Calculation Of NPV, IRR, Payback Period & PI For Investment Decisions

Net Present Value (NPV)

Answer to part a 

Project A
Discount Rate	10%
	Year Save Time On Research and Writing Hire a Pro to Write You a 100% Plagiarism-Free Paper. Get My Paper
	Now	1	2	3
Cost of Machine	-500000
Annual Profit/Loss		145,000	-5,000	6000
Estimated Residual Value				35000
Total Cash Flows	-500000	145,000	-5,000	41000
Discounting Factor	0	0.90909	0.82645	0.75131
Present Value of Cashflows	-500000	131818	-4132.2	30803.9
Net Present Value	-341510.1

Project B
Discount Rate	10%
	Year
	Now	1	2	3
Cost of Machine	-300000
Annual Profit/Loss		90,000	-10,000	20000
Estimated Residual Value				30000
Total Cash Flows	-300000	90,000	-10,000	50000
Discounting Factor	0	0.91	0.83	0.75
Present Value of Cashflows	-300000	81818.2	-8264.5	37565.7
Net Present Value	-188880.5

IRR for Project A

IRR = -50%

IRR for Project B

IRR = -41%

Payback Period= Cost of investment/Annual net cash flow

Project A

Cost of investment = 500000

Annual net cash flow = 158490

Payback Period= 3.15 Years

Project B

Cost of investment = 300000

Annual net cash flow = 111119

Payback Period= 2.70 Years

Profitability Index= PV of future cash flows/Initial Investment

Project A

PV of future cash flows = 158490

Initial Investment = 500000

Profitability Index= 158490/500000

PI=0.32

Project B

PV of future cash flows = 111119

Initial Investment = 300000

Profitability Index= 111119/300000

PI=0.37

The management team of the Vina-Team Joint Ventures needs considered a total cash flows of $ 131818 in year 1, $ -4132.231405 in year 2 and $ 30803 in year 3 for project B. In addition to this, as per the NPV of the project A it is determined as $ -341510.1. This shows that the negative value of the NPV is not favourable. The IRR of the project A is also -50% and profitability index is less than 1. Henceforth, the management should not consider investing in this project with a budget of $ 500000. Moreover, Vina-Team Joint Ventures needs to consider a total cash flows of $ 81818 in year 1, $ -8264 in year 2 and $ 37565 in year 3 for project B. In addition to this, as per the NPV of the project B it is determined as $ -188880.5. The IRR of the project B is depicted as -41% along with a profitability index of 0.37. However, the payback period is less that 3 years. Therefore, with the given budget of $ 500000, the project B is seen to be more profitable in nature. It is recommended that the Vina-Team Joint Ventures needs to proceed with Project B. The main rationale for such a recommendation is due to the fact that the initial investment is low as well as the return is seen to be much more feasible in terms of the project A. This is the main consideration which needs to be taken for the choice of Project B.  

NPV is considered as calculating the PV of the cash flows relating to the opportunity cost of capital deriving the value of the wealth of the shareholders. On the contrary, IRR may not be consistent to the shareholders’ wealth maximisation when compared to NPV. It is not seen to be as efficient with differentiating the two projects with the same IRR on the contrary, NPV is consistent in nature. In addition to this, IRR considers the discounting and the reinvestment of the cash flows at the same rate of discounting factor. Even if the IRR of a project is very good like 35%, it is practically not possible to invest money at this rate. On the contrary, NPV assumes the rate of borrowing along with the rate of borrowing along with the lending near the market rate which are not impractical.

Internal Rate of Return (IRR)

The use of the IRR and NPV is used to evaluate the projects which are often seen to be giving similar findings. Despite of this, there has been several numbers of the projects which has stated that IRR is not as effective as the use of the NPV. The main limitation of the IRR is seen with the consideration of the various types of the factors which was taken into account use of a single discount rate for evaluating each investment. Despite of the simplicity of the one discount rate there has been several numbers of issues relating to the cause of the problem for IRR. In case an analyst is evaluating two projects then it is seen to share a common discount rate along with equal risk, predictability of the cash and shorter time horizon. In this case the IRR will be suitable. However, the main catch is seen with the shorter time horizon for IRR to be a suitable method and in general the over time, discount rates usually change substantially. For instance, the rate of return on the T-Bill may last 20 years as a discount rate, but one-year T-Bill returns between 1% and 12% may last for 20 years.

IRR is not seen to be taking into account any changing discount rates without any modification. Therefore, this is not seen to be suitable for the longer-term projects which are expected to vary. A similar nature of the project for the basic IRR computation is ineffective with the mixture of the multiple positive and negative cash flows. Moreover, a single IRR cannot be used. On recalling the IRR is identified as the discount rate or the interest needed for a single project to break given in the initial investment. In case of the chagrin market conditions there may be multiple IRRs for a project. The projects with longer projects is susceptible to be having additional investments of capital with distinct IRR values. The main form of the advantage for using the NPV over IRR is seen with handling multiple discount rates without any major concern.

It needs to be also seen that NPV includes the various types of the present values of the stream of the cash flows at a discount rate. The IRR on the other hand, has been able to solve the rate of return thereby setting to equal to zero. The focus of the NPV is seen to be solving with a present value of a stream of cash flows along with a definite discount rate. On the other hand, IRR is depicted to consider the rate of return thereby setting the value of NPV equal to zero. It needs to be understood that the IRR has been able to answer the questions like what is rate of the return which can be achieved, whereas NPV is able to consider answering the question whether stream of cash flows is worth at a particular discount rate as per the recent value of the dollar.

Payback Period

The appropriateness of the IRR is depicted to be only valid whether to accept a project or a particular investment plan in which the IRR is greater in compare to the cost of capital. However, in case of any change in the rate of discount there several difficulties in making the comparison. In case there are two or more mutually exclusive projects then the application of IRR is not seen to be effective in nature. In addition to this, some of the various types of the other consideration of NPV it needs to be seen that the discount rate for the NPV is depicted to be remaining constant in nature. However, the calculation of the IRR is seen to be comprising of the NOV to remain at zero and the total rate at which the conditions of the IRR is fulfilled.

The various types of the other disadvantages of using IRR does not consider the primary factors such as the project duration along with the future cost of the project. The IRR is seen to compare the cash flow of the project and the existing cost and excluding factors. The overall disadvantage of the IRR may be summed up with economies of scale ignored, impractical implicit assumption of reinvestment rate and dependency on the contingent projects. The pitfall of the use of the IRR method is seen with ignoring the actual dollar benefits. The project value ranking with IRR is considered with a very limited dollar benefit due to the fact of the increase in the 50% increase in the value of IRR.

The analysis of the implicit assumption of the reinvestment rate which is seen to be depicted with the consideration of the various types of the low IRR. In such a state the receiving the cash flows is seen to be rarely possible in nature. The finance managers are seen to come across various situations in which the project evaluation creates a compulsion for investing in other projects. For instance, investing in big projects needs to arrange for several activities and these projects are dependent with the contingent projects which is to be considered by the manager.

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