Use of NPV, IRR and Payback Period in Evaluating Project Cash Flow: Memo

Topic 

Use of NPV, IRR and Payback Period in Evaluating Project Cash Flow: Memo

Assignment Steps 

Resources: Corporate Finance

Create a 350-word memo to management including the following:

  • Describe the use of internal rate of return (IRR), net present value (NPV), and the payback method in evaluating project cash flows.
  • Describe the advantages and disadvantages of each method.

Calculate the following time value of money problems using Microsoft® Excel®: :

  1. If you want to accumulate $500,000 in 20 years, how much do you need to deposit today that pays an interest rate of 15%?
  2. What is the future value if you plan to invest $200,000 for 5 years and the interest rate is 5%?
  3. What is the interest rate for an initial investment of $100,000 to grow to $300,000 in 10 years?
  4. If your company purchases an annuity that will pay $50,000/year for 10 years at a 11% discount rate, what is the value of the annuity on the purchase date if the first annuity payment is made on the date of purchase?
  5. What is the rate of return required to accumulate $400,000 if you invest $10,000 per year for 20 years. Assume all payments are made at the end of the period.

Calculate the project cash flow generated for Project A and Project B using the NPV method.

  • Which project would you select, and why?
  • Which project would you select under the payback method? The discount rate is 10% for both projects.
  • Use Microsoft® Excel® to prepare your answer.
  • Note that a similar problem is in the textbook in Section 5.1.

Answer Preview 

Net Present Value, abbreviated as NPV, is the difference between the present value (PV) of cash outflow and PV of cash outflows. NPV is used to compare the value of a dollar today and the value of the same dollar in the future, considering both inflation and return into account. Where the project NPV is positive, the project needs to be acceptable, and where the NPV is negative the project needs to be rejected since the cash flow will also be negative.

Internal Rate of Return abbreviated as IRR is the discount rate normally adopted in the capital budgeting that makes the NPV cash flows from a given project equal to zero. The higher the project IRR, the more desirable it is to take on the project. This implies that the IRR can be used to rank different projects into the scale, indicating the best projects to take on and the ones to drop. With all other factors constant, the project with the greatest IRR would be pursued first.

Word Count: 400