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

Part 1) Calculation of NPV of project

Year	Cash flows	PVF
0	(200000)	1	(200000)
1	60000	.909	54540
2	80000	.826	66080
3	100000	.751	75100
			NPV=(4280)

NPV of project =($4280)

Part 2)Advantages of NPV

A. NPV considers the time value of money

B. NPV considers all cash inflows and benefits during the life of project whereas under payback method, it ignores the benefits that occur after payback period.

C. NPV is based on cash flows unlike accounting rate of return method which is based on profits (I.e non cash items such as depreciation is also considered).

D.Accounting rate of return method does not also considers the time value of money concept.