an additional unit of capital asset.
Marginal efficiency of capital depends
upon the expected rates of return of a
capital asset over its life time (called
prospective yield by Keynes) and the
supply price of the capital asset. It must
be remembered that a businessman
while investing in a new capital asset
will always weigh the expected rates of
net return (profitability) over the life time
of the capital asset (say a machine)
against its supply price (cost) also called
the “replacement cost.” If the former is
greater than the later, the businessmen
will invest, otherwise not.
Prospective Yield:
Prospective yield refers to total net
return (net of all costs, such as
maintenance expenses, depreciation,
raw material except interest charges)
expected from the asset over its life
time. If we divide the total expected life
of the new capital asset into a series of
periods, say years, we may refer to
annual returns as a series of annuities
represented by Q1, Q2, Q3, …, Qn.
We have to add the net return for all
these years to arrive at the prospective
yield. It is, however, very difficult to
estimate correctly the expected return
from a capital asset over its life time
(because, it is difficult to estimate
correctly the life of the capital asset). At
best, we can guess, intelligently
perhaps, but only guess. “An estimate of
what an investment will earn in five, ten
or twenty years hence is based largely
on guesswork, on animal spirits, on
adapting estimates to the average
estimate, which in turn, is based on
uninformed guesses”. Moreover, the
expected return each year is not the
same (except in static society).
In a changing world, the returns from the
capital asset are likely to vary from year
to year. Besides, Keynes considers the
supply price, which means the cost of
the asset (not of the existing asset but of
the new asset), also called the
replacement cost. Thus, MEC is the
ratio of these two elements (prospective
yield and the supply price). In other
words, marginal efficiency of capital
refers to the rate of discount at which
the prospective yield of an asset is
discounted so as to make it just equal to
the supply price of the asset.
Keynes says, “More precisely, I define
the marginal efficiency of capital as
being equal to that rate of discount
which would make the present value of
the series of annuities given by the
return expected from the capital asset
during its life just equal to its supply
price”.
An example will make it clear:
Suppose an investor feels that a given
investment in new capital asset (say a
machine) will cost him Rs. 10,000.
Suppose this machine (unit of capital
asset) is expected to yield over its life
time a net return (net of all costs like
maintenance, depreciation, raw material
except interest charges) of Rs. 500 per
annum.
To find out MEC of the new capital
asset, we would simply calculate the
ratio (expressed as a per cent) of the
expected annual net return [Rs. 500
(prospective yield) divided by Rs.
10,000]. Here, Rs. 500 (prospective
yield) divided by Rs. 10,000 (supply
price), results in a value of 5%
(500/10,000 x 100/1 = 5%)*. The MEC is
5%, i.e., the expected annual net return
on the investment of Rs. 10,000 is 5%. It
may, however, be noted that in a
dynamic economy it is not so easy to
find out the rate of expected return.
Thus,
Supply Price = Discounted Prospective
Yield.
The formula for its calculation is:
where Cr stands for supply price
(replacement cost) of the new capital
asset, Q1, Q2, Q3, …, Qn denote
expected annual rate of return each
year from the capital asset (also called
series of the prospective annual yields),
r stands for the rate of discount which
will make the present value of the series
of annual returns just equal to supply
price of the capital asset. Thus, r
denotes the rate of discount of the
marginal efficiency of capital.
To take a concrete illustration, let us
suppose that the prospective annual
yields from the use of the new capital
asset whose lives in 3 years only are as
follows:
1st year 2nd year 3rd year
Rs. 1,050 Rs. 3,528 Rs. 9,261
Suppose that current supply price of the
replacement cost of the capital asset is
Rs. 12,200. Now 5% must be that
unique rate of discount which will equate
the sum of the discounted values of the
prospective annual yields to the current We want to know that the present value
supply price of the capital asset. of this asset, the discount formula for
finding the present value of a future
income is:

The unique rate of discount (5%) is

called the marginal efficiency of capital. It this equation, Vp, is the present value
R1, R2, …, Rn is the expected income
In this equation the current supply price
stream in absolute amount, and i is the
is known (Rs. 12,200) whereas the
current rate of interest.
present value V,, is unknown. In this
equation the unknown (MEC or r) or If we assume, the current rate of interest
discount rate has been found out which is 5%, we can apply the above formula
makes the present value of the to find the present value of our asset:
expected income stream, Q1, Q2, Q3,
…, Qn equal to supply price (Cr). But
there also exists a mathematical formula
for finding the present value Vp of an
expected future income. It involves
Thus, we find that the present value of
discounting the some expected at some
the asset is Rs. 8,175, an amount less
future date.
than the sum of the absolute amounts to
The process of discounting is just be received in three years. It shows that
the opposite of compounding. It more remote the date in the future at
means shrinkage at a constant rate, which the income is expected, the less
just as compounding means growth its present value—Rs. 3,000 due in
at a constant rate. The usual three years, for example, has a lower
procedure for determining the present present value than Rs. 3,000 due in one
year.
value of some expected income stream
is to discount it at the current rate of
Even, otherwise, we see that if we lend
interest. To see how it works, let us
a sum of Rs. 2,857 for one year and Rs.
assume that there is an asset that yields
2,721 for two years and Rs. 2,597 for
an income of Rs. 3,000 per year for a
three years at 5% rate of interest, we
period of three years (Rs. 9,000 over its
will get Rs. 3,000 after one, two or three
total life span).
years, respectively. Thus, there is some
rate of discount which makes the
present value of prospective returns
from a capital good equal to its supply
price. This is the rate of discount (r)
which Keynes calls MEC of capital.
The marginal efficiency of a particular
type of capital asset is the highest rate
of return over cost expected from an
additional, or marginal unit of that type
of asset. The marginal efficiency of
capital in general is “the highest rate of
return over cost expected from
producing an additional or marginal unit
of the most profitable of all types of
capital asset.” In other words, the
marginal efficiency of capital in general
is the marginal efficiency of that
particular asset, of which the economy
finds it most worthwhile to produce
another or additional unit.
The Investment Demand Schedule:
The above analysis of the behaviour of
investors in respect of new investment is
conceived in the context of the schedule
of the marginal efficiency of capital or
Investment Demand Schedule. It shows
a functional relationship between the
MEC and the amount of investment
indicating that the demand for capital
asset of any given type is a downward
sloping function of the marginal
efficiency of capital.
For “if there is an increased investment
in any given type of capital during any
period of time, the marginal efficiency of
that type of capital will diminish as the
investment in it is increased partly
because the prospective yield will fall as
the supply of that type of capital is
increased, and partly because, as a
rule, pressure on the facilities for
producing that type of capital will cause
its supply price to increase.”
In other word, as investment in a
particular capital asset increases, its
marginal efficiency decreases. The
marginal efficiencies of all types of
capital assets which may be made
during a given period of time represent
the schedule of the marginal efficiency
of capital (also called the investment
demand schedule). The position and
shape of the investment demand
schedule are of major significance in
determining the volume of employment.
The diagram and the table given below
give us the shape of the investment
demand schedule:

We find that when the investment is Rs.
2,000, the MEC is 12%. As the
investment increases, the MEC declines
and finally it is 2% at Rs. 12,000. The
MEC curve is downward sloping,
showing that the MEC declines with an
increase in investment. Figure 18.2
depicts the investment demand curve or
what is also called the MEC schedule
and shows the inverse relationship
between investment and the MEC.
Marginal Productivity of Capital and
Marginal Efficiency of Capital (MPC and
MEC):
Keynes condemned the use of the
marginal productivity of capital (MPC)
and instead used the term marginal
efficiency of capital (MEC).
The difference between the two is as
follows:
1. The term MPC is used by the
economists to denote an increment of
physical product per unit of time on
account of the employment of one more
physical unit of capital. In other words,
MPC is related with an increment of
value due to the employment of one
more value unit of capital. On the other
hand, Keynes used the term MEC to
denote the rate of return over cost,
using the term ‘prospective yields’ for
the series of absolute prospective
returns from a capital good. The
marginal product of capital can be gross
or net. It is gross if estimated before
deducting depreciation otherwise it is
net; while MEC is the rate of discount
which equates the gross marginal
product with replacement cost of the
capital asset.
2. MPC is related with the increment of
value obtained by using an additional
quantity of capital in the existing
situation. MEC relates to the series of
increments which it is expected to obtain
over the whole life of the additional
capital assets. Symbolically, the MPC is
concerned with Q and the MEC with
complete series Q1, Q2, Q3, …, Qr.
Thus, MEC involves the significance of
expectations.
3. In defining the MPC, attention is given
to the current marginal product, i.e., that
absolute annual product, after deducting
running expenses and depreciation
allowances, while Keynes estimated the
MEC as the net return over cost
throughout the whole expected life of
the capital good—the net aggregate
return is obtained after deducting the
running expenses only and not
depreciation. Thus, while the term MPC
refers to the expected current product,
the later refers to the anticipations with
respect to the whole series of
prospective yields from a capital asset.
Marginal Productivity of Capital and
Marginal Efficiency of Capital (MPC
and MEC):
Keynes condemned the use of the
marginal productivity of capital (MPC)
and instead used the term marginal
efficiency of capital (MEC).
The difference between the two is as
follows:
1. The term MPC is used by the
economists to denote an increment of
physical product per unit of time on
account of the employment of one more
physical unit of capital. In other words,
MPC is related with an increment of
value due to the employment of one
more value unit of capital. On the other
hand, Keynes used the term MEC to
denote the rate of return over cost,
using the term ‘prospective yields’ for
the series of absolute prospective
returns from a capital good. The
marginal product of capital can be gross
or net. It is gross if estimated before
deducting depreciation otherwise it is
net; while MEC is the rate of discount
which equates the gross marginal
product with replacement cost of the
capital asset.
2. MPC is related with the increment of
value obtained by using an additional
quantity of capital in the existing
situation. MEC relates to the series of
increments which it is expected to obtain
over the whole life of the additional
capital assets. Symbolically, the MPC is
concerned with Q and the MEC with
complete series Q1, Q2, Q3, …, Qr.
Thus, MEC involves the significance of
expectations.
3. In defining the MPC, attention is given
to the current marginal product, i.e., that
absolute annual product, after deducting
running expenses and depreciation
allowances, while Keynes estimated the
MEC as the net return over cost
throughout the whole expected life of
the capital good—the net aggregate
return is obtained after deducting the
running expenses only and not
depreciation. Thus, while the term MPC
refers to the expected current product,
the later refers to the anticipations with
respect to the whole series of
prospective yields from a capital asset.
Net Present Value
NPV and IRR are two methods for
making capital-budget decisions, or
choosing between alternate projects and
investments when the goal is to
increase the value of the enterprise and
maximize shareholder wealth. Defining
the NPV method is simple: the present
value of cash inflows minus the present
value of cash outflows, which arrives at
a dollar amount that is the net benefit to
the organization.
To compute NPV and apply the NPV
rule, the authors of the reference
textbook define a five-step process to be
used in solving problems:
1.Identify all cash inflows and cash
outflows.
2.Determine an appropriate discount
rate (r).
3.Use the discount rate to find the
present value of all cash inflows and
outflows.
4.Add together all present values. (From
the section on cash flow additivity, we
know that this action is appropriate
since the cash flows have been indexed
to t = 0.)
5.Make a decision on the project or
investment using the NPV rule: Say yes
to a project if the NPV is positive; say no
if NPV is negative. As a tool for
choosing among alternates, the NPV
rule would prefer the investment with the
higher positive NPV.
Companies often use the weighted
average cost of capital, or WACC, as
the appropriate discount rate for capital
projects. The WACC is a function of a
firm's capital structure (common and
preferred stock and long-term debt) and
the required rates of return for these
securities. CFA exam problems will
either give the discount rate, or they
may give a WACC.
Example:
To illustrate, assume we are asked to
use the NPV approach to choose
between two projects, and our
company's weighted average cost of
capital (WACC) is 8%. Project A costs
$7 million in upfront costs, and will
generate $3 million in annual income
starting three years from now and
continuing for a five-year period (i.e.
years 3 to 7). Project B costs $2.5
million upfront and $2 million in each of
the next three years (years 1 to 3). It
generates no annual income but will be
sold six years from now for a sales price
of $16 million.
For each project, find NPV = (PV
inflows) - (PV outflows).
Project A: The present value of the
outflows is equal to the current cost of
$7 million. The inflows can be viewed as
an annuity with the first payment in three
years, or an ordinary annuity at t = 2
since ordinary annuities always start the
first cash flow one period away.
PV annuity factor for r = .08, N = 5: (1 -
(1/(1 + r)N)/r = (1 - (1/(1.08)5)/.08 = (1 -
(1/(1.469328)/.08 = (1 -
(1/(1.469328)/.08 = (0.319417)/.08 =
3.99271
Multiplying by the annuity payment of $3
million, the value of the inflows at t = 2 is
($3 million)*(3.99271) = $11.978 million.
Discounting back two periods, PV
inflows = ($11.978)/(1.08)2 = $10.269
million.
NPV (Project A) = ($10.269 million) - ($7
million) = $3.269 million.
Project B: The inflow is the present
value of a lump sum, the sales price in
six years discounted to the present: $16
million/(1.08)6 = $10.083 million.
Cash outflow is the sum of the upfront
cost and the discounted costs from
years 1 to 3. We first solve for the costs
in years 1 to 3, which fit the definition of
an annuity.
PV annuity factor for r = .08, N = 3: (1 -
(1/(1.08)3)/.08 = (1 - (1/(1.259712)/.08 =
(0.206168)/.08 = 2.577097. PV of the
annuity = ($2 million)*(2.577097) =
$5.154 million.
PV of outflows = ($2.5 million) + ($5.154
million) = $7.654 million.
NPV of Project B = ($10.083 million) -
($7.654 million) = $2.429 million.
Applying the NPV rule, we choose
Project A, which has the larger NPV:
$3.269 million versus $2.429 million.
The Internal Rate of Return
The IRR, or internal rate of return, is
defined as the discount rate that makes
NPV = 0. Like the NPV process, it starts
by identifying all cash inflows and
outflows. However, instead of relying on
external data (i.e. a discount rate), the
IRR is purely a function of the inflows
and outflows of that project. The IRR
rule states that projects or investments
are accepted when the project's IRR
exceeds a hurdle rate. Depending on
the application, the hurdle rate may be
defined as the weighted average cost of
capital.
Example:
Suppose that a project costs $10 million
today, and will provide a $15 million
payoff three years from now, we use the
FV of a single-sum formula and solve for
r to compute the IRR.
IRR = (FV/PV)1/N -1 = (15 million/10
million)1/3 - 1 = (1.5) 1/3 - 1 = (1.1447) -
1 = 0.1447, or 14.47%
In this case, as long as our hurdle rate is
less than 14.47%, we green light the
project.
particular investment. However, IRR
does not assess the financial impact on
a firm; it only requires meeting a
minimum return rate.
The NPV and IRR methods can rank
two projects differently, depending on
thesize of the investment. Consider the
case presented below, with an NPV of
6%:

NPV vs. IRR

Each of the two rules used for making

capital-budgeting decisions has its
strengths and weaknesses. The NPV
rule chooses a project in terms of net
dollars or net financial impact on the
company, so it can be easier to use
when allocating capital.

However, it requires an assumed

discount rate, and also assumes that
this percentage rate will be stable over
the life of the project, and that cash
inflows can be reinvested at the same
discount rate. In the real world, those
assumptions can break down,
particularly in periods when interest
rates are fluctuating. The appeal of the
IRR rule is that a discount rate need not
be assumed, as the worthiness of the
investment is purely a function of the
internal inflows and outflows of that