Page 225 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

International Financial Management

Notes The accept-reject criterion can be specified as:
NPV > 0—– > Finance manager accepts the investments
NPV < 0—– > Finance manager rejects the investments
NPV = 0—– >Finance manager is indifferent toward acceptance or rejection of the project

If the NPV of the project is greater than zero, the project should be accepted because the rate of
return exceeds the required rate of return, the project’s cost-of-capital rate, and this excess cash
accrues solely to the company’s stockholders. When the NPV of the project is equal to zero, the
finance manager may or may not accept the project because the return is exactly equal to the
required rate of return. If the NPV is less than zero, the project is rejected because the project
earns a rate of return less than the required rate of return. If a company accepts a project with a
positive NPV, the wealth of the stockholders improves.
Mathematically, NPV can be expressed as:
n CF
NPV = ∑ t t − IO
t=1 (1 + k)
CF CF CF CF
Or NPV = 1 + 2 + 3 + ... ... ... ... + n − Initialcashoutlay
(1 + k) 1 (1 + k) 2 (1 + k) 3 (1 + k) n
Where:

CF = annual after tax cash flows in Period, t
t
k = the project’s cost of capital
n = the project’s expected life

IO = the initial cash outlay
t = time period

13.2.2 Internal Rate of Return

The IRR method is a discounted cash-flow technique. Similar to the NPV method, it takes into
account the magnitude and timing of cash flows.

IRR is defined as the discount rate that equates the present value of expected future cash inflows
with the present value of the project’s initial cash outflows. Various empirical surveys have
shown that companies prefer the IRR method because it is a relative measure of the projects
worth.
Mathematically, IRR can be expressed as:

n A
IO = ∑ t
t1 (1 + r) t
=
Where:
A = is the cash inflow flow at the end of year t
t
IO = the initial cash outlay

n = the project’s expected life
r = the IRR of the project
t = the time period

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