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 $57,500. Whathat is the present value index of the project if the required rate of return is set at 10%?
|Present value index||=||Total present value of net cash flows|
Note: Round total present value of net cash flows and initial investment to nearest dollar. Round present value index to two decimal places.
|Present value index =||$||=|
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.
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?
|Annual cash flowsc|
|aIRR 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.|
|bInvestment: 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.|
|cAnnual Cash Flows: This is the amount of cash flows to be received annually as a result of the project.|
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?
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.
IRR =NPV= 0
Fiver year cash inflow = 57,500*5= 265,000
0 = -211,600+265,000/(1+r)^5
Get Answers For Free
Most questions answered within 1 hours.