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 |
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 |
Present Value Interest Factor at 7.5% |
Present Value |
(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
- On calculating the values, we get the value of r to be 34.9%.
- Therefore, 34.9% is the internal rate of return from the investment in the proposed project.
- As the IRR is 34.9% surpasses the cost of capital 10%, the project must be acknowledged for investment.
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