Net Present Value, Internal Rate of Return and Payback Period

Student Name (Anonymous)

University of the People, MBA

BUS 5110: Flexible Budget Analysis

Dr. Geetika Arora

March 09, 2022

 WA 6 NPV, IRR and Payback

Introduction

From time to time a business may be faced with a difficult and expensive decision. It

is here that the expertise of a managerial accountant are needed in order to ease the process.

The accountant will then calculate necessary numbers applying certain tools within the

capital budget. These may include the Net Present Value, Internal Rate of Return,

Profitability Index and the Payback Period. This paper thus, seeks to discuss the case of a

washing machine and dryer manufacturer who has to decide between two options. To assist

with this decision, the present paper will investigate the company’s NPV, IRR and Payback

period as required.

The company has provided the following details.

Option 1 

 $75,000 for equipment with useful life of 7 years and no salvage value. 

 Maintenance costs are expected to be $2,500 per year and increase by 3% in Year 6
and remain at that rate. 
 Materials in Year 1 are estimated to be $20,000 but remain constant at $10,000 per
year for the remaining years. 
 Labour is estimated to start at $50,000 in Year 1, increasing by 3% each year after. 

Estimated Revenues

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

   
-    50,000    125,000    150,000    150,000
113,000 125,000

Option 2 

 $50,000 for equipment with useful life of 7 years and a $10,000 salvage value 
 Maintenance costs are expected to be $4,500 per year and increase by 3% in Year 6
and remain at that rate. 
 Materials in Year 1 are estimated to be $25,000 but remain constant at $20,000 per
year for the remaining years. 
  Labour is estimated to start at $70,000 in Year 1, increasing by 3% each year after. 

Estimated Revenues

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

   
-    75,000    125,000    200,000    150,000
100,000 155,000
The company’s required rate of return and cost of capital is 8%.

Net Present Value

The Net Present Value is the cost of future cash flows, calculated at a discount

suitable to the present time (Hart, 2020), which “allows you to calculate the expected return

on investment (ROI) you’ll receive (para. 2). To calculate the NPV an accountant must know

the upfront cost of the investment, projected revenues for each year and the company’s

return/discount rate. A negative result indicates a need to reject the project while a positive

result is the opposite (Harvard Business Review, 2017).

Internal Rate of Return (IRR)

This is the discount rate needed to get an NPV of zero (Heisinger and Hoyle, n.d.). It

tells accountants how much rate of return is received from the project (PM Tycoon, 2015).

Similarly to the NPV, if the IRR is found greater or equal to the company’s rate of return, the

project should be accepted if not it should be rejected (Heisinger and Hoyle, n.d.).

Payback Period

While the payback period calculates the amount of time it takes to pay back the initial

investment (Heisinger and Hoyle, n.d.). Experts argue that the IRR should be higher than the

cost of funds (Maths is Fun, n.d.). Hence, “if it costs 8% to borrow money, then an IRR of

only 6% is not good enough!” (para. 14).

 Computation and Data

NPV Calculation

To calculate NPV one must know the Present Value(PV) of all the cash inflows and

outflows. Next sum up all inflows in order to subtract the outflow from them.

This is the Present Value formula. PV = FV ÷ ( 1+ K )n

Option 1

7 year Cash Inflows

Period Computation Result
PV Year 1 -
PV Year 2 $50 000/(1.08)^2 $42 866. 94
PV Year 3 $113 000/(1.08)^3 $89 703
PV Year 4 $125 000/(1.08)^4 $91 878. 73
PV Year 5 $125 000/(1.08)^5 $85 072. 89
PV Year 6 $150 000/(1.08)^6 $94 525. 44
PV Year 7 $150 000/(1.08)^7 $87 523. 55
Cash Inflow all $491 570. 55
PVs

Similarly to the Cash Inflow computation, the total outflows are calculated using the PV

formula for all 7 years.

a7 year Cash Outflows

1 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

Maintenance $2 500 $2 500 $2 500 $2 500 $2 500 $2 575 $2 575

Materials $20 000 $10 000 $10 000 $10 000 $10 000 $10 000 $10 000
Labour $50 000 $51 500 $51 500 $51 500 $51 500 $51 500 $51 500
Outflows PV $72 500/ $64 000/ $64 000/ $64 000/ $64 000/ $64 075/ $64 075/
Computation
(1.08) (1.08)^2 (1.08)^3 (1.08)^4 (1.08)^5 (1.08)^6 (1.08)^6

Result $67 129.62 $54 869.68 $50 805.26 $47 041.91 $43 557.32 $40 378.11 $37 387.14

Total
Outflows $341 169.04
PVs
Therefore Total Cash Outflows($416 169.04) = Total Outflows PVs($341 169.04) + Initial

Investment($75 000)

NPV is calculated using the following formula: NPV = PV Cash inflow – PV Cash

outflow = ($491 570. 55 - $416 169. 04) = $75 401. 51

The NPV is positive, which indicates that the manufacturer should consider/opt for Option 1.

Process of computation

Step 1: Calculated the PV of all the years from year 1 to year 7.

Step 2: Summed up the PV of all the years

Step 3: Calculated the NPV which = Present Value of all cash inflows – Present value of all

cash outflows

Step 4: As stated earlier if the NPV is positive, then. The project should be accepted and

rejected if negative.

Calculating the IRR

IRR Option 1

$0 = (−$75,000) + $67,129. 62 ÷ (1 + 10)-1 + $54, 869. 68 ÷ (1 + 10)-2 + $50,805. 26 ÷ (1 +

10)-3 + $47,041. 91 ÷ (1 + 10)-4 + $43 557. 32 ÷ (1 + 10)-5 + $40 378. 11 ÷ (1 + 10)-6 +

$37 387. 14 ÷ (1 + 10)-7 = - $185 797. 69

IRR Option 1 = 10%

Given that the company’s cost of capital is 8%, management should continue with this

option.
 NPV is calculated using the following formula: NPV = PV Cash inflow – PV Cash outflow =

($491 570. 55 - $416 169. 04) = $75 401. 51

7 year Cash Inflows

Period Computation Result
PV Year 1 -
PV Year 2 $50 000/(1.08)^2 $42 866. 94
PV Year 3 $113 000/(1.08)^3 $89 703
PV Year 4 $125 000/(1.08)^4 $91 878. 73
PV Year 5 $125 000/(1.08)^5 $85 072. 89
PV Year 6 $150 000/(1.08)^6 $94 525. 44
PV Year 7 $150 000/(1.08)^7 $87 523. 55
Cash Inflow all $491 570. 55
PVs

Calculating the Payback Period

Investment (Cash Cash Inflow Unrecovered Investment

Outflow) Balance
Year 1 $75 000
Year 2 - $50 000 $25 000
Year 3 - $113 000 -
Year 4 - $125 000 -
Year 5 - $125 000 -
Year 6 - $150 000 -
Year 7 - $150 000 -

Recommendations

The pay-back period for this company was in just over a year. While this method

ignores the value of time, this company is in a good position, considering it’ll only take less

than two years to repay the investment fee. Therefore with a positive NPV and an IRR well

below zero, option 1 is clearly a good option to take up for the manufacturer.
References

Hart, M. (2020, February 10). Net Present Value (NPV), explained in 400 words or less.

https://blog.hubspot.com/sales/net-present-value

Harvard Business Review. (2017, March 23). The refresher: Net Present Value [Video].

YouTube. https://hbr.org/video/5369743863001/the-refresher-net-present-value

Heisinger, K., & Hoyle, J. B. (n.d.). Accounting for

Managers. https://2012books.lardbucket.org/books/accounting-for-managers/

index.html

Maths is Fun. (n.d.). Internal rate of return (IRR). Maths is Fun.

https://www.mathsisfun.com/money/internal-rate-return.html

PM Tycoon. (2015, April 8). NPV – Net Present Value, IRR – Internal Rate of Return,

Payback Period [Video]. YouTube. https://www.youtube.com/watch?

v=C5o6U7zOebM