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Accounting and Corporate Finance

It follows the principals of having discounted cash flows. The formula to find out the Net present value precisely can be written as: Cash flow (today i.e. year 0) + Cash flow (1 year from now) [/1+r (cost of capital)]^1 + Cash flow (2 years from now)/](1+r)^2 Cash flow refers to the amount of expected cash to be received at a certain point in time X years from now. Cash flows can either be negative or positive. An inflow of cash is a positive cash flow such as an income whereas an outflow is represented with a negative sign and denotes an outgoing cash amount due to for instance expenditure. If the NPV of a certain project equals zero, it denotes that the project is a break-even project; working at no profit-no loss. In simple words it means that the amount of capital invested is exactly equal to the return that would be generated by undertaking the project. A project should be taken up or initiated only if the net present value is at least zero or greater than zero. Even though the calculations of Net Present Value are fairly simple and convenient, it is still quicker to use a financial calculator for these calculations because if there are a large number of cash flows, it will become very inconvenient and time consuming to make the calculations with the formula (Brigham et al, 2010). IRR (Internal rate of Return) IRR is the value where the NPV is equal to zero. It is the optimal value where a project is most beneficial. IRR can gauge the profitability of a proposed investment by taking into consideration the concept of discounted cash flows. IRR is not as easy to calculate as Net Present Value especially if each cash flow is different every year therefore it needs to be calculated using financial calculator. If not, then it is done on the basis of trial and error. The IRR can also be calculated in Microsoft Excel but it begins with guessing. IRR is very closely related to Net Present Value and it marks the next step to the calculation of Net Present Value. The IRR is the yield at which the investments constitute of cash outflows and inflows that occur at a certain time period in a fixed amount (Helfert, 2001). Profitability Index: Profitability Index is basically a measure of the per dollar value of the initial investment spent on a project. This means that if a project’s PI is 1, then the project will give a break-even value of return in comparison to the initial spending done on it. If the value is below 1.0, it means that the project is going to incur a loss and the investment done on it will be greater than the relative return it will give back over the years. If the Profitability Index is greater than 1 then the project can be accepted as it will be giving a profit. For mutually exclusive projects, the project with the higher Profitability Index is a better option. It is calculated as: Present Value of future cash flows/initial cost (ACCA, 2008). Discounted Payback Period: Payback period is another technique used to measure the viability of projects in terms of the number of years that it takes to pay back an initial investment. It is measured in number of years till recovery and the following formula can be used to measure it. No. Of years prior to full recovery+ Unrecovered cost at beginning of year/Cash flow during full recovery year (Kinney et al, 2009). b) Discuss the results for the numerical examples NPV Year CF Project First CF Project Second 0 (1000) (1000) 1 500 500 2 600 400 3 700 300 4 800 100 Project First: (1000)+ 500/1.10^1+600/1.10^2+700/1.10^3+800/1.10^4 = -1000+ 454.54+
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