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INVESTMENT APPRAISAL
ASSIGNMENT DEADLINE:
17 DECEMBER 2009
Submitted to:
DR.GERALD POLLIO/S A PALAN
4. High Risk Involvement: Projected future benefits and costs are hard to
forecast. As a result, the risk and uncertainty of undertaking medium to long-
term investment can be high.
NPV is one of the most common universal methods being used by managers to
select the best alternative options. Net present value (NPV) can be defined as the
difference between the present value of investment and the present value of benefits
in the future, which are discounted at the cost of capital.
Net Present Value of Project A & Project B for FIRMEX
Project A
Project B
1 50 0.9090 45.45
2 100 0.8264 82.64
3 150 0.7513 112.69
Present Value 240.78
Less: Initial (150.00)
investment 90.78
NPV@10%
Profitability index is the ratio of the present value of project benefits to the present
value of initial cost. Profitability sometimes called the benefit-cost ratio.
A ratio of 1.0 is logically the lowest acceptable measure on the index. Any value
lower than 1.0 would indicate that the project's PV is less than the initial investment.
As values on the profitability index increase, so does the financial attractiveness of the
proposed project.
Profitability Index = PV of future cash flows
Initial Investment
Project
A 241.88 = 1.2094
200
Project
B 90.78 = 1.6052
240.78
As far as profitability index of Project A and Project B are concern, both profitability
index are more than 1. However, Profitability Index of Project B is more than Project
A.
Internal Rate of Return (IRR) or DCF is also used widely by different organizations to
evaluate different projects. This method is defined as the discount rate at which the
present value of the cash flows generated by the project is equal to the present value
of the capital invested, so that the net present value of the project is zero. (Weetman
P, 2006). Formula to calculate the IRR is as following:
Assuming the internal rate of return is 0 per cent, NPV for project A will be:
When IRR is 0%, NPV will be zero, i.e. IRR<cost of capital investment
Let again assume the internal rate of return is 100 per cent, NPV for project A will be:
Assuming the required rate of return is 20 per cent, NPV for project B will be:
Let again assume the internal rate of return is 40 per cent, NPV for project B will be:
The NPV method is new concept as compare to traditional methods i.e. Payback
and Accounting Rate of Return (ARR).NPV method discounts the future cash
flows linked with the investment project using the cost of capital as the
appropriate discount rate. If NPV of required project is positive then we should
accept the project and if it is negative then we should not accept the project.
However if NPV of any project is zero then we can accept or reject the project it
depends on management decision. Normally, to be competitive in market,
managers like to accept the project if NPV is zero.
Advantages of NPV are:
• Time Value of Money: It takes account of time of value of money, by
discounting the cash flows arising in the future
• Conclusion:
After analyzing data available to assess Project A and Project B, Project B seems
much more beneficial to accept. The NPV, Profitability Index and IRR are much
higher than Project A. So Project B should be accepted.
• References: