1. Calculation of NPV -
Computation of NPV | |
Initial Cost | $150,000 |
Useful life of Project | 5 years |
Annual Cash Inflow | $50,000 |
Salvage Value | 0 |
Required Rate of Return | 18% |
Item | Years | Amount of Cash Flow | 18 % Factor | Present Value of Cash Flow |
Annual Cash Inflow | 1-5 | $50,000 | 3.127 | $156,350 |
Initial Investment | Now | ($150,000) | 1 | ($150,000) |
Net Present Value | $6,350 |
Investment Decision -
Yes, the project should be accepted, because the net present value is positive ($6,350). Having a positive net present value means the project promises a rate of return that is higher than the Minimum rate of return (18%) required by management.
Internal Rate of Return is 19.87% for factor 3 (Calculations provided below)
Item | Years | Amount of Cash Flow | *IRR- 19.87 % Factor (3) | Present Value of Cash Flow |
Annual Cost Saving | 1-5 | $50,000 | 3 | $150,000 |
Initial Investment | Now | ($150,000) | 1 | ($150,000) |
Net Present Value | $0 |
*IRR Factor | Initial Investment | $150,000 | = | 3 | |
Annual cash inflow | $50,000 |
IRR Calculations with Trial & Error
IRR= (((Change in Rate(20%-19%)/(PV of Lower Cash Inflow-PV of Higher Cash Inflow))* NPV of Lower Rate (19%)) + Lower Rate (19%)
IRR=(((0.01)/(152900-149550))*2900=0.87% +19= 19.87%
Calculations as per below:
NPV with 19 % (Factor- 3.058)
Item | Years | Amount of Cash Flow | 19 % Factor | Present Value of Cash Flow |
Annual Cash Inflow | 1-5 | $50,000 | 3.058 | $152,900 |
Initial Investment | Now | ($150,000) | 1 | ($150,000) |
Net Present Value | $2,900 |
NPV with 20 % (Factor- 2.991)
Item | Years | Amount of Cash Flow | 20 % Factor | Present Value of Cash Flow |
Annual Cash Inflow | 1-5 | $50,000 | 2.991 | $149,550 |
Initial Investment | Now | ($150,000) | 1 | ($150,000) |
Net Present Value | ($450) |
Analysis-
If IRR is greater than or equal to the Required Rate of Return, the company would accept the project as a good investment. In Our case it is more than our Required rate of Return of 18%.
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