2.2 DESCRIPCIÓN DE LOS DUCTOS
2.2.4 Criterios a tomar en cuenta en la fabricación de duetos
Using the net present value method of discounted cash flow the cash inflows and outflows expected from implementation of a project are discounted to their present value with the help of a self-adopted (target) rate for comparing the receipts and outlays on a common basis (for example, the cost of capital rate) and afterwards the difference between the discounted cash flows – the net present value, is calculated. In contrast, by using the internal rate of return method in evaluation of investment projects the attempt is to calculate the rate of return at which the net present value equals the value of the original capital outlay and the net present value is zero.
If this calculated rate of return (internal rate of return) exceeds an adopted target rate of return, the project should be accepted.
Without the help of computers or appropriate calculator programs, the estimation of the internal rate of return is made using a hit-and-miss technique known as the interpolation method.
Under the interpolation method two different net present values are calculated, both as close as possible to zero, using rates for the cost of capital expressed in whole numbers. Ideally, one NPV should be positive and the other negative.
In order to be able to calculate the required net present values, several attempts may be needed to select satisfactory rates for the cost of capital (that is, rates for the cost of capital which are close to the adopted internal rate of return).
Internal rate of return (IRR) This method presupposes that the investors have a preliminary knowledge of an acceptable project rate of return. Based on several different rates of return by way of elimination the rate that is indeed acceptable to the investment project in question is identified. The rate of return found this way (internal rate of return)
is compared to investor’s target rate of return and conclusions about profitability on the investment project are made.
if the internal rate of return exceeds the target rate of the investor, the investment is beneficial;
if the internal rate of return is below the target rate of the investor, the investment is not beneficial.
Internal rate of return of an investment project is calculated as an interest rate at which the net present value (NPV) is zero, which means that at a certain discount rate the project would pay back to the extent of the capital used but will not give extra return. Therefore, the internal rate of return is defined as a discount rate which makes the net present values of cash outflows and inflows equal.
Discount rate can be adjusted until the NPV reaches zero without splitting up the discount rate into units below 1 percent. In this case the rate is obtained by using the hit-and-miss exercise or interpolation.
Arithmetic calculation for interpolation, using 2 discount rates – one resulting in a positive NPV and the other - in negative NPV, is as follows:
IRR =r1+ (r2-r1)*NPV1 (NPV
1 -NPV2 ),
where r1 – the lowest discount rate, r2 – the highest discount rate,
NPV1-NPV2 at the lowest and the highest discount rate
Two different net present values are calculated, both as close as possible to zero, using various rates for the cost of capital expressed in whole numbers. Preferably, one of the net present value (NPV) figures should be positive and the other – negative.
In order for the project to be acceptable, the internal rate of return ratio should be higher than the interest rate of borrowed capital or the cost of capital defined by the investor. Usually the minimum required IRR is allowed to be higher than the cost of capital due to project risk considerations.
One of the advantages of this figure is that it can be used as a reference as it takes into account the future cash inflows and outflows, the factor of impairment of the value. One of its drawbacks is that the IRR figure is not dependent on the size of the financing. It has to be also admitted that the calculation of the exact IRR figure is only possible with the help of a computer where there is a module incorporated in MS Excel for calculation of IRR. Approximate IRR figures may be calculated with the use of a graph.
Example 7
Decision is being taken on whether an enterprise should purchase a machine costing Ls 80,000 which would reduce the costs in 5 consecutive years by Ls 20,000 per year and which would be sold at the end of Year 5 for Ls 10,000.
What is the internal rate of return of the investment project?
First of all the rate of the cost of capital should be determined at which the net present value would be zero.
Option 1 If the rate of the cost of capital is 10%.
Year Cash flows, Ls Discount factor 10% Discounted value, Ls
1-5 20,000 At the
end of Year 5
10,000
Net present value:
This is already quite close to zero. As the net present value arrived at is a positive figure, it means that the actual internal rate of return is higher by 10 percent.
Option 2 If the rate of the cost of capital is 15%.
Year Cash flows, Ls Discount factor 15% Discounted value, Ls
0 -80,000
1-5 20,000 At the end
of Year 5
10,000
Net present value:
This figure is negative. Therefore the actual internal rate of return is above …….%. (NPV = ………..), but below ……..% (NPV = ………).
Which method should be chosen – NPV or IRR?
Essentially each evaluation method provides additional information about the investment project.
The accounting rate of return and the payback period method is used to: 1. exclude those projects that are obviously inappropriate;
2. evaluate small in size or short-term projects;
3. determine the risk and liquidity levels as well as to select out of two projects with the same NPV the one with the shortest payback period.
The NPV method shows the generated project value and describes return on capital investment. NPV is basically used to evaluate long-term investment projects.
If contribution of capital is planned in parts over a longer period of time the NPV method is more appropriate.
Both the IRR method and the NPV method provide information about ‘the risk free margin reserve’ as they both calculate what yield there is from each lat invested in the project.
When mutually exclusive projects are evaluated all risks and their impact on the project results should be considered, also called the sensitivity analysis.