Answer to Question #255381 in Accounting for swati

Question

You are reviewing a financial model prepared by someone who hasn’t taken MKM704. The proposal being analyzed requires an upfront investment of $8.0 million and the company has a hurdle rate of 12%. The output from the individual’s model shows a NPV of $1.2 million and an IRR of 10.5%. What do you conclude about the analysis and why?

Answer 1

Solution:

Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time.

The rationale behind NPV is to project all of the future cash inflows and outflows associated with an investment, discount all those future cash flows to the present day, and then add them together. The resulting number after adding all the positive and negative cash flows together is the investment's NPV.

The model has a positive NPV of $1.2 million, which stipulates that the projected earnings generated by a project or investment exceed the projected costs. It is assumed that an investment with a positive NPV will be profitable.

 

The internal rate of return (IRR) is a metric used in financial analysis to estimate the profitability of potential investments.

The IRR rule states that if the IRR on a project or investment is greater than the minimum cost of capital, then the project or investment can be pursued.

Conversely, if the IRR on a project or investment is lower than the cost of capital, then the best course of action may be to reject it.

The model has an IRR of 10.5%, which is less than the cost of capital of 12%. Therefore, the investment should be rejected.

 

According to NPV, the project will be profitable and should be continued, whereas, according to IRR, the investment should be rejected since its IRR is less than its cost of capital. Select your decision based on IRR since it is a single and independent project.