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 $195,000, and is expected to yield annual cash flows of $56,000. Whathat is the present value index of the project if the required rate of return is set at 8%? Total present value of net cash flows Present value index 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 = Feedback Check My Work 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 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 5-year life, requiring an initial investment of $225,600, and is expected to yield annual cash flows of $56,500. What is the internal rate of return? IRR Investment Factora Annual cash flows IRR Factor: This is the factor which bInvestment: This is the present CAnnual Cash Flows: you'll use on the table for the present value of cash outflows associated This is the amount value of an annuity of $1 dollar in with a project. If all of the of cash flows to be order to find the percentage which investment is up front at the received annually as corresponds to the internal rate of beginning of the project, the present a result of the return. value factor is 1.000. project. Calculation Steps Present Value of an Annuity of $1 at Compound Interest. IRR Factor = rounded to 6 decimals The calculated factor corresponds to which percentage in the present value of ordinary annuity table? % APPLY THE CONCEPTS: Net present value and Present value index Rydell Manufacturing is looking to invest in Project A or Project B. The data surrounding each project is provided below. Rydell's cost of capital is 8%. Project A Project B This project requires an initial investment of $170,000. The project will have a life of 8 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 7 years. Annual revenues associated with the project will be $111,000 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 $ Amount to be invested Net present value $ 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 Amount to be invested Net present value Present value index: Project A Project B Based upon net present value, which project has the more favorable profit prospects? Based upon the present value index, which project is ranked higher? Part Six APPLY THE CONCEPTS: Internal rate of return The Rydell 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 $249,600. The Project B's revised investment is $97,300. The project's life and cash flow have changed to 6 project's life and cash flow have changed to 5 years and $54,000, respectively, while expenses years and $80,000 while expenses reduced have been eliminated. 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 and this value corresponds to which percentage in the present value of ordinary annuity table? % Project B: The calculated IRR factor is and this value corresponds to which percentage in the present value of ordinary annuity table? %
