Question

A firm is considering investing in a project that requires an initial investment of $200,000 and is expected to produce cash inflows of $60,000, $80,000, and $100,000 in first, second, and third years. There will be no residual value.

The firm applies a discount rate of 10%.

Discount factors for Year 1, 2 and 3 are 0.909, 0.826, and 0.751 respectively.

Required:

i) Calculate the NPV of the project.

ii) Explain the meaning of NPV and its advantages as an investment evaluation method compared with the Accounting Rate of Return and Payback methods.

Answer 1

i)

NPV = PV of future cash flows – Initial investment

        = ($ 60,000 x 0.909 + $ 80,000 x 0.826 + $ 100,000 x 0.751) - $ 200,000

        = ($ 54,540 + $ 66,080 + $ 75,100)- $ 200,000

         = $ 195,720 - $ 200,000 = - $ 4,280

ii)

Net present value (NPV) is the difference between present value of cash inflows discounted at specific interest rate and cash outflows of a project. NPV is used to evaluate profitability of the project considering time value of money, where s Accounting Rate of Return and Payback methods don’t consider any time value of money.