Some firms calculate the net present value NPV of a project for knowing its work and few firms prefer to calculate the internal rate of return (IRR) to know whether project’s return is lower or greater than the opportunity cost of given project’s capital. For example, take a real estate sector, a firm wants to build a house and is planning to invest amount of $600,000 in this project to calculate a cash flow of C1= 700,000 after one year. Therefore the firm forecasts a profit of $100,000 on the project (700,000-600,000=100,000). This is a one period investment in which it is easy to find out the IRR. Internal rate of return for various periods will be calculated as follows:
IRR = PROFIT/INVESTMENT=C1-INVESTMENT/INVESTEMENT=700,000-600000/600,000
The investing in the alternative in a treasury note would just give a return of 8%, though the return on the real estate project is greater than the opportunity cost of invested capital. This gives two rules for deciding to go with real estate project:
An investment with a net present value of zero will have a return that is same as the cost of capital. Suppose treasury notes have 16.7% of the return instead of 8%. Since real estate project also gives a return of 16.7%, the rule number two suggest that now a firm can invest in a project or treasury notes because both have same return.
The net present value shows that if the return rate is 16.7% then the project is also balanced with a zero NPV.
NPV= Co +C1/1+R= -600,000+700,000/1.167=0
This indicates that real estate investment would not make a firm poorer or richer; here worth is equal to the cost of a project. Thus both rules provide the same decisions about the project.
Rate of Return (ROR) Rule:
It is clear that if the real estate project is discounted at 8%, it has the net present value of 48,200. If project is discounted at 16.7%, than it has a net present value of zero. The two noticeable things about the Rate of Return are:
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awesome...!!!
I wish to get project topics related with a public sector undertaking in finance to have analysis of profit,return etc