INVESTMENT APPRAISSAL
The project would generate total profits of $4,431
The project would generate a positive NPV of $2,569. A key difference between the profits and cash flows is that depreciation is deducted in arriving at profits while it is ignored in calculating cash flows. The incremental working capital is the relevant cash flows associated with working capital. Increases in working capital represent a cash outflows and decreases in the working capital represents a cash inflow. The working capital cash flows are calculated as follows:
The internal rate of return (IRR) is the discount rate that would equate the project’s cash flows to its initial cost. The IRR of a project can be calculated through extrapolation as follows:
IRR = A + (Na/ (Na-Nb)) x (B – A)
Where:
A – The lower discount rate
B – The higher discount rate
Na – NPV at the lower discount rate
Nb – NPV at the higher discount rate
Electronics Unlimited should introduce the new product because the project has a positive NPV of $2,569 and has an IRR of 29.62% that is greater than the cost of capital of 20%. The NPV measures the absolute dollar wealth a project will create to the shareholders of the firm (Shim & Siegel, 2008); in this case, the project will increase shareholders wealth by $2,569. On the other hand, the IRR is a relative measure of return that gives a clearer picture of how sensitive a project is to changes in the cost of capital (Brigham & Ehrhardt, 2014); in this case, the cost of capital would have to increase from 20% to 29.62% before the project is rejected.
References
Brigham, E. & Ehrhardt, M. (2014). Financial management. Mason, Ohio: South-Western.
Shim, J. & Siegel, J. (2008). Financial management. Hauppauge, N.Y.: Barron's Educational
Series.
