Question

Give a real-life example of how each of the three calculations can be used in real life situations

Payback

NPV

IRR

Answer 1

Payback, NPV and IRR can be used in real life when making capital investment decisions.

The capital investment process is the method of analyzing and selecting long term investments which are in line with the goal of companies wealth maximization.

The capital investment process decisions are important, vital and significant business decisions because:

1.substantial expenditure involved.  

2. long period for the project.  

3. irreversibility of decisions.

4. The complexity involved in decision making.

Good Example:

House rent or Buy.

And Suppose we buy the house then it's purchasing amount is a cash outflow.

And the amount we save in rent its cash inflows.

Suppose we have multiple options in Houses to buy: say House 1, House 2, House 3...

1. Payback period: it is the amount of time required to recover the original cost of the project.

The House with the lowest payback period is given the priority.

2. Net present value.

NPV = present value of cash inflow- the present value of cash outflow.

Discounted at the cost of capital/required rate of return.

NPV must be positive to accept the House.

House with the highest NPV is chosen.

3. Internal rate of return (IRR)

IRR: It is the discount rate at which the present value of projects cash outflows (cost) is equal to the present value of projects cash inflow.

The IRR must be above the cost of capital/required rate of return to accept the project.

House with the highest IRR is preferred.