Question

Consider an investment that costs $100,000 and has a cash inflow of $25,000 every year for 5 years. The required return is 9% and required payback is 4 years.

What is the payback period?

What is the NPV?

What is the IRR? Can you step by step show me how to calculate the IRR?

Should we accept the project?

What decision rule should be the primary decision method?

When is the IRR rule unreliable?

Answer 1

Payback period=full years until recovery + unrecovered cost at the start of the year/cash flow during the year

                              = $25,000*4 years

                       = $1,000,000.

The payback period is 4 years.

Net present value can be calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= -$100,000. Indicate the initial cash flow by a negative sign since it is a cash outflow.
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the NPV button and enter the required return of 9%.
• Press enter after that. Press the down arrow and CPT buttons to get the net present value.

The net present value is -$2,758.72.

Internal rate of return can be calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= It is -$100,000. It is entered with a negative sign since it is a cash outflow.
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the IRR button and enter the interest rate to get the IRR of the project.

The IRR is 7.93%.

We should not accept the project since it generates a negative net present value.

Net present value is the primary decision method. The NPV shows if the shareholder wealth is increased or decreased. Net present value is the tool of choice for financial analysts. It gives them a clearer picture in making capital budgeting decisions

Cash flows are reinvested at the weighted average cost of capital in case of net present value. It is reinvested at the internal rate of return in case of internal rate of return.

Reinvestment at WACC is the superior assumption, so when mutually exclusive projects are evaluated the NPV approach should be used for the capital budgeting decision.

The internal rate of return is unreliable because the internal rate of return does not factor the changing discount rates, in situations where the discount rate is not known for evaluating a project and in case of projects which have changing cash flows.

In case of any query, kindly comment on the solution.