Question

Ezzell Corporation is considering a new project. It requires initial costs of $25,000 and is expected to generate annual cash inflows of $1,000, -$3,000, $6,000, $8,000, and $15,000 in the following five years. Suppose the cost of capital to finance the project will be 10%.

1. Use the NPV rule to make a decision on the acceptance of the project and justify your choice.
2. What does the IRR rule say about the project?
3. In general, discuss the advantages and disadvantages of NPV vs. IRR when they are used to select long term investment projects.

Answer 1

NPV =Pv of inflows -Initial Outflow.

Here Excel is used to calculate NPV.NPV is calculated using the formula =NPV(10%,B3:B7)+B2.NPV is -7284.43.

Since the NPV is negative the project is rejected.

The IRR of the project is the rate at which the NPV =0.IRR can be calculated using the function.=IRR().The formula used is =IRR(B2:B7).IRR is equal to 1.75%.Since IRR is lower than the cost of capital which is 10%.the project is rejected.

NPV VS IRR

NPV

NPV(net Present Value)

NPV =Pv of inflows -Initial Outflow.The NPV method is used by firms to asses the viability of the project.Projects with a positive NPV are accepted since they add value to the firm.NPV is measured in dollar value.It is an absolute measure.

IRR(Internal rate of return)

Internal rate of return refers to the rate at which the NPV of a project =0.It is expressed as a percentage.It is a relative measure.

When it comes to the decision making process NPV is preferred by firms,this is because of the fact that IRR makes the implicit assumption that the cash flows are re invested at IRR which is an unrealistic assumption and also because NPV is a dollar figure while IRR is a percentage.