Net Present Value Net Present Value (NPV) is one of two discounting models that explicitly...
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Net Present Value Net Present Value (NPV) is one of two discounting models that explicitly considers the time value of money and, therefore, incorporates the concept of discounting cash inflows and outflows. Net present value (NPV) isthe difference in the present value of the cash inflows and outflows associated with a project and is calculated as follows: where I = The present value of the projects cost (usually the initial outlay) = The cash inflow to be received in period t, with t=1, ..., n i = The required rate of return n = The useful life of project t = The time period P = The present value of the projects future cashinflows , the discount factor Net present value measures the profitability of an investment. If the NPV is positive, it measures the increase in wealth. For a firm, this means that the size of a positive NPV measures the increase in the value of the firm resulting from an investment. To use the NPV method, a required rate of return must be defined. The required rate of return is theminimum acceptable rate of return . It is also referred to as the discount rate or the hurdle rate and should correspond to the cost of capital. The cost of capital is a weighted average of the costs from various sources, where the weight is defined by the relative amount from each source. In theory, the cost of capital is the correct discount rate, although, in practice, some firms choose higher discount rates as a way to deal with the uncertain nature of future cash flows. Internal Rate of Return The Internal Rate of Return (IRR) is defined as the interest rate that sets the present value of a projects cash inflows equal to the present value of the projects cost. In other words, it is the interest rate that sets the projects NPVbelow zero . The following equation can be used to determine a projects IRR: where t = 1, ..., n The right-hand side of Equation 2 is thepresent value of future cash flows and the left-hand side is the investment. I, , and t are known. Thus, the IRR (the interest rate, i, in the equation) can be found by settingI = 0 and solving Equation 2 for i. Once the IRR for a project is computed, it is compared with the firms required rate of return. If the IRR is greater than the required rate, the project is deemed acceptable; if the IRR is equal to the required rate of return, acceptance or rejection of the investment is equal; and if the IRR is less than the required rate of return, the project is rejected. Solving for I to determine the IRR is a straightforward process when the annual cash flows are uniform or even. Since the series of cash flows is uniform, a single discount factor from the present value table can be used to compute the present value of the annuity. Letting df be this discount factor and CF be the annual cash flow, Equation 2 assumes the following form: Solving for df, we obtain: = Investment / Annual Cash Flow Once the discount factor is computed, go to a table of discount factors for an annuity find the row corresponding to the life of the project, and move across that row until the computed discount factor is found. The interest rate corresponding to this discount factor is the IRR. Scenario 1 Star Company is considering production of a surface tablet with the following associated data: Expected annual revenues, $3,000,000. A projected product life cycle of five years. Equipment costs $3,200,000 with a salvage value of $400,000 after five years. Expected increase in working capital, $400,000 (recoverable at the end of five years). Annual cash operating expenses are estimated at $1,800,000. The required rate of return is 12 percent.
Required: 1. Estimate the annual cash flows for the tablet project by completing the following table:
Net Present Value Net Present Value (NPV) is one of two discounting models that explicitly considers the time value of money and, therefore, incorporates the concept of discounting cash inflows and outflows. Net present value (NPV) isthe difference in the present value of the cash inflows and outflows associated with a project and is calculated as follows: where I = The present value of the projects cost (usually the initial outlay) = The cash inflow to be received in period t, with t=1, ..., n i = The required rate of return n = The useful life of project t = The time period P = The present value of the projects future cashinflows , the discount factor Net present value measures the profitability of an investment. If the NPV is positive, it measures the increase in wealth. For a firm, this means that the size of a positive NPV measures the increase in the value of the firm resulting from an investment. To use the NPV method, a required rate of return must be defined. The required rate of return is theminimum acceptable rate of return . It is also referred to as the discount rate or the hurdle rate and should correspond to the cost of capital. The cost of capital is a weighted average of the costs from various sources, where the weight is defined by the relative amount from each source. In theory, the cost of capital is the correct discount rate, although, in practice, some firms choose higher discount rates as a way to deal with the uncertain nature of future cash flows. Internal Rate of Return The Internal Rate of Return (IRR) is defined as the interest rate that sets the present value of a projects cash inflows equal to the present value of the projects cost. In other words, it is the interest rate that sets the projects NPVbelow zero . The following equation can be used to determine a projects IRR: where t = 1, ..., n The right-hand side of Equation 2 is thepresent value of future cash flows and the left-hand side is the investment. I, , and t are known. Thus, the IRR (the interest rate, i, in the equation) can be found by settingI = 0 and solving Equation 2 for i. Once the IRR for a project is computed, it is compared with the firms required rate of return. If the IRR is greater than the required rate, the project is deemed acceptable; if the IRR is equal to the required rate of return, acceptance or rejection of the investment is equal; and if the IRR is less than the required rate of return, the project is rejected. Solving for I to determine the IRR is a straightforward process when the annual cash flows are uniform or even. Since the series of cash flows is uniform, a single discount factor from the present value table can be used to compute the present value of the annuity. Letting df be this discount factor and CF be the annual cash flow, Equation 2 assumes the following form: Solving for df, we obtain: = Investment / Annual Cash Flow Once the discount factor is computed, go to a table of discount factors for an annuity find the row corresponding to the life of the project, and move across that row until the computed discount factor is found. The interest rate corresponding to this discount factor is the IRR. Scenario 1 Star Company is considering production of a surface tablet with the following associated data: Expected annual revenues, $3,000,000. A projected product life cycle of five years. Equipment costs $3,200,000 with a salvage value of $400,000 after five years. Expected increase in working capital, $400,000 (recoverable at the end of five years). Annual cash operating expenses are estimated at $1,800,000. The required rate of return is 12 percent.