In this paper, I am going to perform NPV calculations for both plans and explain, how I did them. Then I will try to justify if we should pursue this idea and then will present my logic and arguments behind the conclusion.
NPV is used to determine if a proposed project would be profitable. NPV is calculated by finding out the difference between cash outflow and aggregated future cash inflows (Investopedia, n.d.).
IRR or Internal rate of return is used to estimate the profitability of proposed project/investment. It is a discount rate that makes the NPV of future cash flows to zero (Investopedia, n.d.).
Keywords: NPV, IRR
Before we start the NPV calculation, here are the facts we are going to use –
- The cost to install the required equipment will be $75,000, this is the outflow on year 0
- Per my business partner, the firm will receive $15,000 annually for 7 years.
- I think cash inflows will be of $14,000 in years 1-2, then inflows of $15,000 from years 3-4, and then inflows of$17,000 for years 5-7.
- In 7 years, the equipment will stop working and can be sold for its parts for about $5,000.
- The Capital cost or Discount rate: 6%
|Approach 1 ( Partner’s Plan)||Approach 2|
|Year||Cash Flow||NPV||Cash Flow||NPV|
This NPV calculation is not complete without including the $5000 that would be generated from the equipment sale
On year 0 or right away we will invest $75000 that is the cash outflow
We will have to calculate the PV of future cash flow, keeping in mind we will pay 6% on capital
So the we calculate PV of cash flow = Cash flow / (1 + Discount Rate) ^ year
So in approach 1, cash flow in 5th year would be calculated: 15000 / (1+6%) ^5 = 11208.87
And we have applied the formula for each year, and cash flow is same each year in this instance
But for approach 2, the cash flows differ, but we can use the same formula, apply same discount factor, since the cost of capital does not change, neither does the timeline, in both cases the equipment lasts 7 years. And at the end of 7 years, the equipment can be sold for the same amount which is $5000.
Let us do the NPV calculation including the cash that would be generated from the sale of equipment.
In approach 1, or cash flow projection by my friend, the 7th year cash flow will be $20000 ($15000 + $5000)
In approach 2, or cash flow projection by myself, the 7th year cash flow will be $22000 ($17000 + $5000)
|Year||Cash Flow||NPV||Cash Flow||NPV|
Now including $5000 with the cash flow projected on the 7th year, our NPV and IRR changes.
We use the discount factor because the projected cash flow is in future and Present value of the future cash flow can be determined only if we use the discount factor that is derived from the interest rate and time.
A positive net present value tells us that the projected earnings generated in present value by the project exceed the anticipated costs in present value (Investopedia, n.d.).
This project is definitely worth considering, since the NPV in both approaches (my partners or mine) greater than 0 that means, this project will yield in positive cash flow and yield better return, in a nutshell, this would be a profitable project.
In approach 1, where cash flow for 7 years would be $15000 and then the equipment can also be sold for $5000, the NPV would be $8,735.72 excluding the cash that would be generated from equipment sell. Including the $5000 from the sale of the equipment the NPV would be $12,061
In approach 2, the cash flow for 1 and 2 years would be $14000, over years 3 – 4 it would be $15000 and over years 5-7 it would be $17000, we have applied the same discounting factor to calculate the PV of those future cash flows and added them up to get the NPV. The NPV would be $11,136.88, excluding the $5000 that would be generated from the sale of the equipment after 7 years. Including the $5000 from the sale of the equipment the NPV would be $14,462.17
Logical Summary and Conclusion:
The NPVs are positive in both approach, so this is a profitable project, and the company should pursue it. Moreover, if we calculate IRR, we get 10% IRR with approach 1, that my friends approach or cash flow projection and we get 11% IRR with approach 2 or with my cash flow projection. Our cost of capital is 6%, so we get a good return on this project either way.
Now that our NPV and IRR calculation shows that the project will generate profit, we need to keep in mind that my business partner thinks that this project will generate more leads in future, so we should definitely go ahead with this project.
Retrieved on 4/21/2018. Retrieve from https://www.investopedia.com/terms/n/npv.asp
Retrieved on 4/21/2018. Retrieved from https://www.investopedia.com/terms/i/irr.asp