Question

art Three

**Present Value Index**

When funds for capital investments are limited, projects can be ranked using a present value index. A project with a negative net present value will have a present value index below 1.0. Also, it is important to note that a project with the largest net present value may, in fact, return a lower present value per dollar invested.

Let's look at an example of how to determine the present value index.

The company has a project with a 5-year life, an initial investment of $220,000, and is expected to yield annual cash flows of $57,500. Whathat is the present value index of the project if the required rate of return is set at 10%?

Present value index | = | Total present value of net cash flows |

Initial investment |

Calculation Steps

*Note*: Round total present value of net cash flows and
initial investment to nearest dollar. Round present value index to
two decimal places.

Present value index = |
$ | = |

$ |

Feedback

To calculate the total present value of net cash flows, find the correct present value discount factor. Then multiply it by the annual cash flow for the project.

Part Four

Internal Rate of Return Method

The internal rate of return (IRR) method uses present value concepts to compute the rate of return from a capital investment proposal based on its expected net cash flows. This method, sometimes called the time-adjusted rate of return method, starts with the proposal's net cash flows and works backward to estimate the proposal's expected rate of return.

Let's look at an example of internal rate of return calculation
with **even** cash flows.

A company has a project with a 5-year life, requiring an initial investment of $211,600, and is expected to yield annual cash flows of $53,000. What is the internal rate of return?

IRR Factor^{a} |
= | Investment^{b} |

Annual cash flows^{c} |

^{a}IRR Factor: This is the factor which
you’ll use on the table for the present value of an annuity of $1
dollar in order to find the percentage which corresponds to the
internal rate of return. |

^{b}Investment: This is the present value
of cash outflows associated with a project. If all of the
investment is up front at the beginning of the project, the present
value factor is 1.000. |

^{c}Annual Cash Flows: This is the amount
of cash flows to be received annually as a result of the
project. |

Calculation Steps

Present Value of an Annuity of $1 at Compound Interest.

IRR Factor = |
$ | = , rounded to 6 decimals |

$ |

The calculated factor corresponds to which percentage in the present value of ordinary annuity table?

%

Answer #1

Part Three:

The net present value is $(2,030). Since this is a project with negative net present value the present value index is below 1. Therefore this preject is not feasible and reject the project.

Part Four:

IRR =NPV= 0

Fiver year cash inflow = 57,500*5= 265,000

0 = -211,600+265,000/(1+r)^5

r= 8%

Internal Rate of Return Method
The internal rate of return (IRR) method uses present value
concepts to compute the rate of return from a capital investment
proposal based on its expected net cash flows. This method,
sometimes called the time-adjusted rate of return method, starts
with the proposal's net cash flows and works backward to estimate
the proposal's expected rate of return.
Let's look at an example of internal rate of return calculation
with even cash flows.
A company has...

Net Present Value Method, Internal Rate of Return Method, and
Analysis for a Service Company
The management of Advanced Alternative Power Inc. is considering
two capital investment projects. The estimated net cash flows from
each project are as follows:
Year
Wind
Turbines
Biofuel Equipment
1
$390,000
$700,000
2
390,000
700,000
3
390,000
700,000
4
390,000
700,000
The wind turbines require an investment of $1,113,450, while the
biofuel equipment requires an investment of $1,812,300. No residual
value is expected from either...

Net Present Value Method, Internal Rate of Return Method, and
Analysis
The management of Quest Media Inc. is considering two capital
investment projects. The estimated net cash flows from each project
are as follows:
Year
Radio Station
TV Station
1
$320,000
$610,000
2
320,000
610,000
3
320,000
610,000
4
320,000
610,000
Present Value of an Annuity of $1 at
Compound Interest
Year
6%
10%
12%
15%
20%
1
0.943
0.909
0.893
0.870
0.833
2
1.833
1.736
1.690
1.626
1.528
3...

Net Present Value Method, Internal Rate of Return Method, and
Analysis for a Service Company
The management of Advanced Alternative Power Inc. is considering
two capital investment projects. The estimated net cash flows from
each project are as follows:
Year
Wind
Turbines
Biofuel Equipment
1
$340,000
$710,000
2
340,000
710,000
3
340,000
710,000
4
340,000
710,000
The wind turbines require an investment of $970,700, while the
biofuel equipment requires an investment of $2,156,270. No residual
value is expected from either...

Net Present Value Method, Internal Rate of Return Method, and
Analysis
The management of Quest Media Inc. is considering two capital
investment projects. The estimated net cash flows from each project
are as follows:
Year
Radio Station
TV Station
1
$350,000
$740,000
2
350,000
740,000
3
350,000
740,000
4
350,000
740,000
Present Value of an Annuity of $1 at
Compound Interest
Year
6%
10%
12%
15%
20%
1
0.943
0.909
0.893
0.870
0.833
2
1.833
1.736
1.690
1.626
1.528
3...

The management of Advanced Alternative Power Inc. is considering
two capital investment projects. The estimated net cash flows from
each project are as follows:
Year
Wind
Turbines
Biofuel Equipment
1
$170,000
$320,000
2
170,000
320,000
3
170,000
320,000
4
170,000
320,000
The wind turbines require an investment of $516,290, while the
biofuel equipment requires an investment of $913,600. No residual
value is expected from either project.
Present Value of an Annuity of $1 at
Compound Interest
Year
6%
10%
12%...

The management of Quest Media Inc. is considering two capital
investment projects. The estimated net cash flows from each project
are as follows:
Year
Radio Station
TV Station
1
$200,000
$360,000
2
200,000
360,000
3
200,000
360,000
4
200,000
360,000
Present Value of an Annuity of $1 at
Compound Interest
Year
6%
10%
12%
15%
20%
1
0.943
0.909
0.893
0.870
0.833
2
1.833
1.736
1.690
1.626
1.528
3
2.673
2.487
2.402
2.283
2.106
4
3.465
3.170
3.037
2.855
2.589...

When applying the concept of present value to capital budgeting
decisions, which of the following statements is TRUE?
Question 28 options:
Internal rate of return cannot be computed when cash flows are
unequal year to year
A project with a higher IRR will be preferable over one with a
lower IRR.
A positive NPV means that a project earns less than the cost of
capital on a project.
Residual value is not included in the calculation of Net Present
Value.

Net Present Value Method and Present Value Index
Diamond and Turf Inc. is considering an investment in one of two
machines. The sewing machine will increase productivity from sewing
180 baseballs per hour to sewing 324 per hour. The contribution
margin per unit is $0.52 per baseball. Assume that any increased
production of baseballs can be sold. The second machine is an
automatic packing machine for the golf ball line. The packing
machine will reduce packing labor cost. The labor...

11.
The discount rate that makes the net present value of an
investment exactly equal to zero is the:
A)
Payback period.
B)
Internal rate of return.
C)
Average accounting return.
D)
Profitability index.
E)
Discounted payback period.
12.
The internal rate of return (IRR) rule can be best stated
as:
A)
An investment is acceptable if its IRR is exactly equal to its
net present value (NPV).
B)
An investment is acceptable if its IRR is exactly equal to...

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