FR - Investment Ratio

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Thursday, 21 August 2008 18:36

NPV - Net Present Value Net present value (NPV) or net present worth (NPW) is defined as the total present value (PV) of a time series of cash flows. It is a standard method for using the time value of money to appraise long-term projects. Used for capital budgeting, and widely throughout economics, it measures the excess or shortfall of cash flows, in present value terms, once financing charges are met. How to calculate Each cash inflow/outflow is discounted back to its present value (PV). Then they are summed. Therefore NPV is the sum of all terms Ct*(1+r)t, where t - the time of the cash flow r - the discount rate (the rate of return that could be earned on an investment in the financial markets with similar risk.) Ct - the net cash flow (the amount of cash, inflow minus outflow) at time t (for educational purposes, C0 is commonly placed to the left of the sum to emphasize its role as the initial investment). Decision Making If... It means... Then... NPV >0 the investment would add value to the firm the project may be accepted NPV < 0 the investment would subtract value from the firm the project should be rejected NPV = 0 the investment would neither gain nor lose value for the firm We should be indifferent in the decision whether to accept or reject the project. This project adds no monetary value. Decision should be based on other criteria, e.g. strategic positioning or other factors not explicitly included in the calculation. IRR - Internal Rate of Return The internal rate of return (IRR) is a capital budgeting metric used by firms to decide whether they should make investments. It is an indicator of the efficiency of an investment, as opposed to net present value (NPV), which indicates value or magnitude. How to calculate Given a collection of pairs (time, cash flow) involved in a project, the internal rate of return follows from the net present value as a function of the rate of return. A rate of return for which this function is zero is an internal rate of return. NPV =∑(Ct*(1+r)t = 0 Decision Making A project is a good investment proposition if its IRR is greater than the rate of return that could be earned by alternate investments (investing in other projects, buying bonds, even putting the money in a bank account). Thus, the IRR should be compared to any alternate costs of capital including an appropriate risk premium.

Last Updated ( Monday, 25 August 2008 14:20 )