Question

1. In paragraph form (100 words or more) state the definition and their values. (ANALYSED THEM)

1. IRR
2. NPV
3. Payback
4. Discounted payback
5. WACC (weighted average cost of capital)

Answer 1

1. NPV:

NPV in expanded form is Net Present Value. It is important concept when a decision is to be made for investment of money in some project or asset. If an amount is to be invested (out-flow) to earn returns (in-flows) over a period of time, the NPV shall be the difference between the present value of all the cash in-flows in the future and present value of out-flow. So, formula is

NPV = (Present Value of All future cash in-flows) - (Investment out-flow)

or mathematically

Present Value = PV = F / (1 + r)^t

where, F = Future Cash Flow; r = rate of return of other safe investment per term; t = number of terms;

Hence, If I = Investment out-flow and F1, F2, F3......Fn are the future cash in-flows at time t1, t2, t3, .....tn and rate of return is r then

NPV = ( F1/(1+r)^t₁ + F₂/(1+r)^t₂+ F₃ / (1+r)t₃ ........F_n / (1+r)^t_n - I

This tool come handy, when there are more than one investment opportunities and they are needed to be compared to take a decision, which one to chose. The opportunity or project with highest NPV should be the right choice. But, it is very important to predict the future cash flows with as much confidence possible to ensure the best results.

2. IRR

IRR is expanded as Internal Rate of Return. Mathematically, it is the rate of return that make the NPV of a project or investment zero. The formula is same as above. We have to calculate for the r. This can be used similar to NPV, to decide on which investment or project is to be undertaken. The project with highest IRR is the best project, given IRR is higher than the cost of capital (the rate at which business borrows the money) for that business. IRR is called internal rate of return because it calculates the intrinsic rate of return built into the cash in and out flows, while ignoring the cost of capital, inflation, etc means the external factors that normally impacts the business.

NPV = ( F1/(1+r)^t₁ + F₂/(1+r)^t₂+ F₃ / (1+r)t₃ ........F_n / (1+r)^t_n - I = 0 (solve for r)

3. Payback

Payback is the time by when the investment made breaks even. That means that if an investment is made now, and the cash inflows over a certain period make up for the investment (cash is recouped), then that time is called payback period. Any returns earned after that period are going to add to the return. The earlier in the payback in a business is better. This is also a tool that is used in business decision making.

4. Discounted Payback

It is same as payback, but in this case, the cash inflows are discounted with the expected rate of return (r) as mentioned above. Hence, it is the time when I (investment) - PV of all cash inflows is zero.

5. WACC

Weighed Average Cost of Capital is the average cost of capital that is available to a business from all the sources like equity, debt, short term loans, bonds, etc. While calculating the rate WACC proportionate weight is assigned for the contribution of each type of money available in the total money available for the business. Given that interest is the cost that is deducted while paying out the taxes, hence cost of debt is multiplied by (1 - t), where t is tax rate.

Hence, the formula is

WACC = (E/V) (Ce) + (D/V) * (Cd) (1-t)

Where,

E = Market Value of Equity

D = Market Value of Debt

Ce = Cost of Equity

Cd = Cost of Debt

V = D + E = Total market value of business.