Financial Management: The Internal Rate - Essay Example

Financial Management Internal rate of return is the discount rate used when the total present value of periodic usually done once a yearfor many years) cash inflows is equal to the initial cost of the investment. The internal rate of return is the maximum rate of interest that could be paid for the capital employed over the life of an investment without loss on the project. Another topic introduced to bolster our internal rate of return and net present value study here is the payback method of financial management, a decision making tool also. In this assignment, it is instructed that we are to analyze the relationship of internal rate of return and discount rate. The internal rate of rate based on the graph for Project A is 16.463 percent. This is proven by mathematical computation based on the book definition of internal rate of return. The mathematical computation was done thru trial and error rounding or adjusting the final result to the to make the net present value zero.(www.investopedia.com ). The formula for Present value per year is 1/((1+Discount Rate) raised the power of the current year). The power raised of 1 is for first yr, 2 for 2nd year and so on) The two post popular tools in investment management is Internal Rate of Return and Net Present Value.(www.sc.edu). It is a discounted cash flow method of financial management.(www.valuebasedmanagement.com). At present, there is only the trial and error method of mathematically arriving at the internal rate of return of investing you capital in a project. For Project, A you have to use the textbook way by using the formula 1/((1+discount rate)power of the current year). To get the current year present value factor. Therefore for the first year, by using the discount rate of 16.463 percent, we have come up with the following annual cash inflows for the three years. For the first year, $60,000.00 cash inflow multiplied by present value factor of .858640 resulted to present value of $51,518.40. The second year multiplication of the cash inflow of $40,000.00 times present value factor of .7372660 resulted to total amount of $29,490.60. The third and last year, when computing cash inflow of $110,000.00 with the present value factor of .6330472, resulted to the present value of $18,991.42. We then add up the present values for the three years. The total present values will result to the grand amount of $10,000.46. By rounding off this amount to the nearest ones unit, we will get $10,000.00. This amount when deducted from the cost of investment will result to a zero net present value. Therefore the internal rate of return using the trial and error and comparing it with trend line in the line graph will result to the correct and unquestionable 16.463 percent. If the discount rate decreases lower than the Internal Rate of Return of 16.463, it will be better for the company. If , of the other hand, the discount rate increases higher the discount rate of 16.463, this will look bad for your investment decision. As proof of this conclusion, We will compute for the net present value of investing your capital at the internal rate of 14%. For the first year, multiplying the cash inflow of $60,000.00 with the present value factor of .88, we can generate the present value of P52,620. For the second year, by multiplying cash inflow of $40,000,00 with the present value factor of .77, we will gain a present value of $30,760.00. For the third year, the cash inflow of $30,00.00 will be multiplied with the present value factor of .64 to get a present value of $20,250.00. Adding now the total present values for the three years, we can come up with the grand present value amount of $103,630.00. When we deduct this total present value amount of $103,630.00 from the investment capital cost of $100,00.00, the net present value is $3,630.00. Using again a higher discount rate of 18%, we can come up with the following computations. For the first year, multiplying cash inflow of $60,000.00 with the present value factor of .85, we can surely get a present value of $50,820.00. The second year will result to a present value of $28,720.00 if we multiply the cash inflow of $40,000 with the present value factor of .72. The third and final year will result to a present value of $18,270.00. This is due to the fact that the cash inflow of $30,000 is multiplied by the present value factor of .61. We then have to combine the total present values for the three years and come up with the grand amount of $97,810.00. By deducting the total present value of $97,810.00 from the capital investment of $100,000.00, we get a net present value of $ (2,190.00). Since the net present value is negative or lower than zero, then the discount rate of 18 percent is a bad management decision. Internal rate of return is computed based on funds used from period to period, the accounting periods used is usually intervals of 1 year. This means also that money borrowed at effective rate of interest of 16.463 is enough pay the loan for the cost of asset investment bought at $100,000.00 with no loss or gain. The internal rate of return for Project B is 13.316 percent. This could be estimated by looking at the graph here. The Internal rate of return of 13.316 can also be computed mathematically by trial and error. For the first year, multiplying the cash inflow of $10,000.00 by the present value factor of .88249, we can generate the present value of $8,824.88. During the second year, we multiply the cash inflow of $20,000.00 with the present value factor of .77878, we get the resulting present value of $15,575.60. The third and last year will have a present value of $75,599.70. This is the result when we multiply the cash inflow of $110,000.00 with the present value factor of .68727. By adding up the total present values of the first three years of operation, we get a grand total of P100,000.18. We can then round off this number to the ones unit. We will get a rounded off amount of $100,000.00. By deducting the total present value of $100,000.00 from the investment capital cost of $100,000.00 we then will arrive at the net present value, you guessed it, zero. We can now compare the internal rate of return of project A and the internal rate of return of project B. Since the Internal Rate of Return of Project A of 16.463 percent is higher than the internal rate of return of Project B of 13.316 percent, project B has a slight advance over project A. Present value, by looking at the computations explained in the above mathematical explanation, is the total of the annual cash inflow multiplied by the value indicated in the formula 1/((1+Discount Rate)raised to power of current year)). Net present value is the difference between the present value and the cost of the capital investment.(Horngreen, Cost Accounting, Prentic Hall.1977). When net present value is equal to capital cost of investing scarce money resources, this rate is technically called internal rate of return(www.answers.com). We can generate a graph using the net present values and the discount rates as the vertical and horizontal axis amounts respectively. SIX PERCENT DISCOUNT In the next question, we will use six percent as the discount rate for project A and project B. We will then compare the present values and the net present values of both investment choices. As it is well known in financial management, the investment choice that you did not choose is an opportunity cost. For project A, using 6 percent rate, multiplying the first year cash inflow of $60,000.00 by the present value factor of .94, we get a present value of $56,580.00. By multiplying next the cash inflow of $40,000.00 of the second year by the present value factor of .89, we can come up with the present value of P35,600.00. On the third and final year, we must multiply the cash inflow of P30,000.00 by the present value factor of .84 to get the present value of $25,200.00. The total present value, if we choose this project and disregard project B, is $117,380.00. We can then subtract this total present value of P117,380.00 from the long term investment cost of P100,00.00. The net present value of alternative A is P17,380.00. In project B, we will come up with the following mathematical computations in using the same discount rate of 6 percent. During the first year of operations, the cash inflow of $10,000.00 will be multiplied to the present value factor of .94 to get a present value of $9,430.00 only. The second year present value of P 17,800.00 is the dollar figure resulting multiplying cash inflow of $20,000.00 with the present value factor of .89 and come up with a bigger amount due the bigger cash inflow. The third and final year will result in the cash inflow of a very big $ 92,400.00. This amount is the result of multiplying the cash inflow of the very big $ 110,000.00 against the present value factor of .84. The total net cash inflows for the first three years of operations is estimated at $ 119,630.00. Then we now deduct the total cash inflows from the capital cost investment of $100,000.00 to come up with a difference of $19,630.00. The next step in answering this study is to the compare the net present value of project A, which is $ 17,380.00, and the net present value of project B, which is $ 19,630.00. We can now concluded finally that project B is a better financial management decision making move since the net present value of project B is higher than the net present value of project A by as much as $2,250.00. TWELVE PERCENT DISCOUNT. In project A, We can now compute for the net present value for the first three years of operations. For the first year, We have to multiply the cash inflow of $60,000 by the present value factor of .89 to come up with the present value of $ 53,580.00. The second year of will result in present value of $ 31,880.00. This results from multiplying the second year's cash inflow of $40,000.00 by the present value of .80. The third and final year will generate a present value of $ 21,360.00. The present values of these three years is $ 106,820.00. We finally deduct this amount from the capital investment cost of $100,000.00 to get the difference of P6,820.00. This difference is called the net present value. In project B, the following computations can be arrived at. We multiply the first year cash inflow of $10,000.00 by the present value factor of .89 to come up with the present value of $8,930. The second year of operations will result in the cash inflow of $20,000 multiplied by the present value factor of .80 to get a bigger $15,940.00. The third and last year will result to cash inflow of $78,320.00 This amount can be generated by multiplying the very big cash inflow of $ 110,000.00 with the present value factor of .71. The total cash inflows will be, for project B, $103,190.00. The net present value of $3,190.00 is the difference between the total cash inflow of $ 103,190.00 and capital cash investment of $100,000.00. Finally, we can compare the net present values of project A and project B. Since the net present value of project of A, which is $6,820.00 is much higher than the net present value of 3,190.00 of project B. The difference is $3,640.00. Therefore obviously, we should recommend to Mr Cowdrey that Project A be implemented. The net present value method, as of the present, entails trial and error in arriving at the internal rate of return or, simply explained, the discount rate that will result in zero difference between the total present value of annual cash inflows and the loan cost of the investment. As shown by the above computations, at a lower rate of 6%, Project B is clearly a better investment choice. As shown, also, in the above net present value computation, it is a better deal to invest in Project A if the discount rate is 12%. This is only one of the many advantages of using Net Present Value method and Internal Rate of Return in financial management' investment cost decisions. Another analytical finding of the project is that Project A has a bigger cash inflow of $60,000.00 for the first year as compared to only measly $10,000.00. For the second also, project A can come up with a cash collection of $40,000.00 whereas project B can only come up with a $20,000.00 cash collection. We can then use the bigger cash inflows collected in Project A in investing in other major projects like a needed equipment or company wide major repair thus increasing operational facilities. Therefore, in Project B, much needed money will come at the 3rd year of operations yet, $110,000. If management has a tight cash position ( low idle cash), Project A is a better choice. We will notice that internal rate of return, which results in zero net present value, is like investment returning from cash inflows and outflows. (www.advicenter.com) You can compute for the internal rate of return of your scarce investment under several conditions but some problems may occur. Thus we have to study many management and accounting literatures regarding the topic of internal rate of return or present value of cash inflows from collections of cash sales and credit sales and other related topics. Some of the problems arrived can easily be resolved using a new internal rate of return computerized program using several kinds of cash inflows. (www.osti.gov) Another tool that management can use in its routine daily decision making is to determine how long will management recover the capital investment cost it has put into operations. The use of the payback method of long term capital budgeting is one of many other management decision making techniques. We can also use other methods of financial management to decide whether to pick Project A or Project B. Payback method is when you compute, using math, as to how long you will recover the scarce resources, like huge cash, that you generated for the investment. In this present study, the payback period of Product A and Product B will be calculated. From the computation below, its will take Mr Cowdrey only two exact years to recover the P100,000 cash that we invested. Whereas, in Product B, it takes us more than two years to recover our investment. Under the new topic payback method, Project A will get cash inflow of $60,000.00 and then project A will get the remaining $40,000.00 during the second year of operations. Whereas, if you decide to implement project B, You will only get a mere $10,000.00 during the first year of operations and the $20,000.00 during the second year of operations. The remaining $70,000 capital cost investment will only be received by you in 7.68 months of the third year. When you divide the remaining $70,000.00 balance of your $100,000.00 investment cost by the Cash inflow of $ 110,000, you will get a fraction of 7.68 months. In this case it is preferable to choose alternative capital cost investment of P100,000.00 in Project A especially if you need immediate cash for repairs, maintenance, addition of new building, plant, or department. The relative merits of the net present value and the internal rate of return are that it is a major management tool to steer management thru the daily business travels, obstacles and opportunities. In this case Mr Cowdrey to choose the better project to invest his money. As shown above, when there is a change in the interest rate, there is also an overwhelming effect on the decision making process. CONCLUSION: As shown above, If the discount rate decreases, the net present value inversely increases. If the discount rate is lower than the internal rate of return, then this will give a positive, which is good, net present value for the company. In the project A, if the discount rate is lower than the internal rate of return of Project A of 16.463 percent, we should accept this lower rate. On the other hand, if the discount rate is higher than the internal rate of return, then we must not accept the project at this discount rate because the resulting net present value will a negative or bad decision. In Project B, if the discount rate is higher than the internal rate of return of Project B, here it is 13.316 percent, then accepting the project is a bad financial management decision. Between Project B and Project A, Since B has a lower internal rate of return, (13.316 is better than 16.463) then it is more beneficial for us to choose project B. The Internal rate of return is the benchmark to determine as to when we will have a positive net present value. It is believed that this paper covers most of the needed possibilities and goes further as to clearly define what internal rate of return is in every discounting situation. Net present value and internal rate of return is much needed to determine whether the long term investments are feasible or not feasible due to the large money outlay like, in this case, $100,000.00. After the above recommendations, only Mr Cowdrey will decide which recommendation, as owner, to implement. http://www.investopedia.com/terms/i/irr.asp (internal rate of return) http://hadm.sph.sc.edu/COURSES/ECON/invest/invest.html ( net present value) http://www.valuebasedmanagement.net/methods_irr.html (IRR Horngreen, Cost Accounting, Prentice Hall.1977 /www.answers.com/topic/internal-rate-of-return(IRR). http://www.advicenter.com/calcs/cTIM06i.htm( IRR) http://www.osti.gov/energycitations/product.biblio.jsposti_id=5648785(IRR) Project A Net Present Discount rate Value 4 21,690.00 6 17,380.00 8 13,660.00 10 10,110.00 12 6,820.00 PROJECT B: Net Present Discount Rate Value 4 27,010.00 6 19,630.00 8 13,740.00 10 8,220.00 12 3,190.00 Read More