Net Present Value and Correct Answer

Internal Rate of Return is a discount rate in which the net present value of an investment becomes zero. The investment should be accepted if the IRR is not less than the cost of capital. The IRR measures risk, by showing what the discounted rate would have to reach to lose all present value. Futronics Inc. investment would have an IRR of 14.79%. The investment should be accepted since it is greater than the 8% cost of capital. The 14.79% IRR shows the growth expected from the

The payback’s reciprocal would be more useful for projects with very long lives. The payback reciprocal is best used when the useful life of an investment is twice the payback period. The IRR rises when the useful life of an investment increase which would then get closer to the higher reciprocal.

Now we want to examine the analysis business report concerning the cost of capital that has been increased at 28% in accordance with the Net Present Value which is $500,000 the question being would still be worth it to make the investment to the company (Needles, 2010). While at the same time the internal rate of return is still at 21% which is lower than the 25% in the expenditures. In reflection of these calculations the investment would not

The present value of an outlay in perpetuity for a particular project can be calculated as follows:

For the purpose of calculating the net present value of the project, an appropriate cost of capital has to be calculated at which free cash flows of the project should be discounted. Since the project will be solely financed by selling new shares, cost of equity will be used as the discount rate. Beta for the company can be assumed to be equal to average of the betas of the competitors of the company. This average beta value comes out to be 1.2. Risk free rate is 0.17% while risk premium has been estimated to be 6%. Thus by putting these values in CAPM formula, we can find the cost of equity for the company which is 7.39%.

See Table 1: Expected non-operating cash flow when the project is terminated at year 4 = 165,880$

Thus, by year three the company will be making a profit off the investment as year three is 86.73 million profit by 55.35 cost giving the company a 31.38 million dollar surplus. Generally, a period of payback of three year or less is acceptable (Reference Entry) causing this project to be viable based off the payback analysis. Although, these calculations are flawed. The reason for this is because the time value of money is not taken into effect when calculating payback periods which is where IRR can further assist in a more realistic financial picture (Reference Entry).

The payback period looks at a project only until the costs have been recovered. This analysis tool is often ignored because it does not take into consideration the time value of money. The time value of money limitation of the payback period can be modified by using the discounted cash flows of a project for the analysis of when the outflows will be recovered.

6.The Year 0 net investment outlay for the project is $-475,000. This computed by adding the price of the machinery, installation, shipping, and the change in net working capital. The non-operating cash flow when the project is

Net Present Value and Internal Rate of Return can disagree when the initial investments are substantially different as well but in this case the initial investment was the same.

The PAYBACK technique is based on cash flows and it measures the time which is required for a proposal’s initial cash outflow to equal its cash inflow generated by the investment, the solution is expressed in years and month or days.

The internal rate of return (IRR) and the net present value (NPV) techniques are 2 investment decision tools that satisfy the 2 major criteria for the correct evaluation of capital projects. This criterion is that the techniques should incorporate the use of cash flows and the use of the time value of money. This makes them viable techniques for evaluating investment proposals.

There are three important criticisms of the payback period method. The first is clearly fundamental and relates to the fact that cash flows after the payback period are ignored. So it could be the case that whilst a project produces a large net cash flow (i.e., where cash inflows significantly exceed outflows), they are generated in the later part of the project and may be ignored as this is after the payback period. For example, in the case of project A and B in this question , project B was preferred because of its shorter payback period, but overall project A generates more cash inflows, totaling £2,10,000 as compared to only £2,00,000 in the case of project B. However, project A`s cash inflows were mainly earned in the later years.

The use of an accounting rate of return also underscores a project 's true future profitability because returns are calculated from accounting statements that list items at book or historical values and are, thus, backward-looking. According to the ARR, cash flows are positive due to the way the return has been tabulated with regard to returns on funds employed. The Payback Period technique also reflects that the project is positive and that initial expenses will be retrieved in approximately 7 years. However, the Payback method treats all cash flows as if they are received in the same period, i.e. cash flows in period 2 are treated the same as cash flows received in period 8. Clearly, it ignores the time value of money and is not the best method employed. Conversely, the IRR and NPV methods reflect that The Super Project is unattractive. IRR calculated is less then the 10% cost of capital (tax tabulated was 48%). NPV calculations were also negative. We accept the NPV method as the optimal capital budgeting technique and use its outcome to provide the overall evidence for our final decision on The Super Project. In this case IRR provided the same rejection result; therefore, it too proved its usefulness. Despite that, IRR is not the most favorable method because it can provide false results in the case where multiple negative

This is similar to the payback period but more reliable and accurate as the cash flows use in it are discounted by using the company’s cost of capital which is described as above. All the other things are same for the calculation part as like payback period but the cash flows will be different. As in this case we can see the different answers for both the corporation in both the scenarios of Payback period and Discounted Pay back periods. Results for both the corporation A and Corporation B is 4.6 years and 4.24 years respectively.