Sara’s Cake Company – Satellite Location Offer Whenever a company is given the opportunity to expand their business, the process of deciding whether the venture is most likely profitable or a waste of money takes a lot of behind the scene’s work and number crunching. If a company simply decides to take on a project without investing the necessary time to plan, analyze and project their current and long-term standings, they may find that down the road they no longer have a business. For that reason, it is important to review every aspect of the project and how it will affect the bottom line. There are several factors that are normally considered when deciding on a capital budget decision . Some of the most common ways to evaluate if…show more content… It is used in capital budgeting decisions to analyze the profitability of a projected investment or project (Net Present Value/Investopedia).” Generally if the NPV is positive, it means that you are expected to yield a return equal to or greater than what you put out and it is advisable to invest in the project. If the NPV is negative, it means that the investment won’t yield a return equal to or greater than what you invested, and therefore should not be considered as a worthwhile option. In order to calculate NPV, you need a couple things… the future amount to be received, the interest rate being used, when the future amount will be received and your initial investment. The formula is as follows:
NPV = [Net period cash flow / (1 + r) nth power ] – Initial Investment (where r is the int. rate used)
(What is the formula for calculating net present value (NPV) in Excel?/Investopedia). This is a rather simplified formula that was derived from Investopedia.com and I will use it in more detail later when we get to the example for Sara’s Cake Company. For now, let’s move on to IRR.
IRR is similar to NPV in that it also utilizes the Time Value of Money concept to determine a potential investment’s favorability. The IRR, simply put, “is the actual return expected to be earned by the project; it is the discount rate at which NPV of an investment becomes $0 (Davis, 2012)” (this will make more sense later when the actual calculations are