The NPV and IRR methods are interrelated and are sometimes used together to make
ID: 2700926 • Letter: T
Question
The NPV and IRR methods are interrelated and are sometimes used together to make capital budgeting decisions.
Consider this:
The project has the same risk as the firm's average project. Although you don't know the project's initial cost, you have been told that the project has an IRR of 13.8%. Your boss wants to accept the project because the project's IRR exceeds the desired rate of return of 9.00%, but another manager has mentioned that the NPV should be considered.
Although you do not know the value of the project's initial investment, your boss would like you to evaluate a project with the following cash inflows.
Year 1 $325,000
Year 2 $450,000
Year 3 $400,000
Year 4 $475,000
You plan to start the calculations by estimating the initial investment using information available to you. IRR is the cost of capital at which NPV equals $0.
1. Using this information, the initial investment of the project turns out to be what?
2. How much value does this project create for the firm?
Explanation / Answer
Hi,
Please find the answer as follows:
Part 1
IRR is 13.8%
At IRR, NPV = 0
0 = -Initial Investment + 325000/(1+.138)^1 + 450000/(1+.138)^2 + 400000/(1+.138)^3 + 475000/(1+.138)^4 = 1187702.31
Initial Investment = 1187702.31 or 1187702
Part 2
NPV @ 9% = -1187702 + 325000/(1+.09)^1 + 450000/(1+.09)^2 + 400000/(1+.09)^3 + 475000/(1+.09)^4 = 134594.50
The Value created by the project turns out to be 134594.50
Thanks.