- Payback Period and Net Present Value [LO1, 2] If a project with conventional cash flows has a payback period less than the project’s life, can you definitively state the algebraic sign of the NPV? Why or why not? If you know that the discounted payback period is less than the project’s life, what can you say about the NPV? Explain.
Internal Rate of Return [LO5] Concerning IRR:
- Describe how the IRR is calculated, and describe the information this measure provides about a sequence of cash flows. What is the IRR criterion decision rule?
- What is the relationship between IRR and NPV? Are there any situations in which you might prefer one method over the other? Explain.
- Despite its shortcomings in some situations, why do most financial managers use IRR along with NPV when evaluating projects? Can you think of a situation in which IRR might be a more appropriate measure to use than NPV? Explain.
- Net Present Value [LO1] It is sometimes stated that “the net present value approach assumes reinvestment of the intermediate cash flows at the required return.” Is this claim correct? To answer, suppose you calculate the NPV of a project in the usual way. Next, suppose you do the following:
- Calculate the future value (as of the end of the project) of all the cash flows other than the initial outlay assuming they are reinvested at the required return, producing a single future value figure for the project.
- Calculate the NPV of the project using the single future value calculated in the previous step and the initial outlay. It is easy to verify that you will get the same NPV as in your original calculation only if you use the required return as the reinvestment rate in the previous step.