Help Me With This Question

Peyton Manning

Hey guys,

Basically, I have some questions to do for class tomorrow with Capital Budgeting. Its nothing important, doesn't count towards examinations or anything so you're not helping me cheat or anything Basically, Ive been giving the following information...

My business has to decide whether to buy a new machine or fix the existing machine. The initial outlay is £10,000, and the lifespan is 3 years. Heres what info I have....

Year.........Cash Flow
0.............(£10,000) Initial Outlay
1...............£5,000
2..............£10,000
3..............£15,000

Cost of Capital: 10%

I have to use the following 2 methods (2 different questions) to make the decision:

(1) Net Present Value (N.P.V)
(2) Internal Rate of Return (I.R.R)

Im a bit clueluess for the first part, and I think I need that for part (2) but am I right for (2) if I did as follows....

NPV = -10,000 + 5,000/(1+0.1)1 + 10,000/(1+0.1)2 + 15,000/(1+0.1)3 = 0

Or maybe its wrong?

Any help appreciated, thanks guys.

Running Bing

Archimedes wrote: »

Hey guys,

Basically, I have some questions to do for class tomorrow with Capital Budgeting. Its nothing important, doesn't count towards examinations or anything so you're not helping me cheat or anything Basically, Ive been giving the following information...

My business has to decide whether to buy a new machine or fix the existing machine. The initial outlay is £10,000, and the lifespan is 3 years. Heres what info I have....

Year.........Cash Flow
0.............(£10,000) Initial Outlay
1...............£5,000
2..............£10,000
3..............£15,000

Cost of Capital: 10%

I have to use the following 2 methods (2 different questions) to make the decision:

(1) Net Present Value (N.P.V)
(2) Internal Rate of Return (I.R.R)

Im a bit clueluess for the first part, and I think I need that for part (2) but am I right for (2) if I did as follows....

NPV = -10,000 + 5,000/(1+0.1)1 + 10,000/(1+0.1)2 + 15,000/(1+0.1)3 = 0

Or maybe its wrong?

Any help appreciated, thanks guys.

Thats right accept the numbers you multiplying the discount factor by should be "powers".

Maybe thats what you meant but its /1.01+/(1.01) Squared+ /(1.01) Cubed.........

Also you have =0 at the end and Im not sure what thats there for (unless it actually does equal zero as I have not done the calculations)

Hope thats clear:P

Peyton Manning

Babybing wrote: »

Thats right accept the numbers you multiplying the discount factor by should be "powers".

Maybe thats what you meant but its /1.01+/(1.01) Squared+ /(1.01) Cubed.........

Also you have =0 at the end and Im not sure what thats there for (unless it actually does equal zero as I have not done the calculations)

Hope thats clear:P

lol aye, I meant them to be powers, just couldnt be bothered opening up the character map to get the right symbols

Any clues on the first part, the NPV?

Running Bing

Archimedes wrote: »

lol aye, I meant them to be powers, just couldnt be bothered opening up the character map to get the right symbols

Any clues on the first part, the NPV?

Well that will get you the NPV Archimedes (NPV will be the initial outlay (the 10,000) minus the discounted future cash flows. Whatever that equals is the NPV)


To get IRR just set the initial outlay=future cash flows and solve for the cost of capital and this is the IRR i.e. in the above example the discount rate is 10% or 0.1, this is what you need to find (i.e. this will be the unknown, r) in the above calculation.


Just use trial and error or google the rules of logs to solve this.


Sorry for the explanation its hard to get it across in a post on the internet:P

Peyton Manning

You're a star Babybing - thank you!

An Citeog

Just to add to what Babybing said,

NPV= initial outlay(-£10,000) + discounted future cash flows = £14,079.64

The IRR is the rate at which the NPV=0 (65% in this case)

If the time period is any more than 2 years, things get slightly complicated and your best bet is just to use excel.

Newaglish

Howdy,

I've attached two files

1) Excel file showing calculation of IRR and NPV

The IRR in reality is 65%, the formula itself gives a kind of wacky result as the cashflows are a bit odd, and there's such a difference between the two discount factors (went up to 80% to get a negative NPV!)

2) Some capital budgeting notes that are pretty straightforward and should help

Best of luck!

An Citeog

Newaglish wrote: »

Howdy,

I've attached two files

1) Excel file showing calculation of IRR and NPV

The IRR in reality is 65%, the formula itself gives a kind of wacky result as the cashflows are a bit odd, and there's such a difference between the two discount factors (went up to 80% to get a negative NPV!)

2) Some capital budgeting notes that are pretty straightforward and should help

Best of luck!

Mountain out of a molehill!:p

Type in =IRR(B2:B5) in excel and it'll do the calculation for you.

The formula you used IRR = LDR + [LRNPV/(LRNPV-HRNPV) * (HDR-LDR)] only gives a rough approximation of the IRR. Excel is far more accurate.

Peyton Manning

Thank you all so much for the help, really appreciate it.

Newaglish, those notes are fantastic, thank you!

An Citeog - yeah I really wanted to use excel but what I have to do is pretend im explaining to shareholders what NPV and IRR are and give numerical examples - in real life, you know Im using excel every time

Newaglish

An Citeog wrote: »

Mountain out of a molehill!:p

Type in =IRR(B2:B5) in excel and it'll do the calculation for you.

The formula you used IRR = LDR + [LRNPV/(LRNPV-HRNPV) * (HDR-LDR)] only gives a rough approximation of the IRR. Excel is far more accurate.

Yeah, you're quite right - I used the Excel IRR formula to test my result, which is how I knew it was a bit off the mark.

In college exams though you always need to be able to do the formulaic method (often wrong!) so I figured I'd stick it in there.

Hanley

Newaglish wrote: »

Yeah, you're quite right - I used the Excel IRR formula to test my result, which is how I knew it was a bit off the mark.

In college exams though you always need to be able to do the formulaic method (often wrong!) so I figured I'd stick it in there.

I used to hate it. Especially when you get a weird one and need to make several guesses at the DF before getting a final approximation.

One thing I always wondered tho, why is IRR actually used?? I know NPV is used to find out how much value the outlay will return down the road, but not why you're looking to find a discount factor which equals zero when using IRR.

Anyone care to explain?

An Citeog

Hanley wrote: »

I used to hate it. Especially when you get a weird one and need to make several guesses at the DF before getting a final approximation.

One thing I always wondered tho, why is IRR actually used?? I know NPV is used to find out how much value the outlay will return down the road, but not why you're looking to find a discount factor which equals zero when using IRR.

Anyone care to explain?

It's all relative to the investor's cost of capital. The NPV gives the value of the cashflows minus initial investment, discounted to their present value using a given cost of capital. The IRR (65%) gives the cost of capital at which the investor is indifferent between investing in a project or not. If the investor's cost of capital is lower than this, they should invest. If it's higher, they shouldn't.