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Social ScienceI am in corporate finance. We have to find the IRR and NPV for a word problem and I am stuck on how to figure these out.
I am in corporate finance. We have to find the IRR and NPV for a word problem and I am stuck on how to figure these out.
Expert Answer
Before we get into the formula to calculate NPV and IRR, let's understand them conceptually.
In a capital budgeting process, once we have estimated the potential cash flows, we need to carry out a discounted cash flow analysis.
The cash flows need to be discounted because there is a time value of money.
Cash flows which occur earlier are more valuable than cash flows which occur later.
The time value of money is important for three reasons: inflation, uncertainty, and opportunity costs. The discount rate by which cash flows are discounted should be good enough to compensate an investor for all the three parameters. T
There are two important methods of discounted cash flow analysis – NPV and IRR method.
NPV method discounts all the future cash flows of the firm with the required rate of return (RRR) to obtain their present values.
Present value of a future cash flow is that value of cash required today that will grow to the future value if invested at RRR.
Hence, present value of a cash flow (CFt) in period t (years) from now at a RRR of k is given by the formula on the white baord
The present values of all the future cash inflows are aggregated and netted against the present values of all the future cash outflows to obtain NPV.
NPV = PV (Cash Inflows) - PV (Cash out flows)
Projects with normal or conventional cash flows have outflows, or costs, in the first year (or years) followed by a series of inflow...
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Capital Budgeting
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