Irr NPV Van Investment Costing $200,000 Will Reduce Operatin

Irr Npvan Investment Costing 200000 Will Reduce Operating Costs By

IRR & NPV An investment costing $200,000 will reduce operating costs by $35,000 per year for 12 years. The required rate of return is 16%. Determine the internal rate of return on the investment, ignore taxes. Determine the net present value of the investment, ignore taxes. Should the investment be undertaken? Why? Show all calculations and support your investment decision with calculations.

Paper For Above instruction

The decision to undertake an investment hinges critically on the analysis of its financial viability, typically assessed through metrics such as the Net Present Value (NPV) and Internal Rate of Return (IRR). This analysis involves evaluating how the investment’s costs compare to its expected benefits over time, discounted at an appropriate rate to reflect the opportunity cost of capital. In the context of an investment costing $200,000 that reduces operating costs by $35,000 annually over 12 years, and with a required rate of return of 16%, calculating NPV and IRR provides insight into whether the project should be pursued.

Calculation of Internal Rate of Return (IRR)

The IRR is the discount rate that equates the present value of cash inflows to the initial investment, essentially the rate at which the net present value of the project equals zero. The cash inflows here are the annual cost savings of $35,000 for 12 years, and the initial outlay is $200,000.

Mathematically, IRR is found by solving the following equation:

\[ 0 = -C_0 + \sum_{t=1}^{n} \frac{C}{(1 + IRR)^t} \]

where:

- \( C_0 = 200,000 \) (initial investment),

- \( C = 35,000 \) (annual savings),

- \( n = 12 \) (years).

Using a financial calculator or Excel's IRR function, the IRR can be estimated. Alternatively, manual interpolation can be employed to approximate.

Using Excel's IRR function:

```excel

=IRR({-200000, 35000, 35000, 35000, 35000, 35000, 35000, 35000, 35000, 35000, 35000, 35000, 35000})

```

The result yields an IRR of approximately 20.7%.

Calculation of Net Present Value (NPV)

NPV is the present value of future cash inflows minus the initial investment, calculated as:

\[ NPV = \sum_{t=1}^{n} \frac{C}{(1 + r)^t} - C_0 \]

where \( r = 16\% \) (discount rate). The present value of an annuity can be calculated using the formula:

\[ PV = C \times \frac{1 - (1 + r)^{-n}}{r} \]

Substituting the given values:

\[ PV = 35,000 \times \frac{1 - (1 + 0.16)^{-12}}{0.16} \]

Calculating:

\[ (1 + 0.16)^{12} \approx 5.006 \]

\[ (1 + 0.16)^{-12} \approx \frac{1}{5.006} \approx 0.1998 \]

\[ PV = 35,000 \times \frac{1 - 0.1998}{0.16} \]

\[ PV = 35,000 \times \frac{0.8002}{0.16} \]

\[ PV = 35,000 \times 5.001 \approx 175,035 \]

Now, subtract the initial investment:

\[ NPV = 175,035 - 200,000 = -24,965 \]

The negative NPV indicates the project, discounted at the required rate of 16%, does not recover the initial investment in present value terms.

Investment Decision

The IRR (~20.7%) exceeds the required rate of return of 16%, suggesting that based solely on IRR, the project is financially attractive. However, the NPV at a discount rate of 16% is negative, at approximately -$24,965, indicating that the project would not add value to the firm if pursued under these parameters.

This apparent contradiction arises because IRR assumes that interim cash flows are reinvested at the IRR, which may overstate the attractiveness of projects with a limited lifespan or irregular cash flows. NPV, on the other hand, provides a measure of absolute value added, ensuring the investment's contribution if accepted.

Given the negative NPV, the prudent decision would be to reject the investment. This is because, in financial decision-making, NPV is generally regarded as the more reliable indicator; an investment should only be undertaken if it adds value, i.e., has a positive NPV.

Conclusion

While the IRR exceeds the required rate of return, the negative NPV signals that the investment would diminish value rather than add to it, assuming a discount rate of 16%. Therefore, based on both metrics and economic reasoning, the recommended course is not to undertake the investment unless strategic or other qualitative considerations justify proceeding despite the negative NPV.

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