Capital Investment Time value of money and Importance of NPV and IRR

Question: Describe about Time value of money, Net present value of IRR and Importance of NPV and IRR? Answer: Introduction The feasibility of a business project for building a new project or investment in a long term venture can be determined by the capital budgeting procedures. The cash inflows from the investment in a project can be determined in order to determine whether the returns generated from the investment will be sufficient for the target project (Belli, 2001). Time Value of money The idea that money is available at the present time is worth more than the same amount of money in the future due to the potential earning capacity can be determined by time value of money (Clayton and Spivey, 2015). It is used for the comparison of the investment alternatives and solving the problems related to loans, mortgages, savings and annuities. For example, dollar can be invested for one year at an interest rate of 6% annually. At the end of one year an interest amounting to $1.06 will be accumulated (Silver, 2009). Net Present value and IRR Net present value can be defined as the sum of the present values of the cash inflows and the outflow of cash during a period of time. Net present value serves as a tool for determining the feasibility of a particular project (Nikbakht, Nikbakht and Groppelli, n.d.). The net present value of inflows includes the salvage value if there is any which is subtracted from the investment in the project initially. It is considered as one of the reliable methods as it considers the time value of money by using the inflows which has been discounted (Belli, 2001). Internal rate of return is a capital budgeting method to measure and compare the profitability of the various investments. It is also known as the cash flow return at discounted rate. It is also known as the interest rate which is effective in context of the loans and savings. However the environmental factors are not considered in the calculation of IRR (Wright, 2015). Importance of NPV and IRR The feasibility of a project can be determined from the net present value method. It is an authentic method of project evaluation as it uses the time value of money as the cash inflows are determined using discounted cash flow method. The original return from a project can be determined from the internal rate of return. It determines the outflow of cash that has been spent on investment and the cash inflows that comes to a company as a result of investment. The feasibility of an investment project can be determined from IRR (Khan Jain, 2004). Calculation of NPV and IRR Initial Capital Outlay $25,000.00 Rent per month $2,000.00 Annual rent $24,000.00 Gross profit per cake $7.00 Cakes sold to grocery store $500.00 Total gross profit per month $3,500.00 Annual Gross Profit $42,000.00 Capital inflow Rent + Sale of cake $66,000.00 Year Capital Inflow PVF PV 1 $66,000.00 $0.94 $62,264.15 2 $66,000.00 $0.89 $58,739.77 3 $66,000.00 $0.84 $55,414.87 4 $66,000.00 $0.79 $52,278.18 5 $66,000.00 $0.75 $49,319.04 Present value of Total Capital inflow $278,016.01 Net Present value $253,016.01 Capital outlay ($25,000) Year 1 66000 Year 2 66000 Year 3 66000 Year 4 66000 Year 5 66000 IRR 264% References Belli, P. (2001). Economic Analysis of Investment Operations: Analytical Tools and Practical ... (pp. 200-230). Clayton, G., Spivey, C. (2015). The time value of money: worked and solved problems. Khan, M., Jain, P. (2004). Financial management ; Text, problems and cases. New Delhi: Tata McGraw-Hill. Nikbakht, E., Nikbakht, E., Groppelli, A. Finance. New York: Barron's. Silver, T. (2009). The Time Value of Life: Why Time Is More Valuable Than Money (pp. 5-30). Wright, T. (2015). Why Is the Internal Rate of Return Important to an Organization?. Small Business - Chron.com. Retrieved 12 February 2015, from https://smallbusiness.chron.com/internal-rate-return-important-organization-67279.html