# Net Present Value And Internal Rate Of Return Finance Essay

In this Finance Assignment I have defined Net Present Value, Internal Rate of Return and relative calculation using my lectures, books and internet. In business future, decision making plays an important role. Increasing shareholder’s assets and profits is key role of organizations. Organizations can give more money and profit to shareholders by taking timely decisions. Wrong decision making also put shareholders money in danger. Net Present Value and Internal Rate perform an active role in decision making in any organization.

Net Present Value is basically a difference between inflows and outflows of present value of cash. Using NPV in capital budgets we can analyze profitability of any investment or projects. Net Present Value analysis helps getting profitability of a project by discounting all future cash inflows and outflows to the present time, using available discount rate. On any investment or project, discount rate is the minimum acceptable rate of return. Organization can expect that rate of return to get an investment comparable risk.

Below is the formula of NPV

(Investopedia 2010)

## Project A

Company’s cost of capital-10%

Discount Factor = 1 / (1+r)n , where ‘ r ’ is the cost of capital.

## Year Cash Flow Amount(\$) Discount Factor Present Value(\$)

0 Initial Cost (200) 1.000 (200)

1 Net Cash Flow 200 0.909 181.8

2 Net Cash Flow 800 0.826 660.8

3 Net Cash Flow (800) 0.751 (600.8)

## Year Cash Flow Amount (\$) Discount Factor Present Value (\$)

0 Initial Cost (150) 1.000 (150)

1 Net Cash Flow 50 0.909 45.45

2 Net Cash Flow 100 0.826 82.60

3 Net Cash Flow 150 0.751 112.65

Company’s cost of capital-10%

Discounted cash flows for Project B

## Q (i) Which project should the firm undertake if its not financially constrained?

Company is not financially constrained so its mean it can go for both given projects. If we consider payback while firm investing in project A it should must gain its investment in first year while investing in project B, firm would have to wait for second year. Calculating Net Present Value of both projects we can see clearly that project A and B have gained Value which states both of these projects have good viability. Firm existing capital can have Value by choosing any given project from these.

## Q(ii) Suppose the company lacks the capital to undertake both projects. Which of the two projects then should the company select?

In a scenario if company loses enough capital to undertake from project A or B, then firm should go for project B because its NPV is higher, which is \$90.7 and with a minimum investment of \$ 150. Firm can add up more value to the capital by accepting project B. Payback process of project A, clearly states that by choosing project A, investment can be achieved back within one year’s time, whereas project B payback process is longer enough compared to A. If considering payback process then firm should undertake project A, but realising that fact that NPV is reliable enough to calculate viability of project, beside this Net Present Value would be more accurate as well.

## Project A

Total present value of future net cash flows = NPV + Initial investment = \$241.8

Profitability index = \$241.8 = 1.209

## Project B

Total present value of future net cash flows = \$240.7

Profitability index = = 1.604

With above calculation’s help we can see now that profitability index is higher in project B as compared to A. We are getting highest profitability index in project B so company should go for project B.

## Internal Rate of Return

Internal Rate of Return is a discount rate where a project’s present value of expected cash inflows equals to a project’s present expected cash outflows. Capital budgeting often use discount rate which makes all cash flows’ Net Present Value equal to zero from a particular project. It can also be described that if Internal Rate of Return of a project is higher, then it is more desirable to undertake. Any project with high Internal Rate of Return would be best considered to undertake by assuming other factors among various projects. (Investopedia 2010)

## Year Cash Flow Amount (\$) Discount Factor Present Value (\$)

0 Initial Cost (200) 1.000 (200)

1 Net Cash Flow 200 1.000 200

2 Net Cash Flow 800 1.000 800

3 Net Cash Flow (800) 1.000 (800)

## NPV = \$0

At 0% discount rate, NPV of Project A is zero.

At 10% discount rate, NPV of Project A is \$41.8

## Year Cash Flow Amount (\$) Discount Factor Present Value (\$)

0 Initial Cost (200) 1.000 (200)

1 Net Cash Flow 200 0.497 99.50

2 Net Cash Flow 800 0.247 198.0

3 Net Cash Flow (800) 0.123 (98.48) NPV = (\$0.98)

At 101% discount rate, NPV of Project A = (\$0.98)

## Year Cash Flow Amount (\$) Discount Factor Present Value (\$)

0 Initial Cost (150) 1.000 (150)

1 Net Cash Flow 50 0.714 35.7

2 Net Cash Flow 100 0.510 51.0

3 Net Cash Flow 150 0.364 54.6

## NPV = (\$8.7)

At 10% discount rate, NPV of Project B is \$90.7.

At 40% discount rate, NPV of Project B is (\$8.7).

## Do the IRR results confirm those obtained from the NPV analysis in terms of which project adds greater value to the firm?

Considering Net Present Value, its more clear that project B is adding higher Value to firm than project A, which is not able to generate a higher value. But if we take a look on project A while considering IRR results then project A should be given higher priority to choose over project B. IRR results do not confirm the results which were obtained from the Net Present Value analysis.