After meeting with the Accounting Vice President (VP) within Superior Living a better understanding of the financial aspects of the plant construction project is needed by me. With this in mind, I requested help from the financial analyst that is working on the project. In order to get a better understanding of the project I asked her to bring the financials so that we can discuss the key valuation methodologies that companies use when making investment decisions regarding a project. With that being said, I will be defining, explaining, and providing examples of the Net Present Value (NPV), the Internal Rate of Return (IRR), and the Modified Internal Rate of Return (MIRR) which are three key valuation methodologies that can be used by the company in order to make sound investment decisions regarding the plant construction project.
Net Present Value (NPV)
The NPV is utilized in capital budgeting to evaluate the success of a project. This method is considered to be a consistent technique for making investment decisions regarding a project because it will show the actual change in the value of the company as a result of taking on the project. What is meant by this is by estimating the present value of the project and expected profits from the project we can evenly compare the projects financial outlook and a sound decision can be made as to whether the project will be profitable for the company to consider taking on (“Net Present Value,” n.d.) Generally speaking, a project that has a positive NPV is undertaken whereas a project that has a negative NPV is not taken on (CTU Online, 2011). For example, if we were going to make an initial investment of $10,000 for the project, and the project was expected to bring in a positive cash flow of $2,000 per year over a 3 year period, and our discounted rate is 10%. If I am correct the answer I get by using the present value table for year 1 would be $1818.20, year 2 would be $3471, and year 3 would be $4973.80 (Ross, Westerfield, & Jordan, 2010). I would then formulate to get the NPV which would look like this:
Y0 = -$10,000
Y1 = $1818.20
Y2 = $3471
The results would be:
NPV = -$10,000 + $1818.20 + $3471 = 263
Since the NPV returns a cash flow that is positive we would accept the project as being a good one to consider.
Internal Rate of Return (IRR)
The IRR is another method often used in capital budgeting decisions. It is the rate of interest, or rate of discount, that will convey a sequence of cash flows to a NPV of zero, or to the present rate of the money spent on the project. What is meant by this is the IRR will represent the return rate of the project while compelling the cash flows that are negative to equal the cash flows that are positive. For example, assuming all factors are equal among the various projects that are being considered, the project that yields the highest IRR would be considered the best to undertake. In addition, the higher IRR of a project the better it will look for investors in considering whether they want to invest in the project (“Internal Rate of Return,” 2011).
Modified Internal Rate of Return (MIRR)
The MIRR is used in capital budgeting decisions to create a more realistic value of the IRR. It is measured by determining the interest rate where the projects inflow will be discounted to equal the present value of the projects outflows. What is meant by this is the MIRR will represent the return on the project with positive cash flows reinvested at a rate of return which will be established by the company. For example, future value will be used to calculate this figure and if this figure is less than the IRR figure it will be used for the project (CTU Online, 2011).
For the project that the company is considering financial methodologies show that the calculation of the MIRR will be easier to evaluate than the NPV or the IRR. This is because of the assumptions that are made regarding the MIRR, such as how it reflects the actual investment practices more accurately for a company in determining whether to invest or not invest in a project. With that being said, understanding the different investment measures to use in order to determine whether a project will be profitable or not is of great importance since these measures can allow the company to make correct capital budgeting decisions (CU Online, 2011).
CTU Online. (2011). Applied Managerial Finance. Phase 1 course materials [text]. Retrieved from https://campus.ctuonline.edu/pages/MainFrame.aspx?ContentFrame=/Home/Pages/Default.aspx
Internal rate of return: An inside look. (2011). Retrieved from http://www.investopedia.com/articles/07/internal_rate_return.asp#axzz1WWUhs7l0
Net present value – NPV definition. (n.d.). Retrieved from http://www.investopedia.com/terms/n/npv.asp#axzz1WWUhs7l0
Ross, S., Westerfield, R., & Jordan, B. (2010). Fundamentals of Corporate Finance, (9th ed.). New York, NY: McGraw-Hill Irwin.