BGA1 Task 4
Bonds and Debt
Net present value (NPV) method is used to decide whether or not a company should take on a new project or acquisition. The formula for NPV is the difference between the present value of a project’s cash inflows and its cash outflows. To calculate the present values the future cash flows are discounted using the time value of money method. For the project to be accepted the NPV should be positive, because it means the return is greater than the required rate of return; or zero, because that means the return is equal to the required rate of return. However, if negative the project should be rejected, because its return is less than the required rate of return. This required rate of return is also referred to as the cost of capital. When cost of capital is used a discount rate it serves as a screening device to advise the company on accepting or discarding the new venture. For the project to be accepted the required rate of return used should be at least as high as the cost of capital. The company might also use the weighted average cost of capital; which is the average rate of return for the company to pay its long-term creditors and shareholder for the use of their funds.
The internal rate of return (IRR) is defined as the discount rate that results in a net present value of zero. IRR uses the time value of money method to calculate the present value of the projects cash inflows and outflows. Cost of capital, or minimum required rate of return, is compared to the IRR to evaluate a project. The IRR needs to be equal to or greater than cost of capital for the project to be acceptable. If the IRR is less than the cost of capital, the project should be rejected. When using IRR the cost of capital is referred to as the “hurdle rate”.