Table Npv Calculation For Project A

Cash

Year Inflows Present Value

Present value of cash inflows $ 8,722

This indicates that the cash inflows discounted to the present will not recover the initial investment. This, in fact, is a bad investment to consider. Previously, we stated that the cash flow stream yielded a payback period of four years. However, using discounted cash flow, the actual payback is greater than five years, assuming that there will be cash inflow in years 6 and 7.

If in Table 14-16 the initial investment was $5,000, then the net present value would be $3,722. The decision-making criteria using NPV are as follows:

• If the NPV is greater than or equal to zero dollars, accept the project.

• If the NPV is less than zero dollars, reject the project.

A positive value of NPV indicates that the firm will earn a return equal to or greater than its cost of capital.

The internal rate of return (IRR) is perhaps the most sophisticated capital budgeting technique and also more difficult to calculate than NPV. The internal rate of return is the discount rate where the present value of the cash inflows exactly equals the initial investment. In other words, IRR is the discount rate when NPV = 0. Mathematically

The solution to problems involving IRR is basically a trial-and-error solution. Table 14-17 shows that with the cash inflows provided, and with a $5,000 initial investment, an IRR of 10% yielded a value of $3,722 for NPV. Therefore, as a second guess, we should try a value greater than 10% for IRR to generate a zero value for NPV. Table 14-17 shows the final calculation.

The table implies that the cash inflows are equivalent to a 31% return on investment. Therefore, if the cost of capital were 10%, this would be an excellent investment. Also, this project is "probably" superior to other projects with a lower value for IRR.

14.25 INTERNAL RATE OF RETURN (IRR)

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