Decisions on investment, which take time to mature, have to be based on the returns which that investment will make. Unless the project is for social reasons only, if the investment is unprofitable in the long run, it is unwise to invest in it now. As a result, most medium-sized and large organisations have developed special procedures and methods for dealing with these decisions. A increases npv investment decision rule cash flow of project B.
A decreases the cash flow of project B. Conventional cash flow: only one change in the cash flow sign e. Non-conventional cash flows: more than one change in the cash flow sign, e. The time value of money Recall that the interaction of lenders with borrowers sets an equilibrium rate of interest. Borrowing is only worthwhile if the return on the loan exceeds the cost of the borrowed funds. Lending is only worthwhile if the return is at least equal to that which can be obtained from alternative opportunities in the same risk class.
Thus we can compute the future value of what Vo will accumulate to in n years when it is compounded annually at the same rate of r by using the above formula. 10 at the end of 5 years? The NPV method is used for evaluating the desirability of investments or projects. At this point the tutor should introduce the net present value tables from any recognised published source.
600 in the first, second and third years respectively. Should the firm go ahead with the project? Attempt the calculation without reference to net present value tables first. Perpetuities A perpetuity is an annuity with an infinite life. Economic rationale for IRR: If IRR exceeds cost of capital, project is worthwhile, i. So, which method leads to an optimal decision: IRR or NPV?
NPV vs IRR: Independent projects Independent project: Selecting one project does not preclude the choosing of the other. If cash flows are discounted at k2, NPV is negative and IRR 2: reject the project. Hence, IRR and NPV lead to the same decision in this case. NPV vs IRR: Dependent projects NPV clashes with IRR where mutually exclusive projects exist. Which project is a “better option” for Agritex? Choosing project B is tantamount to choosing a hypothetical project “B minus A”.
5,500 will be realised each year for the next 3 years. IRR prefers B to A even though both projects have identical initial outlays. 4 Timing of the cash flow The horizon problem NPV and IRR rankings are contradictory. 174 at the end of the fourth year. The profitability index – PI This is a variant of the NPV method. Disadvantage of PI: Like IRR it is a percentage and therefore ignores the scale of investment. The CIMA defines payback as ‘the time it takes the cash inflows from a capital investment project to equal the cash outflows, usually expressed in years’.
Payback period lies between year 2 and year 3. Depreciation is charged on the straight line basis. Allowing for inflation So far, the effect of inflation has not been considered on the appraisal of capital investment proposals. Inflation is particularly important in developing countries as the rate of inflation tends to be rather high. As inflation rate increases, so will the minimum return required by an investor.