Question

Prepare a pro-forma statement by using assumptions to calculate the annual operating net cash flow for three years to calculate the the NPV and IRR.

Assess project feasibility using NPV and IRR method.

Company is Z-energy

For the data part you can refer to the Yahoo finance or assume any relevant data according to the company

Answer 1

Answer :-

1). Net present value (NPV):- The NPV of an investment proposal / investment project is defined as the sum of the present value of all the cash inflows less the sum of present value of all the cash outflows associated with an investment proposal. The investment proposal which is having high annual NPV is generally selected for investment decision.

Advantages of NPV Method:-

a). NPV method recognizes the time value of money.

b). NPV method is based on cash flow rather than accounting profit.

Disadvantages of NPV method :-

a). It required the pre-determination of the required rate of return which itself is a difficult job.

b). It does not provide own rate of return. It evaluate investment project against the minimum rate of return.

2). Internal rate of return (IRR):- IRR is the discount rate at which the present value of cash inflows and present value of cash outflow is equal. In other words, IRR is defined as the discount rate which produces zero net present value (NPV).

The investment alternative which has high IRR is generally accepted i.e., selected for investment opportunity.

Advantages of IRR :-

a). All cash flows are considered in IRR calculation.

b). IRR consider time value of money.

Disadvantages of IRR :-

a). IRR involves tedious calculation.

b). It is assumed in such method (IRR) that all funds (i.e., cash flows) earn rate equals to internal rate of return which is not correct.

Conflict between NPV and IRR: -

Two investment proposal / project may give the conflicting result as per Net present value (NPV) and Internal rate of return (IRR) method. Such conflict arises in the finance due to any of the following three reasons: -

1). Time Disparity: - Short term project have higher IRR whereas Long-term project have higher NPV.

2). Size Disparity: - Project uses high investment have high NPV and project uses low investment have high IRR.

3). Reinvestment rate assumption: - In IRR, it is assumed that intermediate cash inflow in a project is reinvested at IRR itself whereas in NPV it is assumed that intermediate cash flow is reinvested at the rate of cost of capital.

Conclusion: - IRR measures only the quality of investment while NPV takes into account both the quality and the scale of investment. This is because the IRR provide a relative measure of value while NPV provides an absolute measure of value in the finance.