2 It assumes cash flows are re invested at the companys cost of capital the

2 it assumes cash flows are re invested at the

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conventional cash flow when negative cash flows occur during the life of the project. (2) It assumes cash flows are re- invested at the company’s cost of capital: the company’s cost of capital represents the average opportunity cost of the company’s providers of finance. (3) Directly related to the objective maximising shareholders’ wealth: the NPV of a projects represent the change in the total market value of the company. (4)NPV is an absolute measure of return. Able to reflect the amount of initial investment or the absolute increase in the corporate value. (5) NPV consider the time value of money while appraising investment projects. (6) NP V does not consider the accounting profit. (7) Consider all the cash flows related with a project. Part 2.6: Limitation of Net Present Value Method (1) More complex than ROCE and IRR (2) It fails to relate the return of the project to the size of the cash outlay. (3) It requires detailed forecasts of long term flows (4) It is difficult to compare NPV with economic variables, e.g. inflation and interest rates. Part 3: The Internal Rate of Return Method (1) Definition : An investment project’s internal rate of return is the required rate of return or cost of capital which produces a net present value of zero when used to discount the project’s cash flows. (2) When IRR used, the discount factor which will give ZERO NET Present Value, the present value of outflows and present value of inflows will be equal. (3) The calculation of the internal rate of return is made using a interpolation method. Step 1: Calculate a net present value using a rate for the cost of capital that Step 2: Having calculated the NPV using the company's cost of capital, calculate the NPV using a second discount rate. (a)If the NPV is positive, use a second rate that is greater than the first rate (b)If the NPV is negative, use a second rate that is less than the first rate Step 3: Use the two NPV values to estimate the IRR . The formula to apply is as follows.
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___________________________________________________________________________________________________________________ Page 7 of 9 IPK COLLEGE 1664, JALAN KULIM, 14020 BUKIT MERTAJAM, PENANG TEL : 012-5203212 / 0125113212 / 04-5512588 Subject: Financial Management (DFM1) Prepared by N.Thacharyane Email : [email protected] Example 2: A company is trying to decide whether to buy a machine for $80,000 which will save costs of $20,000 per annum for 5 years and which will have a resale value of $10,000 at the end of year 5. If it is the company's policy to undertake projects only if they are expected to yield a DCF return of 10% or more, ascertain whether this project be undertaken. Exercise 6: Find the IRR of the project given below and state whether the project should be accepted if the company requires a minimum return of 17%. Time $ 0 Investment (4,000) 1 Receipts 1,200 2 " 1,410 3 " 1,875 4 " 1,150 Part 4: Advantages and disadvantages of IRR method (1) The main advantage of the IRR method is the information provided is more easily understood by managers, especially non-financial managers.
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