Equating Cash Flows with IRR
The Internal Rate of Return (IRR) is a key metric used to evaluate the profitability of potential investments.
Definition: IRR is the specific discount rate at which the present value (PV) of a project's expected cash inflows precisely equals the present value (PV) of its cash outflows. Mathematically, it's the rate '$r$' where:
$ \sum_{t=1}^{n} \frac{CF_t}{(1+r)^t} = \text{Initial Investment} $
This is equivalent to finding the discount rate where the Net Present Value (NPV) equals zero.
Analyzing Other Investment Metrics
- Net Present Value (NPV): NPV determines the difference between the present value of cash inflows and cash outflows. It does not equate them.
- Payback Period: This metric measures the time required for the initial investment to be recovered by subsequent cash inflows. It ignores the time value of money beyond the payback point and doesn't equate present values.
- Accounting Rate of Return (ARR): ARR is based on accounting profits rather than cash flows and does not account for the time value of money, making it unsuitable for equating present values.
Therefore, the Internal Rate of Return (IRR) is the metric that equates the present value of cash outflows and the present value of expected cash inflows.
Important Questions from Capital Budgeting
- Assume B is social benefits, C is social costs, r is the social discount rate, t is the time and T is the life of the investment project. The Net Present Value (NPV) of a project is
- In certainty-equivalent approach, risk adjusted cash flows are discounted at
- Statement - I : In payback period method, the risk of the project is adjusted by lessening the target payback period.
Statement - II : Sensitivity Analysis helps in calculation of net present value of the proposal.
Code : A public works project is proposed that has total present-worth benefits of ₹ 75 million and total present-worth cost of ₹ 55 million. In deliberating this proposal, some members of the Municipal Board have suggested that the project has a total present-worth disbenefits of ₹ 15 million; other members feel that ₹ 15 million should be treated as a cost. What will be the benefit cost ratio and net benefits value while considering the disbenefits as a cost?
Select the correct statement/s from the following :
Statement I : The slope of the NPV profile reflects how sensitive the project is to discount rate changes.
Statement II : To find total NPV of more than one projects, their NPV cannot be added.
Statement III : The certainty equivalent coefficient applies adjustments to both, the cash flows (in the numerator) and the discount factor (in the denominator).
Statement IV : The risk - adjusted discount factor applies adjustment for risk only to the discount factor (denominator).
Codes :
