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NPV Criterion, Capital Investment

  NPV Criterion, Capital Investment

As per this, capital investment project should be accepted if NPV > 0. That is, with the given cost of capital parities 6% for capital investment project to be undertaken.

5
Σ      76000        =  76000 +      76000  +          76000  +          76000  +          76000
t=1 (1+r) ^t          (1+r)           (1+r) ^2           (1+r) ^3           (1+r) ^4           (1+r) ^5

                                    5
            NPV    =          Σ               NCFt          - C >0
                                    t=1       (1+0.06) ^t

As computed, above net cash flow NCF is $76000 per year for five years. Therefore,

                                    5
            NPV    =          Σ               76000         200000
                                    t=1       (1+0.06) ^t

                        =          76000 (     1     +      1          +       1      +      1         +  1         )
                                                 (1.06)     (1.06) ^2      (1.06)^3    (1.06) ^4   (1.06) ^5)

                        =          76000 (0.94 + 0.88 + 0.83 + 0.79 + 0.75)

                        =          76000 * 4.19   =          318440

              NPV    =          318440 – 200000        =          118440

Therefore, Net Present Value of the cash flows of the investment project is greater than null which is positive. Hence investment in the project should be embarked on as it will enhance the value of the firm or investor’s wealth.

Illustration 99

Another Printing and Binding Company proposes an investment for purchasing new machinery for binding  for which it has to incur cost of $1250000. It has been valued by the company’s manager that new binding machinery will cause cost saving in the publication of the books.

For which the cost savings it has been valued that it will produce supplementary net cash flows which are given below over its projected life of five years. If the company requires return of 7.5% on investment project, must the investment in the new binding machinery be proposed? Net Present Value Method to be used to evaluate this proposal.

Year

Net Cash Flow
(NCFt)

1

300000

2

400000

3

400000

4

300000

5

125000

Solution

                                    5
            NPV    =          Σ               NCFt          - C*
                                    t=1       (1+0.075) ^t

We compute the present value of cash flows                (NCFt)         in the following table.
                                                                              (1+0.075) ^t

Year

Net Cash Flow
(NCFt)

Present Value Interest Factor at 7.5%
1 / (1.075) ^t

Present Value
PV
(II * III)

(I)

(II)

(III)

(IV)

1

300000

0.93

279000

2

400000

0.87

348000

3

400000

0.81

324000

4

300000

0.75

225000

5

125000

0.70

87500

Total

1263500

Therefore,

                                    5
            NPV    =          Σ               NCFt          - C*
                                    t=1       (1+0.075) ^t

                        =          1263500 – 1250000    =          -13500

Hence, the Net Present Value of the provided investment project is negative and it should not be embarked on.

Illustration 100

Presume an industry is considering investing in a project whose initial investment cost parities $500. Net cash flows from this project which commences after one year is $ 225 every year for 5 years. Industry has to borrow investment funds at 10% per annum from a commercial bank.

Compute the internal rate of return from the project and give suggestion whether to acknowledge or eliminate the project.

Solution

            The internal rate of return can be computed as follows:

R1       +             R2    +             R3    +             R4    +            R5       =        C0
1+r                   (1+r)^2            (1+r)^3            (^41+r)            (1+r)^5

R1 to R5 amounts to $225.

            225      +          225      +          225      +          225      +          225      =          500
           1+r                   (1+r)^2            (1+r)^3           (^41+r)          (1+r)^5

  1. On calculating the values, we get the value of r to be 34.9%.
  1. Therefore, 34.9% is the internal rate of return from the investment in the proposed project.
  1. As the IRR is 34.9% surpasses the cost of capital 10%, the project must be acknowledged for investment.

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