Capital Budgeting Case
NPV or net present value illustrated as the present value of an investment’s annual free cash flow less the investment’s initial outlay (Keown, Petty, & Martin 2014 Pg. 314). While assessing both Corporation A and Corporation B, NPV formula’s represented by (present value of all the future annual free cash flows) - (the initial cash outlay). Calculations of Corporation A, has a 10% rate of return and the present value of the free cash flow is $270,980. Subtracting the initial $100,000 outlay leaves an NPV of $170,980. Corporation B has an 11% rate of return and the present value of the free cash flow is $290,252. Subtracting the initial $150,000 outlay leaves an NPV of $140,252. Analyzing the results, the NPV tells the value of the project and if that particular project is worth the investment. If ...view middle of the document...
It also allows the recognition of time value of money in regard to benefits and costs and the comparison of logic.
IRR or Internal Rate of Return expressed as the rate of return that the project earns. For computational purposes, the internal rate of return depicts as the discount rate that equates the present value of the project’s free cash flows with the project’s initial cash outlay (Keown, Martin & Petty, 2014 Pg. 316). In more basic terms, an IRR is the rate of return that the project earns. If the IRR is greater than or equal to the rate of return, the project should be accepted however if the IRR is below the investors required rate of return it will decrease the firm’s stock prices therefore the project receives rejection. When evaluating Corporation A and Corporation B, the IRR’s are both greater than the rate of return, therefore they are both in good standing. However, the NPV method is still better for reinvestment rate assumption although IRR does present favorable conditions, the method can rank projects differently in terms of desirability.
The relationship between NPV vs. IRR relies heavily on the discount rate. As stated earlier, NPV or IRR measure projects credibility through expected cash inflows and outflows. IRR reveals the potential growth percentage of the investment while NPV specifies the value of the projects potential income. NPV indicates the desirability of the project and how much profitability the project can actually result within a certain amount of time. It provides a more definite account of success with the investment. IRR is the return rate that the project will provide and although it gives way to success of a project it merely gives the rate that the project should receive within a certain amount of time.
Keown, A. J., Martin, J. D., & Petty, J. W. (2014). Foundations of finance: The logic and practice of financial management (8th ed.). Retrieved from The University of Phoenix eBook Collection.