300 words or more Acctng Discussion wk6 in 24 hours

What Are NPV and IRR?

© 2021 Walden University, LLC. 1

What Are NPV and IRR?

Program Transcript

[MUSIC PLAYING]

NARRATOR: The language of business is accounting. It can help you know how to

move assets, when is a good time to invest in a project, and more importantly, when the

time is not right. In many organizations, the accounting department is responsible for

assembling their reports. However, a manager will be tasked with understanding the

information gathered in those reports and making decisions based on that information.

It is crucial that you have a solid understanding of accounting terms and concepts, so

you can communicate with the financial team effectively. When an organization is

looking to invest in a project, leadership needs to know the project's profitability

potential. This is measured with net present value, or NPV, and the internal rate of

return, or IRR. While both of these calculations are used to assess profitability, they

express this information in different ways.

Let's examine net present value, or NPV. Its formula provides a calculation of how much

an investment is worth in today's money by taking into consideration the timeline for the

investment. In the formula, we note that NPV equals the net cash inflow over time. Time

is represented by t and is divided by the interest or discount rate, or r. The process of

calculating NPV requires four elements, all cash inflows, all cash outflows, the discount

rate, and the number of periods for t.

Once we have that information, we can calculate the present value of each cash flow.

Adding the present values or PVs of all inflows and outflows identifies the NPV. Once

we know the NPV, we can determine if an investment is worth taking.

As a general rule, an investment is acceptable if it has a positive net present value and

should be rejected if the NPV is negative. When we calculate the NPV of a project, we

must take into consideration the opportunity cost of capital. The amount of money spent

on one investment means an organization will not be able to spend that money on other

projects. A company may evaluate multiple opportunities based on the NPV and choose

the effort that will benefit the organization the most.

What Are NPV and IRR?

© 2021 Walden University, LLC. 2

For an example of NPV, consider a company building a new state of the art factory for

manufacturing an electric vehicle. This innovative factory will save money over the long

run by being more energy efficient and producing the existing product for less money.

However, it will cost $150 million to build. Each year, the new factory will make $70

million. Let's see if the NPV is positive or negative.

In one year, the company will have a cash outflow of 150 million to build the factory.

However, in the same year the organization's cash flow will be $70 million, which is

discounted by 9% or 0.09 to the power of 1 for the first year. When the initial investment

of 150 million is subtracted from the PVs for each of the three years, we see a positive

cash flow by the end of year three of $27,190,627. Only positive NPVs should be

considered for investment.

The other way to evaluate a project's profitability is through the internal rate of return, or

IRR. It is important to note that with IRR, the discount rate makes the net present value

equal to zero. The purpose of IRR is to find the interest rate that equates the initial

investment to the sum of the PV of the future cash flows. The point at which the initial

outlay of cash equals the future cash inflows is the IRR.

It is expressed as a percentage. Looking back to the electric vehicle factory with an

initial investment of $150 million and 70 million in returns each year, we calculate an

IRR of 18.91%. When IRR is calculated manually, it takes numerous attempts to reach

the point of NPV equaling zero. The easiest way to compute IRR is to use a

spreadsheet.

Step one, on the spreadsheet, we placed the initial investment of 150 million in the first

cell. Then next to that cell, we entered the three positive cash flows. Step two, the

spreadsheet can use these numbers to calculate the IRR. The IRR function is built into

most spreadsheet programs. However, the way you enter the function may differ in

each program.

To use the function, choose a cell, and type the equal sign, and then type IRR. Choose

the IRR function. We will then need to enter the values of all cash flows, in this case,

cells A1 to D1, or as A1:D1, and then hit Enter. 18.91% will then appear. Both NPV and

IRR are helpful when making decisions about investments. The NPV provides a

decisive amount, while the IRR offers a percentage. It is critical for a manager to

What Are NPV and IRR?

© 2021 Walden University, LLC. 3

understand how these techniques can help you evaluate where company funds are best

invested.

[MUSIC PLAYING]

What Are NPV and IRR?

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