Net Present Value(NPV) is the difference between the present value of cash inflows and the present value of cash outflows. It is used in evaluating capital budgeting decisions. Projects with NPV greater than 0 are investable.
The profitability index(PI) describes an index that represents the relationship between cost and benefit of a project.
PI = Present value of future cash flows / Initial investment
We accept the project if PI > 1.
The Internal rate of return(IRR) is a measure of an investment’s expected future rate of return. If IRR > cost of capital, we accept the project. IRR is the rate at which NPV is equal to 0.
We can calculate NPV and IRR in excel,
Year | Cash Flows | PV @ 12%(Discounting factor) | Discounted cash flows |
0 | -185000 | 1.000 | -185000 |
1 | 75000 | 0.893 | 66964 |
2 | 63000 | 0.797 | 50223 |
3 | 69000 | 0.712 | 49113 |
4 | 82000 | 0.636 | 52112 |
NPV | 33,412.82 | ||
Present value of future cash flows | 218,412.82 | ||
IRR | 20.20% |
PI = Present value of future cash flows / Initial investment
PI = 218,412.82 / 185,000 = 1.18
a) Hence firms NPV is $33,412.82 and PI is 1.18. As NPV > 0 and PI > 1, the project is investable.
b) The IRR is 20.20%. As it is greater than cost of capital(12%), we accept the project.
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