npv and irr, a link to project management
DESCRIPTION
How to calculate Net Present Value and Internal Rate of Return of the Project?TRANSCRIPT
Net Present Value Decision Rules IRR (Internal Rate of Return)
in Project ManagementThe two most-used measures for evaluating projects are the net present value and the internal rate of return!
Agenda
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Net Present Value• The difference between the present value of the future cash flows from an investment and
the amount of investment. Present value of the expected cash flows is computed by discounting them at the required rate of return.
Where,N=total number of periodsT= the time of the cash flowi= the discount rate (the rate of return that could be earned on an investment)Rt = the net cash flow i.e. cash inflow – cash outflow at time t (R0: it is subtracted from the whole as any initial investments during first year is not discounted for NPV purpose)
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The NPV Decision Rules
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ExampleAn Investment of $1,000 in year 1
The discount rate is 10% In Year 2, we receive $110 in year 2You expect to receive $1,200 in year 3
Therefore, NPV= ($ 1,000) + $ 100 + $ 991.74= $ 91.74Hence, we can do this investment.
1 2 3Investment ($ 1,000)
Cash Inflows $ 0 $ 110 $ 1200
Discounting Factor
1 1.10 1.21
Discounted Cash Inflow
0 $ 100 $ 991.74
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Internal Rate of Return• The internal rate of return of a project is
known as the rate of return where the particular project’s net present value equals to zero.
• Formula:
– CF: Cash Flow– r: Internal Rate of Return
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Internal Rate of Return RulesIn IRR decisions, if we have only one project, most of the time we need the basic rule «independent project»:
IRR > Cost of capital (should be accepted)IRR = Cost of capital (provides the minimum return)IRR < Cost of capital (shouldn’t be accepted)
In addition, we need to take other situations into account too. Especially, eventhough NPV and IRR will generally give us the same decision, there are some exceptions:•Nonconventional cash flows – cash flow signs change more than once•Mutually exclusive projects
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Example: Independent Project
If we want to decide on to accept the project or not, we should consider the comparison of IRR & cost of capital for an individual project.
In this example; •when the cost of capital is 15%, then the NPV is -227,53 (don’t accept)
• Alternative: IRR < Cost of capital•when the cost of capital is 10%, then the NPV is 34,27 (accept)
• Alternative: IRR > Cost of capital8
Example: Mutual Projects
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NPV versus IRR
Project A Project BInvest -10.000 -25.000
Return +25.000 +50.000
IRR IRR 150% IRR 100%
NPV by i=8% 13.148 21.296
compare two mutually exclusive projects
Key differences:
• NPV Method is preferred over other methods since it calculates additional wealth and the IRR Method does not
• The IRR Method is more used in evaluating short-term projects and NPV is more used in evaluating long-term projects.
• one significant advantage of IRR -- managers tend to better understand the concept of returns stated in percentages and find it easy to compare to the required cost of capital
• Applying NPV using different discount rates will result in different recommendations. The IRR method always gives the same recommendation.
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Link to Project Management
Methods to evaluate a project estimate the value of the project choosing which project gets priority
By applying NPV as time value of money (money figure) IRR calculate the investments profitability as an interest rate
(percentage figure)
NPV and IRR in the decision taking process
included in a business case prepared by the controlling department
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