Question

An investment project has the following cash flows: CF0 = -1,000,000; CF1 – CF8 = 200,000 each. If the required rate of return is 12%:

a.       What decision should be made using NPV? (5%)

b.      How would the IRR decision rule be used for this project? What decision would be reached? (10%)

             c.       How are the above two decisions related? (10%)

Answer 1

A. Net Present Value (NPV) = Present value of Cash Inflow - Present Value of Cash Outflow.

NPV = 2,00,000 * PVAF ( 12% , 8Year) - 10,00,000

NPV = 2,00,000 * 4.968 - 10,00,000

NPV = 9,93,527.95 - 10,00,000

NPV = -6,472.05

It is advised to the company is not to accept the project because it gives loss of amounting to -6472.05

Note -

PVAF stands for Present value Annuity Factor and it is calculated by using calculator.

B. IRR -

Let r = 10%

Then,

Net Present Value (NPV) = Present value of Cash Inflow - Present Value of Cash Outflow.

NPV = 2,00,000 * PVAF ( 10% , 8Year) - 10,00,000

NPV = 2,00,000 * 5.335 - 10,00,000

NPV = 10,66,985.24 - 10,00,000

NPV = 66,985.24

Let R = 15%,

Then,

Net Present Value (NPV) = Present value of Cash Inflow - Present Value of Cash Outflow.

NPV = 2,00,000 * PVAF ( 15% , 8Year) - 10,00,000

NPV = 2,00,000 * 4.487 - 10,00,000

NPV = 8,97,464.30 - 10,00,000

NPV = -1,02,535.70

IRR = Lower Rate + (Lower Rate NPV / Lower Rate NPV - Higher Rate NPV)* (Higher Rate - Lower Rate)

IRR = 10% + (66,985.24 / 66,985.24 + 1,02,535.70)* (15% - 10%)

IRR = 11.976%

C. It is advised to not accept the project that gives negative NPV i.e. Losses during the year. And IRR @ 11.976% is the rate where the NPV of this Project is zero i.e. The project if return is 11.976% gives 0 return.

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