Relationship between Net Present Value and IRR
Net present value of an investment is equal to the present value of its annual free cash flow less the investments initial outlay (Kewon 2013 pg 310). Whenever the NPV is greater or equal to zero we should accept the project, whenever the NPV is negative the project should be rejected. Internal rate of return answers the question of what rate of return will the project earn (Kewon 2013 pg 316). IRR is the discount rate that equates the present value of the projects free cash flows with the projects initial cash outlay (Kewon 2013 pg 316). The discount rate is the rate that is used within capital budgeting that allows for the net present value of cash flow within a project to equal zero. The higher the IRR the more desirable the project is versus the lower the IRR the less desirable the project is.
In consequence, the NPV method indirectly assumes that cash flows over the life of the project can be invested at the projects required rate of return, whereas the use of the IRR method suggests that these cash flows could be invested at the IRR. The better statement is the one made by the NPV that the cash flows can be reinvested at the required rate of return because they can either be returned in the form of dividends to shareholders, who demand the required rate of return on their investments, or invested in a new investment project. (Keown, 2013). The NPV shows that Company B is worth more than Company A. After expenses, taxes and depreciation the company has a value that is better to acquire Corporation B because of a higher IRR of 16.94% and NPV of $40,252.02 than Corporation A whom has an IRR of 13.05% and a NPV of $20,979.41.
Net Present Value
Corporation A $20,979.41
Corporation B $40,252.02
However, with the NPV that Corporation B have it will be give the corporation, over 5 years, a current value cash return of about $40K above the 11% required rate of return. In other words, this plan will not only meet the 11% required rate, but it will give the company an additional $40. Internal Rate of Return
When a project is reviewed with the hurdle rate in viewpoint, then the greater the IRR is above the hurdle rate, the greater the NVP, and on the contrary, the more the IRR is below the hurdle rate , the lower the NVP. When using the IRR, the decision rules are as follows: If IRR > hurdle rate, accept the project
If IRR< hurdle rate, reject the project.
In order for a project to be accepted, the IRR must be greater than or equal to the hurdle rate. If the company is deciding between projects, then the project with the highest IRR is the project to be accepted. As we look at the IRR for both corporations we see that Corporation B is higher than Corporation A and this is why we as a team choose Corporation B.
Corporation A 13.05%
Corporation B 16.94%
Profitability Index, Payback Period and Discount Payback Period The Profitability Index (PI) is just a number and anything 1.0 or higher is confirmation for the project that is being evaluated. The PI is a type of ratio that gives the higher NVP per dollar on an investment. It is better used when you have more than one project comparing. When making decision making measures for the PI methods the best project should be the one that pays off the initial cost outlay.
The PB is the less method used in doing a capital budgeting because it does not consider the time value of the money earned in the project. Looking at Corporation B is shows that it will take 3.31 years to payback the cash inflow to the original cash outflow or the cost of the project. So when making a decision on which corporation to use in PB it is best to take the project that pays off the initial cost outlay in less time. If we look at the PI and PB for Corporation A and Corporation B we will see that Corporation B is much better project than Corporation A. Profitability Index
Corporation A 1.08
Corporation B 1.16
Corporation A 3.64 yrs.
Corporation B 3.31 yrs.
The Discount Payback Period (DPP) does consider the time value of money. It is computed somewhat like the PB method and the only difference is that DPP method uses the discounted cash flow. As we look at the DPP for Corporation A and Corporation B we see that again Corporation B is less time to pay back the cash flow: Corporation A 4.6 yrs.
Keown, A. J., Martin, J. D., & Petty, J. W. (2013). Foundations of Finance, 8th Edition. [VitalSource Bookshelf version]. Retrieved from http://online.vitalsource.com/books/9781269882194/id/ch10lev2sec2
Keown, A. J., Martin, J. D., & Petty, J. W. (2013). Foundations of Finance, 8th Edition. [VitalSource Bookshelf version]. Retrieved from http://online.vitalsource.com/books/9781269882194/id/ch10lev2sec5