Question One
NPV is characterized by the discounted value of all cash flows less the initial cash outflows from the investment project. That is, it is the variance between the discounted value of cash flows and the future flows of a given investment project (Rose, 2015) . The cash flows are discounted for adjustment of risk of investment opportunity and the time value of money.
The decision rule under NPV is that, accept the project when the value is positive and reject when the value is negative.
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Question Two
Payback period statistic is a non-discounted cash flow method of evaluating the viability of an investment project. According to Rose (2015), it is the period taken by the project to recoup the initial cost of capital investment. Moreover, It is the time required by the investment project to break-even. Therefore, it can be characterized by the length of time beyond which the project should not be accepted. The period is determined by dividing the cost of investment by the annual cash flows.
The decision rule in the method depends on the firm’s payback period target. Investments with shorter paybacks are considered attractive while long paybacks are considered less desirable. The problem with the method is that it ignores the time value of money, unlike other methods of evaluating projects.
Question Three
Internal rate of return (IRR) is the discounted rate of return that yields zero NPV. Therefore, it can be referred to as the rate of return that causes the present value of the future cash flows to be equal to its anticipated cash outflows (Andor, Toth, and Mohanty, 2015). It defines the compound annual rate of return that the project will earn.
The decision rule in IRR is that, accept the project when the IRR value is greater or equal to investment opportunity cost, rejecting projects with lower IRR value than the opportunity cost of capital.
Question Four
Modified internal rate of return (MIRR) is an improvement of the IRR that assumes positive cash flows are reinvested in the company’s cost of capital, compared to IRR that assumes cash incomes are reinvested at the IRR itself. Therefore, according to Bora (2015), it can detect the profitability and cost of the project more accurately. The technique is used in the ranking of investments with equal sizes.
The strength of the technique stems from its flexibility in the addition of any specific anticipated reinvestment rate. Thus, it allows the management to change the assumed rate of reinvestment. The technique generates one solution hence eliminating issues of multiple IRRS. However, it has weakness in that it requires computation of the estimated cost of capital in order to make a decision, the computation may be subjective and vary depending on the assumptions. Also, the technique can lead to sub-optimal decisions, that do not optimize value when several investment alternatives are considered at once. The technique is difficult to understand when there is no financial background.
Problem One
NPV= + + + – I
= – 12000
= (2107.143 +3499.681+601.997+1166.936) - 12000
= -4624.263
NPV=-4624.263.
The company should reject the project because it has a negative NPV.
Problem Two
IRR = NPV= - =o
Using the error method.
Taking r= 5%
NPV=-2671.33
Taking r=1%
NPV=-1753.473
(IRR-1)/-1753.476 = (IRR-5)/-2671.33
-2671.33(IRR-1) -1753.473 (IRR-5)
-2671.33IRR+2671.33=-1753.473IRR +8767.38
=-917.857IRR=6096.05
IRR=-6.642%
MIRR=
FV of positive cash flows
= (2360* ) + (4390* ) + (1520* ) + (980* ) + (1250)
=14135.428
=
= -1
=0.0853
=8.535%
Reject the project because it has a lower IRR and MIRR than the initial cost of capital.
References
Andor, G., Mohanty, S. K., & Toth, T. (2015). Capital budgeting practices: A survey of Centraland Eastern European firms. Emerging Markets Review , 23 , 148-172.
Gallo, A. (2016). A refresher on the internal rate of return. Harvard Business Review Digital Articles , 2-4.
Bora, B. (2015). Comparison between net present value and internal rate of return. International journal of research in finance and marketing , 5 (12), 61-71.
Rossi, M. (2015). The use of capital budgeting techniques: an outlook from Italy. International Journal of Management Practice , 8 (1), 43-56.
