A. Suppose the company is considering a potential investment project to add to its portfolio. Calculate the following items:
1. The net present value (NPV) of the project
2. The internal rate of return (IRR) of the project
B. What are the implications of these calculations? In other words, based on each of the calculations, and being mindful of the need to balance portfolio risk with return, would you recommend that the company pursue the investment? Why or why not? Be sure to substantiate your claims.
The calculations show that net present value of this project is positive. The net present value is calculated by deducting investment from present value of cash inflows. This method discounts the future cash flows by cost of capital of the company. The project is considered to be acceptable if net present value of the project is positive and the project is rejected if its net present value is negative. As net present value of the given project is positive, it should be accepted. This project will add wealth of the shareholders (Baker and English, 2011).
Internal Rate of Return is the rate at which present value of cash inflows equals present value of cash outflows. The project is accepted if internal rate of return is more than cost of capital of the company and it is rejected if internal rate of return is less than cost of capital of the company. As internal rate of return of this project is 50% and cost of capital of the company is only 8%, this project should be accepted (Brooks, 2009).
Thus, it can be seen from the above analysis that this project is acceptable according to both the methods. It will increase return of the portfolio along with reducing risk (Brooks, 2009).
C. What is the difference between NPV and IRR? Which one would you choose for evaluating a potential investment and why? Be sure to support your reasoning with evidence.
There is very thin difference between net present value and internal rate of return. Net present value the difference between present values of cash inflows and present value of cash outflows whereas internal rate of return is the rate at which present value of cash inflows equals present value of cash outflows. We should choose net present value method over internal rate of return method while evaluating potential investment project as NPV method is more accurate. The internal rate of return method assumes that cash flows are reinvested at internal rate of return rate. This assumption is not realistic. Therefore, NPV method is preferred over net present value method (Gotze and Northcott, 2010).
Baker, H., and English, P. (2011). Capital Budgeting Valuation: Financial Analysis for Todays Investment Projects. San Francisco: Wiley.
Brooks, R. (2009). Financial Management: Core Concepts. London: Pearson Education.
Gotze, U., & Northcott, D. (2010). Investment Appraisal: Methods and Models. New York: Springer.
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