Decisions on investment, which take time to mature, have to be based on the returns which that investment will make. Unless the project is for social reasons only, if the investment is unprofitable in the long run, types of investment decisions is unwise to invest in it now. As a result, most medium-sized and large organisations have developed special procedures and methods for dealing with these decisions. A increases the cash flow of project B.

A decreases the cash flow of project B. Conventional cash flow: only one change in the cash flow sign e. Non-conventional cash flows: more than one change in the cash flow sign, e. The time value of money Recall that the interaction of lenders with borrowers sets an equilibrium rate of interest. Borrowing is only worthwhile if the return on the loan exceeds the cost of the borrowed funds. Lending is only worthwhile if the return is at least equal to that which can be obtained from alternative opportunities in the same risk class.

Thus we can compute the future value of what Vo will accumulate to in n years when it is compounded annually at the same rate of r by using the above formula. 10 at the end of 5 years? The NPV method is used for evaluating the desirability of investments or projects. At this point the tutor should introduce the net present value tables from any recognised published source.

600 in the first, second and third years respectively. Should the firm go ahead with the project? Attempt the calculation without reference to net present value tables first. Perpetuities A perpetuity is an annuity with an infinite life. Economic rationale for IRR: If IRR exceeds cost of capital, project is worthwhile, i. So, which method leads to an optimal decision: IRR or NPV?

NPV vs IRR: Independent projects Independent project: Selecting one project does not preclude the choosing of the other. If cash flows are discounted at k2, NPV is negative and IRR 2: reject the project. Hence, IRR and NPV lead to the same decision in this case. NPV vs IRR: Dependent projects NPV clashes with IRR where mutually exclusive projects exist. Which project is a “better option” for Agritex? Choosing project B is tantamount to choosing a hypothetical project “B minus A”.