In: Finance
If the net present value of a project is positive, which of the following statements is (are) true? Explain why?
i) Its payback period is less than or equal to the cut-off point
ii) Its payback period is more than the cut-off point
iii) Its internal rate of return is less than the cost of capital
iv) Its internal rate of return is more than the required rate of return
Solution:
(i) and (iv) are true
Justification:
(i)The payback period refers to the amount of time it takes to recover the cost of an investment. Simply put, the payback period is the length of time an investment reaches a break-even point. An investment can either have a short or long payback period. A shorter payback period means the investment will be ‘repaid’ fairly shortly, in other words, the cost of that investment will quickly be recovered by the cash flow that investment will generate.
In order to determine whether the payback period is favourable or not, management will determine the maximum desired payback period or cut-off point to recover the initial investment costs.
A short payback period indicates that the investment generates high cash flows in the early part of its economic life, thus resulting to a high present value of cash flows. As a result, there is a greater possibility that NPV will be positive. A short payback period also indicates a high IRR, thus resulting to a greater possibility that the investment's IRR will exceed the cost of capital. And if IRR is greater than the cost of capital, NPV is positive.
(iv) The IRR is defined as the discount rate that makes the present value of the cash inflows equal to the present value of the cash outflows in a capital budgeting analysis, where all future cash flows are discounted to determine their present values.
If the present value of the expected cash outflows is less than the present value of the expected cash inflows then NPV > 0.
If NPV is positive , it implies that IRR is greater than the required rate of return.