Part Three

Present Value Index

When funds for capital investments are limited, projects can be ranked using a present value index. A project with a negative net present value will have a present value index below 1.0. Also, it is important to note that a project with the largest net present value may, in fact, return a lower present value per dollar invested.

Let's look at an example of how to determine the present value index.

The company has a project with a 5-year life, an initial investment of $220,000, and is expected to yield annual cash flows of $58,000. Whathat is the present value index of the project if the required rate of return is set at 8%?

Present value index	=	Total present value of net cash flows
Initial investment

Calculation Steps

Note: Round total present value of net cash flows and initial investment to nearest dollar. Round present value index to two decimal places.

Present value index =	$fill in the blank 0ff6dffce054fd1_1	= fill in the blank 0ff6dffce054fd1_2
$fill in the blank 0ff6dffce054fd1_3

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Feedback

To calculate the total present value of net cash flows, find the correct present value discount factor. Then multiply it by the annual cash flow for the project.

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Part Four

Internal Rate of Return Method

The internal rate of return (IRR) method uses present value concepts to compute the rate of return from a capital investment proposal based on its expected net cash flows. This method, sometimes called the time-adjusted rate of return method, starts with the proposal's net cash flows and works backward to estimate the proposal's expected rate of return.

Let's look at an example of internal rate of return calculation with even cash flows.

A company has a project with a 4-year life, requiring an initial investment of $182,900, and is expected to yield annual cash flows of $54,000. What is the internal rate of return?

IRR Factora	=	Investmentb
		Annual cash flowsc

aIRR Factor: This is the factor which you'll use on the table for the present value of an annuity of $1 dollar in order to find the percentage which corresponds to the internal rate of return.
bInvestment: This is the present value of cash outflows associated with a project. If all of the investment is up front at the beginning of the project, the present value factor is 1.000.
cAnnual Cash Flows: This is the amount of cash flows to be received annually as a result of the project.

Calculation Steps

Present Value of an Annuity of $1 at Compound Interest.

IRR Factor =	$fill in the blank 47c175006faafb5_1	= fill in the blank 47c175006faafb5_2, rounded to 6 decimals
$fill in the blank 47c175006faafb5_3

The calculated factor corresponds to which percentage in the present value of ordinary annuity table?

fill in the blank 47c175006faafb5_4%

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Feedback

The internal rate of return calculation is a two-step process. First, you must divide the present value of the initial investment by the annual cash flows of the project to arrive at the IRR factor. Next, use the table for the present value of an annuity of $1 at compound interest, looking down the row of the number of years the project will exist. At the column where you hit the value closest to your computed value, you have determined a percentage that is the internal rate of return for the project.

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Part Five

APPLY THE CONCEPTS: Net present value and Present value index

Krause Industries is looking to invest in Project A or Project B. The data surrounding each project is provided below. Krause's cost of capital is 10%.
Project A	Project B
This project requires an initial investment of $172,500. The project will have a life of 3 years. Annual revenues associated with the project will be $130,000 and expenses associated with the project will be $35,000.	This project requires an initial investment of $135,000. The project will have a life of 5 years. Annual revenues associated with the project will be $105,000 and expenses associated with the project will be $60,000.

Calculate the net present value and the present value index for each project using the present value tables provided below.

Present Value of $1 (a single sum) at Compound Interest.

Present Value of an Annuity of $1 at Compound Interest.

Note:
	Use a minus sign to indicate a negative NPV.
	If an amount is zero, enter "0".
	Enter the present value index to 2 decimals.

	Project A	Project B
Total present value of net cash flow	$fill in the blank 67cafa01afa8fd4_1		$fill in the blank 67cafa01afa8fd4_2
Amount to be invested	fill in the blank 67cafa01afa8fd4_3		fill in the blank 67cafa01afa8fd4_4
Net present value	$fill in the blank 67cafa01afa8fd4_5		$fill in the blank 67cafa01afa8fd4_6
Present value index:
Project A	fill in the blank 67cafa01afa8fd4_7
Project B			fill in the blank 67cafa01afa8fd4_8

Based upon net present value, which project has the more favorable profit prospects?

Both are favorableProject AProject BCan't determine

Based upon the present value index, which project is ranked higher?

Both are favorableProject AProject BCan't determine

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Feedback

Subtract the expenses from the revenues to determine net cash flow for each year. Since this is an annuity cash flow, use the appropriate table to look up the present value factor for the project life and required rate of return.

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Part Six

APPLY THE CONCEPTS: Internal rate of return

The Krause purchasing department has made revisions to their costs and annual cash flows for Project A and Project B, as outlined below.
Project A	Project B
Project A's revised investment is $219,600. The project's life and cash flow have changed to 6 years and $47,500, respectively, while expenses have been eliminated.	Project B's revised investment is $97,300. The project's life and cash flow have changed to 5 years and $80,000 while expenses reduced slightly to $55,000.

Compute the internal rate of return factor for Project A and Project B and then identify each project's corresponding percentage from the PV ordinary annuity table.

Note: Enter the IRR factor, to 5 decimal places.

Project A: The calculated IRR factor is fill in the blank 64e8d9026fc8054_1 and this value corresponds to which percentage in the present value of ordinary annuity table? fill in the blank 64e8d9026fc8054_2%

Project B: The calculated IRR factor is fill in the blank 64e8d9026fc8054_3 and this value corresponds to which percentage in the present value of ordinary annuity table? fill in the blank 64e8d9026fc8054_4%