Question

Asked Feb 2, 2019

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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.

Step 1

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.

Step 2

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 (CF_{t}) in period t (years) from now at a RRR of k is given by the formula on the white baord

Step 3

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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