Chapter 7— Net Present Value and Other Investment

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Finance for managers

Chapter 7— Net Present Value and Other Investment

Question 1 : List the methods that a firm can use to evaluate a potential investment.

There are discounted and non-discounted cash-flow capital budgeting criteria to evaluate proposed investments. They are

1) Net present value: NPV is a discounted cash flow technique, which is the difference between an investment’s market value and its cost.

NPV = Present value of cash inflow- Present value of cash outflow

The investment should be accepted if the net present value is positive and rejected if it is negative.

2) Profitability index: PI is a discounted cash flow technique in which present value of an investment’s future cash inflows divided by its initial cash outflow. It is also called benefit/cost ratio.

PI = PV of cash inflows / PV of cash outflows

If PI is positive, it will be accepted otherwise reject.

3) Internal rate of return: IRR is the discount rate that equates the present values of cash inflows with the initial investment associated with the project thereby causing NPV = 0

If IRR ≥ required rate of return the project is accepted. If IRR < required rate of return the project is rejected.

4) Payback period: Payback period is the exact amount of time required for a firm to recover its initial investment in a project as calculated from inflows. It is a non-discounted cash-flow technique.

5) Discounted payback period: The time required for the discounted future cash flow at the firm’s required rate of return of a project to recoup the initial outlay is called discounted payback period. An investment is accepted if its discounted payback period is less than prescribed number of years.

6) Accounting rate of return: ARR is a non-discounted cash flow method in which accounting information’s are used rather than cash flows.

ARR= (Average annual profit after tax/Average investment over the life of the project) * 100.

Question 2 : Why is the NPV a preferred method when evaluating a potential investment opportunity?

NPV is the process of valuing an investment by discounting its future cash flows minus the initial outlay. The investment should be accepted if the net present value is positive and rejected if it is negative.

Most of the companies use both NPV and IRR technique because the theoretical and practical strengths of the approach differ. On a purely theoretical basis, NPV is the better approach to capital budgeting as a result of several factors. Most important is that the use of NPV implicitly assumes that any intermediate cash inflows generated by an investment are reinvested at the firm’s cost of capital. The cost of capital tends to be a reasonable estimate of the rate at which the firm could actually reinvest intermediate cash inflows, the use of NPV, with its more conservative and realistic reinvestment rate is in theory preferable. Use of NPV is not a time consuming because it enhances theoretical superiority.

Question 3 : What is the IRR? How is it related to the NPV? Is the IRR always an effective method when evaluating a potential investment opportunity, and why?

IRR is the discount rate that equates the present values of cash inflows with the initial investment associated with the project thereby causing NPV = 0. If IRR ≥ required rate of return the project is accepted. If IRR < required rate of return the project is rejected. For finding out the IRR, we set NPV equal to zero and solve to find out the discount rate. This discount rate is compared with required rate to find out whether the project to accept or reject. So NPV rule and IRR rule leads to same accept or reject decision.

IRR is always an effective method when evaluating a potential investment opportunity because it helps to calculate the returns on more complicated investments. IRR also have practical advantage because we can still estimate IRR, if we do not know the...
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