Question

How does the NPV, IRR and the payback period of an Investment usually react to the following developments (please indicate, UP/DOWN or N/A)?

1. Increasing Investment amount

2. Increasing tax rate

3. Increased annual depreciation due to change of depreciation method

4. Increasing cost of capital

5. Increasing residual value

So I actually Need 15 indications (5*3) - TIA

Answer 1

1.         Payback Period (PBP)

            One of the most popular and widely recognized traditional methods of evaluating capital investment proposal is the payback period. It is the number of years it takes a firm to recover its original investment from net cash flows. The payback period of an investment is the length of time required for the cumulative total net cash flows from the investment to equals to total initial cash outlays.

General Rule – Earlier the better.

2.         Net Present Value (NPV)

            It is the Present value of the projects net cash flows discounted at the company’s cost of capital to the time of the initial capital outlay, minus that initial capital outlay.

General Rule – Higher the NPV, better it is.

3.         Internal rate of Return (IRR)

            IRR is the rate of return at which present value of cash inflows equals to present value of cash outflows.

General Rule – Higher the better.

Impact of various factor on NPV , IRR and payback period provided in below table -

		NPV	IRR	Payback Period	Reason
1	Increasing Investment Amount	Down	Down	Up	As it increase the cash outflow
2	Increasing Tax rate	Down	Down	Up	As it increase the cash outflow
3	Increased Annual Depreciation	Up	Up	Down	It will increase the tax shield resulting increase in cash-inflow
4	Increasing cost of capital	Down	N.A	N.A	Cost of capital only relevant for NPV. Increase cost of capital reduce the PV of cash inflow.
5	Increasing residual value	Up	Up	N.A	Increase the Cash inflow. Not relevant for Payback period as salvage value received at the end of period

1) Internal rate of Return (IRR) is the rate at PV of cash-inflows equals to the PV of cash-outflow, which means IRR depends upon the Cash flows that's why Cost of capital (required rate of return) has no impact on the IRR. Further, Payback period doesn't consider the time value of money that's why cost of capital has no impact on payback period.

2) Payback period is the period in which cash inflows recover the initial capital investment (cash outflow) and salvage cash inflow received at the end of project that's why it has no impact on payback period. If project fails to recover the initial capital investment till end of the project then there would be no payback period for the period.

3) As discussed in Point-1, IRR depends upon the cash flows and residual/salvage is a cash inflow for the project that's why it increases the IRR of the project.