Investments: Net Present Value and Investment

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Initial investment

An initial investment is the money a business owner needs to start up a firm. It might include the business owner's own money, money borrowed from an array of sources including family and friends or banks, or capital raised from investors. The term initial investment is also used as the money a business owner uses to invest in a capital investment venture such as a piece of equipment or a building.

The higher a projects internal rate of return, the more desirable it is to invest in the project. Some ways to use the IRR method are: • Discounted Cash Flow Analysis - Find the interest rate return that you would receive as your investment return rate. • Capital Budget Planning - Go through the capital budget process so that you make the best economic decision. • Discounted Cash Flow Analysis - When you calculate IRR you will have one number for an objective comparison between capital projects. • Investment Calculator - Determine if a potential investment is a good choice or not. • Compound Rate of Return - Understand the compounding effect of interest on investments. ("Calculating internal rate,")

Deciding between investments

You are deciding between two mutually exclusive investment opportunities.  Both require the same initial investment of $10 million.  Investment A will generate $2 million per year (starting at the end of the first year) in perpetuity.  Investment B will generate $1.5 million at the end of the first year and its revenues will grow at 2% per year for every year after that.

a. Which investment has the higher IRR?


Since IR is defined as the rate of return that makes the NPV = 0:

Investment A:

Setting NPV = $0, and solving for r

$0 = [pic]


r = [pic]

IRR = 20%

Investment B:

Setting NPV = $0, and solving for r

$0 = [pic]


r -0.02 = [pic]

r – 0.02 = 0.15

r = 0.15 + 0.02

IRR = 17%

b. Which investment...
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