Question

Consider the following potential investment, which has the same risk as the firm’s other projects:

Time CF

0 ($900,000)

1 $205,000

2 $215,000

3 $220,000

4 $235,000

5 $245,000

6 $250,000

7 $255,000

a) What are the investment’s payback period, IRR, and NPV, assuming the firm’s WACC is 11%?

b) If the firm requires a payback period of less than 4 years, should this project be accepted? Be sure to justify your choice.

c) Based on the IRR and NPV rules, should this project be accepted? Be sure to justify your choice.

d) Which of the decision rules (payback, NPV, or IRR) do you think is the best rule for a firm to use when evaluating projects? Be sure to justify your choice.

Answer 1

a) The following tables explains the investment's payback period, IRR and NPV assuming the firm's Weighted Average Cost of Capital to be 11%.

Payback Period: It represents, in how much time, we can get our investment back. This is done as follows:

From the above table, it is clearly evident that, we are going to get back our investment in 4-5 year. To know the exact period, the following calculation is to be done,

From the table we can see that, in the 5^th year we are having a cumulative cash flow of Rs. $900,000. That is the investment we are investing in the Year 0, is going to earn a net return in the year 5.

The exact payback period is,

= 4 years + ($25,000/$245,000)*1year

= 4 years + 0.10 years

= 4.10 years.

NPV:

NPV refers to the Net Present Value, the measure by which we can decide whether to invest in the project or not. If the NPV is greater than 0, it is profitable to invest, otherwise it is not recommended. NPV is calculated by deducting the discounted cash outflows from the discounted cash inflows and discounting factor used is the Cost of Capital of the Project.

NPV of the proposed investment is as follows:

IRR:

IRR refers to the Internal Rate of Return, it is the rate at which the NPV of the project equals to 0. It is the highest rate of return which can be achieved from the proposed investment.

Generally, it is easy to compute IRR by taking the discounting values at two different discount factors and deriving thereupon.

Since, NPV at 16.5% is $ 2,802.29 and at 17% is $ (10,784.93) , we can find the rate at which NPV will be 0 as follows,

= 17% – [(10,784.93-2,802.29)/10,784.93]*0.50%

= 17% - 0.3701

= 16.6299% or 16.63%

Therefore, IRR is 16.63%

b) If the firm requires a payback period of less than 4 years, this project is not to be accepted, as its payback period is 4.10 years which is more than 4 years.

c) Based on IRR and NPV rules, the project can be accepted. Because NPV is positive with $176,726.07 of net benefit and IRR is 16.63% which is higher than the weigheted average cost of capital.

d) NPV is the best rule for a firm to use when evaluating projects as it clearly takes the time value of money into consideration and it gives the logical figure of the net benefit a firm can get from the proposed investment. IRR is also better but sometimes it won't work in accordance. Payback period is not good as it doesn't consider the concept of time value of money.

Hope this is helpful!!