ACTIVITY 9: NPV, IRR, ROI, payback period and ARR

1. Why is the $1,000 you receive today worth more than $1,000 you receive next year?
What concept does this illustrate? Why is this concept particularly important when
firms evaluate capital budgeting proposals?
ANSWER
$1,000 we receive today worth more than $1,000 we receive next year or we also call a dollar
today is worth more than a dollar tomorrow is meaningful in a concept of time value of money
(TVM). According to Moyer, Charles, William Kretlow, and James McGuigan (2011), the present
value (PV) is always less than or equal to the future value (FV) because money has interestearning potential. The PV is the value of future cash flow in todays purchasing power, which is

described in a formula: PV

C
t
(1+i)

While:
C: Cash payment
i = inflation rate
t = time
For example, we have $1,000, inflation rate estimating is 3%, so what will we receive after 2
years?
PV
After 1 year
After 2 years

$1,000
$1,000 / (1+0.03)^1 = $971 < $1,000
$1,000 / (1+0.03)^2 = $943 < $1,000

Therefore, we can see that the amount of money we receive by following years is smaller than
the first year. This concept is particularly important when firms evaluate capital budgeting
proposals because of above theory and calculation. If the firm has wrong evaluation in capital
budgeting proposals, it can make a lot of loss. However If the firm has exactly evaluation in
capital budgeting proposals, the company can get many profits.

2. What is the net present value (NPV) of a long-term investment project? Describe how
managers use NPVs when evaluating capital budget proposals.
ANSWER
Net present value (NPV) is a calculation that compares the amount invested today to the present
value of the future cash receipts from the investment. NPV takes into account the size of the cash
inflows, but also makes adjustment for the timing of the money. According to Baker and Powell
(2005, p. 230), NPV is the amount of cash flow in present value terms that the project generates
after repaying the invested capital and paying the required rate of return on that capital.
This is one of the most popularly used in investment decision and the formula is described as:

NPV =

R1
1

(1+i)

R3
R
+
2
(1+ i) (1+i)3

- Initial cost

Where i is rate of return per period

R is net cash flow per period
The project manager will initially take NPV into consideration when choosing investment
appraisal methods. He wants to know how much the project earns back from the invested capital
and how long the return covers the investment. It is difficult to understand the calculation and
estimate the value of inflow and outflow throughout the projects life. Watson and Head (2010, p.
169) point out the difficulty in estimating the cost of capital of company and selecting discount
rate is not straightforward and fixed during project life. The project manager must know that the
assumption of NPV is available in perfect market competition. Finally, he also must assess the
risk of the project whether it can impact on the companys profit or not.

3. As components in the ROI calculation, what are margin and turnover? What are the
three benefits of ROI? Explain how each benefit can lead to improved profitability.
ANSWER
ROI is a major technique to measure how much profits of investment center made compared
with the original amount invested

Formula

Or

ROI

Earnings befor interesttaxes ( EBIT )

x
Net investment assets ( Assets employed)

ROI

EBIT
Sales revenue
x
x
100%
Sales revenue Asset employed

100%

= Profit margin (%) x Asset Turnover

Where:
Profit margin (%)

Asset Turnover (times) =

EBIT
x
Sales revenue 100%
Sales revenue
Asset employed

The benefits of ROI will be as follows:

First of all, many managers will be more concerned with current financial performance instead of
long term and ROI is one of the metrics which managers want to increase most for maintaining
their position. In order to keep high ROI, managers will slow down to replace assets or invest
new assets
Secondly, managers are encouraged to use ROI for short-term decisions. For instance, ROI in
new projects is always low in the first years because these projects will take more time to get
high returns. So, the divisional managers will not invest into such projects in the short run until
they have a high ROI.

Finally, the managers really want to improve ROI to attract more investments of shareholders but
all methods are encouraged to use ROI in short period of time because they all affect the
companys long-term performance
4. East Mullett Manufacturing
a. Average operating assets
Average operating asset = 100% x [operating asset 20X0 operating asset 20X1] / operating
asset 20X0
= 100% x [460,000-380,000] / 380,000
= 18.42%
b. Profit margin ratio
Profit margin = 100% x [SALES OPERATING EXPENSE] / SALES
= 100% x [531,250 - 187,500] / 531,250
= 64.71%
c. Turnover ratio
Turnover ratio = 100% x NET INCOME / NET SALES = 100% x 63,750 / 531,250 = 12%
d. Return on investment (ROI)
ROI = PROFIT MARGIN x TURNOVER = 64.71% x 12% = 7.8%

5. What is the payback period? Compute the payback period for an investment requiring
an initial outlay of 80,000 with expected annual cash inflows of 30,000
Payback period is applied to figure out how many years to recover initial investments. A project
can reject if the payback period is longer than requirement of the company. However, the
payback period will not consider cash flow and risk of investment.
Payback Period

= initial investment / Annual cash flow

= 80,000/30,000 = 2.67 years

Thus, the payback period in this case will be 2.67 years.

6. What is the accounting rate of return? Compute the ARR for an investment that
requires an initial outlay of 300,000 and promises an average net income of 100,000
Accounting Rate of Return is a measure or approach to calculate returns of investment or project
and it is unlike cash flow because it is based on accounting outcomes. Besides, the results of this
method will show in percentage. When the percentage of accounting rate of return is high, the
profit of project or investment is high.
Accounting Rate of Return (ARR)

= Average Net Income / Initial Investment

= 100,000/300,000
= 33.33%

Thus, the Accounting Rate of Return in this case will be 33.33%.

7. What is the role that the required rate of return plays in the NPV model? In the IRR
model?
The required rate of return (RRR) is the minimum percentage return acceptable to compensate
for a projects cost of capital and risk.
NPV method:
For example, an investment of 1,000 today at 10 percent will yield 1,100 at the end of the
year; therefore, the present value of 1,100 at the RRR (10%) is 1,000. The amount of
investment is deducted from this figure to arrive at net present value which here is zero (1,0001,000). A zero net present value means the project repays original investment plus the required
rate of return. The higher the RRR, the lower the initial investment needs to be in order to
achieve the target yield.
IRR method:
IRR or Internal Rate of Return is the investor's required rate of return. At this rate the initial Cash
outlay for the project proposal equals the present value of expected net cash flows. We also call
NPV will be zero at IRR.

For example: The Initial investment is 10,000 and expecting net cash flows at the end of each of
the next 4 years for 5,000 4,000 3,000 and 1,000 and RRR is 11%. The IRR for this project
is calculated to 14.49% when NPV 14.49% = 0. At 11% percent the NPV of the project is
603.30 which will make the investment proposal a feasible choice. However, when NPV 16%
is -242.74 ( a negative amount ). The role of RRR here is that when:

RRR is lower than IRR will yield a positive NPV thus we will accept the project.

RRR is higher than IRR will yield a negative NPV thus we will reject the project.

REFERENCES:
Baker, H.K. and Powell, G.E. (2005) Understanding Financial Management: A Practical Guide.
1st edn, Massachusetts: Blackwell Publishing.
Moyer, Charles; William Kretlow; James McGuigan (2011). Contemporary Financial
Management (12ed.). Winsted: South-Western Publishing Co. pp. 147498
Watson, D., Head, A. (2010) Corporate finance, 5th edn, London: Prentice-Hall.