Question

Use both the NET present value (NPV) and the Internal Rate of return (IRR) to assess and draw conclusions when advising a company which is wondering whether to K18 000 on an item of equipment in order to obtain cash profits as shown below

                      Year                                          K

                        1                                              6000

                        2                                              8000

3            5000

4                                              1000

Note: The company requires a return of 10% per annum.

Answer 1

Intial Investment, C0 = k 18000

Cashflows in

Year 1, C1 = K 6000

Year 2, C2 = K 8000

Year 3, C3 = K 5000

Year 4, C4 = K 1000

Required rate of return, r = 10%

NPV = Present value of future cashflow - Initial investment

NPV = [ (6000 / (1+ 10%)^1 ] + [ (8000 / (1+ 10%)^2 ] + [ (5000 / (1+ 10%)^3 ] + [ (1000 / (1+ 10%)^4 ]   - 18000

NPV = 5455 + 6612 + 3757 + 683 - 18000

NPV =    K - 1494.30

Since, NPV is negative, company should not invest in this equipment.

Now calculating IRR

At IRR

NPV = 0

[ (6000 / (1+ r%)^1 ] + [ (8000 / (1+ r%)^2 ] + [ (5000 / (1+ r%)^3 ] + [ (1000 / (1+ r%)^4 ] = 18000

solving this will give

r = 5.325%

now, IRR < required rate of return wanted by the company (10%)

Hence, company SHOULD NOT invest in this equipment.

Showing the same calculation in excel:

Discount Rate/WACC (r)	10%
PROJECT W
years	0	1	2	3	4
Cash-Outflows	18,000
Cash-Inflows		6,000	8,000	5,000	1,000
Net Cashflows (Inflow - Outflow)	-18,000	6,000	8,000	5,000	1,000
Discounted Cashflow = Net CF / (1+r)^years	-18,000	5,455	6,612	3,757	683
NPV = sum of all discounted CF	-1,494.30
IRR = IRR (net CF)	5.325%