...1.NPV NPV(Net Present Value), is the present value of a project's cash flow minus the present value of its cost, it means that how much the project could create to shareholders' wealth, the more the NPV, the more value the project makes and the higher the stock's price. If NPV equal to zero means the cash flow which the project makes can compensate for the cost of investment, the rate of return equal to required rate of return. If NPV exceeds zero, the part of exceeded belongs to shareholders. Accept the project which has a positive NPV will create positive economic value added and market value added. In this case, it can be seen clearly from Table 1, SSW and CCS both has a positive NPV, they all create value and wealth for the company. What should be mentioned is that, the NPV of SSW is higher than CCS, it means SSW could add more value than CCS. Table 1. the NPVs of SSW and CCS SSW CCS NPV 240,796.39 226,897.07 2.IRR IRR(Internal Rate of Return ) is the discount rate that make the inflows to equal the initial cost, in other word, it makes NPV to equal to zero. IRR is an estimate of expected project's rate of return. If this return exceed the cost of the capital used to the project, the part of difference is a dividend to shareholders and causes the stock's price to rise. If the IRR is less than cost of capital , shareholders have to make up. In this case, the cost of capital of these two restaurants both equal to 10%, the Table 2 shows that the IRR of SSW is 28.35%...
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...The NPV and IRR methods would in certain situations give the same accept-reject decision. But they may differ in the sense that the choice of an asset under certain circumstances may be mutually contradictory. The two methods would give consistent results in terms of acceptance or rejection of investment proposals in certain situations such as conventional investments or independent proposals. A conventional investment is one in which the cash flow pattern is such that an initial investment is followed by a series of cash inflows. Thus, in the case of such investments, cash outflows are confined to the initial period. The independent proposals refer to investments the acceptance of which does not preclude the acceptance of others so that all profitable proposals can be accepted and there are no constraints in accepting all profitable projects. However, in certain situations they will give contradictory results. This is so in the case of mutually exclusive investment projects. The examples of such projects are technical exclusiveness and financial exclusiveness. The term technical exclusiveness refers to alternatives having different profitabilities and the selection of that alternative which is the most profitable. Thus, in the case of a purchase or lease decision the more profitable out of the two will be selected. The mutual exclusiveness may also be financial. If there are resource constraints, a firm will be forced to select that project which is the most profitable rather...
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...firm needs to evaluate it with a process called capital budgeting and the tool which is commonly used for the purpose is called IRR. This method tells the company whether making investments on a project will generate the expected profits or not. As it is a rate that is in terms of percentage, unless its value is positive any company should not proceed ahead with a project. The higher the IRR, the more desirable a project becomes. This means that IRR is a parameter that can be used to rank several projects that a company is envisaging. IRR can be taken as the rate of growth of a project. While it is only estimation, and the real rates of return might be different, in general if a project has a higher IRR, it presents a chance of higher growth for a company. NPV This is another tool to calculate to find out the profitability of a project. It is the difference between the values of cash inflow and cash outflow of any company at present. For a layman, NPV tells the value of any project today and the estimated value of the same project after a few years taking into account inflation and some other factors. If this value is positive, the project can be undertaken, but if it is negative, it is better to discard the project. This tool is extremely helpful for a company when it is considering to buy or takeover any other company. For the same reason, NPV is the...
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...value (NPV), payback period (PBP) and internal rate of return (IRR) approaches for a project evaluation. It is often said that NPV is the best approach investment appraisal, which I why I will compare the strengths and weaknesses of NPV as well as the two others to se if the statement is actually true. Introduction To start of, the essay will attempt to explain the theoretical rationale of the net present value approach to investment appraisal as well as its strengths and weaknesses. From there, introduce the payback period method and then internal rate of return approach, as well as to consider their strengths and weaknesses. After outlining and explaining the three different approaches, it will finish up with comparing the different three and in a conclusion. NPV Net present value or NPV is an approach used to determine the value of an investment today (present) compared to the value of the investment in the future after taking the inflation and return into account. In simpler words, it compares the value of 1 pound today with the same pound in the future. Net present value is used in capital budgeting to analyze the profitability of an investment. It is usually calculated using tables and spreadsheets such as Microsoft Excel, but the main formula used to calculate net present value looks like this: Where C0 = Cash outflow at time t=0 Ct = Cash inflow at time t r = The discount rate As Ross (2013) states in his book, a project should be accepted if the NPV is greater...
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...Contents 1. Assignment Part A Prepare the case, with recommendations to be presented to the Board of Directors of ProGen. Assess the viability of the project using the NPV, IRR, and Payback methods. 2. Assignment Part B “The IRR rule is redundant as an investment criterion because the NPV rule always dominates. Discuss this statement giving examples where possible. 3. Conclusion “The IRR rule is redundant as an investment criterion because the net present value (NPV) rule always dominates it.” 4. Bibliography References Assignment Part A This report evaluates the viability for marketing and distribution of genetically engineered soya seeds developed by a biotechnology firm. The firm will supply seeds and permit ProGen to market and distribute them under a licence. The evaluation methods used for this proposal are net present value (NPV), internal rate of return (IRR), and Payback methods. Assumptions used for this analysis are summarised below • Marketing cost is assumed to be a sunk cost and therefore not included in the calculation • Cash flow will be considered over 5 years as this is the lifecycle of the product • An annual licence fee included at 1M per annum • Capital investment for vehicles £650k is an upfront payment and therefore not discounted • Year 5 will see a cash inflow of 120K assumed a realistic sum...
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...Key differences between the most popular methods, the NPV Method and IRR Method, include: * NPV is calculated in terms of currency while IRR is expressed in terms of the percentage return a firm expects the capital project to return; * Academic evidence suggests that the NPV Method is preferred over other methods since it calculates additional wealth and the IRR Method does not; * The IRR Method cannot be used to evaluate projects where there are changing cash flows (e.g., an initial outflow followed by in-flows and a later out-flow, such as may be required in the case of land reclamation by a mining firm); * However, the IRR Method does have one significant advantage – managers tend to better understand the concept of returns stated in percentages and find it easy to compare to the required cost of capital; and, finally, * While both the NPV Method and the IRR Method are both discounted cash flow models and can even reach similar conclusions about a single project, the use of the IRR Method can lead to the belief that a smaller project with a shorter life and earlier cash inflows is preferable to a larger project that will generate more cash. * Applying NPV using different discount rates will result in different recommendations. The IRR method always gives the same recommendation. (Wilkinson 2013) It makes this adjustment using a "discount rate" that takes into account inflation, the risk of the project and the cost of capital -- either interest paid...
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...Chapter 11 The Basics of Capital Budgeting Integrated Case 11-24 Allied Components Company Basics of Capital Budgeting You recently went to work for Allied Components Company, a supplier of auto repair parts used in the after-market with products from Daimler, Chrysler, Ford, and other automakers. Your boss, the chief financial officer (CFO), has just handed you the estimated cash flows for two proposed projects. Project L involves adding a new item to the firm’s ignition system line; it would take some time to build up the market for this product, so the cash inflows would increase over time. Project S involves an add-on to an existing line, and its cash flows would decrease over time. Both projects have 3-year lives, because Allied is planning to introduce entirely new models after 3 years. Here are the projects’ net cash flows (in thousands of dollars): 0 1 2 3 | | | | Project L -100 10 60 80 Project S -100 70 50 20 Depreciation, salvage values, net working capital requirements, and tax effects are all included in these cash flows. The CFO also made subjective risk assessments of each project, and he concluded that both projects have risk characteristics that are similar to the firm’s average project. Allied’s WACC is 10%. You must determine whether one or both of the projects should be accepted. A. What is capital budgeting? Are there any similarities between a firm’s capital budgeting decisions and an individual’s investment decisions? ...
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...Integrated Case 11-24 Allied Components Company Basics of Capital Budgeting You recently went to work for Allied Components Company, a supplier of auto repair parts used in the after-market with products from Daimler, Chrysler, Ford, and other automakers. Your boss, the chief financial officer (CFO), has just handed you the estimated cash flows for two proposed projects. Project L involves adding a new item to the firm’s ignition system line; it would take some time to build up the market for this product, so the cash inflows would increase over time. Project S involves an add-on to an existing line, and its cash flows would decrease over time. Both projects have 3-year lives, because Allied is planning to introduce entirely new models after 3 years. Here are the projects’ net cash flows (in thousands of dollars): 0 | -100 -100 1 | 10 70 2 | 60 50 3 | 80 20 Project L Project S Depreciation, salvage values, net working capital requirements, and tax effects are all included in these cash flows. The CFO also made subjective risk assessments of each project, and he concluded that both projects have risk characteristics that are similar to the firm’s average project. Allied’s WACC is 10%. You must determine whether one or both of the projects should be accepted. A. What is capital budgeting? Are there any similarities between a firm’s capital budgeting decisions and an individual’s investment decisions? Answer: [Show S11-1 through S11-3 here.] Capital budgeting is the...
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...Elysian Fields’ maximum payback period criterion of 6 years. NPV E10-2. Answer: Year 1 2 3 4 5 Cash Inflow $400,000 375,000 300,000 350,000 200,000 Total $1,389,677.35 Present Value $ 377,358.49 333,748.67 251,885.78 277,232.78 149,451.63 $1,389,677.35 NPV $1,250,000 $139,677.35 Herky Foods should acquire the new wrapping machine. CAPITAL BUDGETING PROBLEMS: CHAPTER 10 E10-3: Answer: NPV comparison of two projects Project Kelvin Present value of expenses Present value of cash inflows PV) NPV –$45,000 51,542 (PMT $20,000, N $ 6,542 3, I 8, Solve for Project Thompson Present value of expenses $275,000 Present value of cash inflows 277,373 (PMT $60,000, N 6, I 8, Solve for PV) NPV $ 2,373 Based on NPV analysis, Axis Corporation should choose an overhaul of the existing system. E10-4: Answer: IRR You may use a financial calculator to determine the IRR of each project. Choose the project with the higher IRR. Project T-Shirt PV 15,000, N Solve for I IRR 39.08% 4, PMT 8,000 Project Board Shorts PV 25,000, N 5, PMT 12,000 Solve for I IRR 38.62% Based on IRR analysis, Billabong Tech should choose project T-Shirt. E10-5: Answer: NPV Note: The IRR for Project Terra is 10.68% while that of Project Firma is 10.21%. Furthermore, when the discount rate is zero, the sum of Project Terra’s cash flows exceed that of Project Firma. Hence, at any discount rate that produces a positive NPV, Project Terra provides the higher net present value. CAPITAL...
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...of Return HEC – MBA Financial Markets 4-1 IRR Definition • IRR = The discounting rate that makes the Net Present Value (NPV) equal to zero • IRR is also called the Yield to Maturity • YTM used for securities • IRR used for capital expenditures, Venture Capital and Private Equity. HEC – MBA Financial Markets 4-2 IRR • IRR is calculated using the same formula as the NPV except that the rate r is unknown: Fn ∑ (1 + r ) n =V 0 n =1 Where V0 is the initial investment in the project • The IRR is the rate r where the market value is equal to the present value of the future cash flows from the investment. N HEC – MBA Financial Markets 4-3 Computing IRR • The solution to the IRR formula is found through trial and error • Use a calculator or spreadsheet • Timing of cash flows is very important to calculation • Accurate models very carefully model the cash flows • Implementation shortfall arrives in an optimistic model of cash flows and the reality of actual magnitude and timing HEC – MBA Financial Markets 4-4 IRR as an Investment Rule • Many companies have a target return on investment – either through policy or historical results. • In the NPV example, a project was started if the NPV was positive. • In the IRR case, the project is not started unless the return (r) of the project is above a certain threshold. HEC – MBA Financial Markets 4-5 Limitations of IRR and NPV • NPV and IRR can give opposing views of a project • Competition...
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...inflows minus its cost. It shows us how much the project contributes to the shareholders wealth. The NPV of each franchise are: a. NPV of Franchise L – $17.08 (In thousands) b. NPV of Franchise S – $18.17 (In thousands) 2. The rationale behind the NPV method is that if we can determine what the project is worth to the share holders. If the franchises are independent then both should be accepted because they both have a NPV > 0. If the franchises are mutually exclusive Franchise S should be accepted because it has a higher NPV than Franchise L. 3. Yes, the NPVs would change if the cost of capital changed. d. 1. The internal rate of return is the discount rate that forces the present value of the inflows to equal the initial cost. The IRR of each franchise are: a. IRR of Franchise L – 18% b. IRR of Franchise S – 24% 2. The IRR is the expected rate of return of the project just like the YTM is the promised rate of return of a bond. 3. The logic behind the IRR method is that if the IRR of the project is greater than the WACC of the project then the project will be good for the shareholders. Since both franchises have a higher IRR than the WACC of 10% both should be accepted if they are independent. If the franchises are mutually exclusive then Franchise S should be accepted because it has a higher IRR than Franchise L 4. No, the IRRs would not change...
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...Quiz 11 Cost of Capital 1(11-2) NPV and IRR F I Answer: b EASY [i]. A basic rule in capital budgeting is that If a project's NPV exceeds its IRR, then the project should be accepted. a. True b. False 2(11-2) Mutually exclusive projects F I Answer: b EASY [ii]. Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method puts the other one first. In theory, such conflicts should be resolved in favor of the project with the higher IRR. a. True b. False 3(11-3) IRR F I Answer: b EASY [iii]. Other things held constant, an increase in the cost of capital will result in a decrease in a project's IRR. a. True b. False 4(11-4) Multiple IRRs F I Answer: b EASY [iv]. The phenomenon called "multiple internal rates of return" arises when two or more mutually exclusive projects that have different lives are being compared. a. True b. False 5(11-5) Reinvestment rate assumption F I Answer: b EASY [v]. The IRR method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost of capital. a. True b. False 6(11-6) Modified IRR F I Answer: b EASY [vi]. When evaluating mutually exclusive projects, the modified IRR (MIRR) always leads to the same capital budgeting decisions as the NPV method, regardless of the relative lives or sizes of the projects being...
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...CAPITAL BUDGETING 7.1 7.2 7.3 7.4 7.5 7.6 7.7 7.8 7.9 7.10 7.11 Overview 159 The NPV Rule for Judging Investments and Projects 159 The IRR Rule for Judging Investments 161 NPV or IRR, Which to Use? 162 The “Yes–No” Criterion: When Do IRR and NPV Give the Same Answer? 163 Do NPV and IRR Produce the Same Project Rankings? 164 Capital Budgeting Principle: Ignore Sunk Costs and Consider Only Marginal Cash Flows 168 Capital Budgeting Principle: Don’t Forget the Effects of Taxes—Sally and Dave’s Condo Investment 169 Capital Budgeting and Salvage Values 176 Capital Budgeting Principle: Don’t Forget the Cost of Foregone Opportunities 180 In-House Copying or Outsourcing? A Mini-case Illustrating Foregone Opportunity Costs 181 Accelerated Depreciation 184 Conclusion 185 Exercises 186 158 0195301501_158-192_ch7.qxd 11/3/05 12:47 PM Page 159 CHAPTER 7 Introduction to Capital Budgeting 159 OVERVIEW Capital budgeting is finance terminology for the process of deciding whether or not to undertake an investment project. There are two standard concepts used in capital budgeting: net present value (NPV) and internal rate of return (IRR). Both of these concepts were introduced in Chapter 5; in this chapter we discuss their application to capital budgeting. Here are some of the topics covered: • Should you undertake a specific project? We call this the “yes–no” decision, and we show how both NPV and IRR answer this question. • Ranking projects: If you have several alternative investments...
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...of cash outflow. It can be used to calculate the profitability of an investment. Year 0 1 2 3 Project L -100 10 60 80 Disc. Cash Flows -100 9.09 49.59 60.11 Project S -100 70 50 20 Disc Cash Flows -100 63.64 41.32 15.02 Rate = 10% Project L NPV = $18.78 Project S NPV = $19.98 2. The rationale behind the NPV method is that an NPV of zero shows that the projects cash flows are exactly sufficient to repay the invested capital and to provide the required rate of return. A positive NPV means that it is generating more cash than is needed to service the debt and provided to shareholders, vice versa for negative NPV. If both projects were independent, you would accept both projects considering the positive NPV. Both projects add to shareholder wealth in that instance. If they were mutually exclusive you would only accept Project L with the higher NPV. 3. Yes, if the cost of capital changed, then the NPV would change considering it is the basis for the NPV. d. 1. Internal rate of return is the rate of return used in capital budgeting to measure profitability of investments. Year 0 1 2 3 Project L -100 10 60 80 Project S -100 70 50 20 Project L IRR = 18.13% (using function) WACC= 10% Project S IRR = 23.56% 2. The YTM is the expected rate of return on a project as it is the rate to be given on a bond. Essentially,...
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...accounting rate of return. In this paper, I will examine the use of the Net Present Value, and the provisions it makes for specific cases, such as unequal lives and mutually exclusive projects. Then I will conclude with the technique that has been proved the best for investment appraisal through the analysis and comparison of project appraisal techniques. The Net Present Value (NPV) method is used by 75% of firms when deciding on investment projects. The reasons for its wide use is that firstly, the NPV rule takes into account the time value of money, meaning that it recognises that a pound today is worth more than a pound tomorrow as the pound today can be invested to start earning interest immediately. Secondly, NPV depends solely on the forecasted cash flows from the project and the opportunity cost of capital. And the final reason for its preference is because the present values are all measured in today’s pounds they have the property of additivity. This property is important as it helps managers to not be misled into accepting a low NPV project just because it is packaged with a high NPV project (Brealey and Myers 116-19). Other reasons for this widely used...
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