Explain the concepts of net present value and internal rate of return analysis. What do the results of net present value and internal rate of return analysis tell senior managers of an organization? Would sensitivity analysis be a useful tool for assessing this capital project’s risk and return?
Solution
The net present value of a project is equal to the sum of the present values of all the cash flows after teh appropriate discount rate (to reflect the risk) is employed to the expected future cash flows.The net present value represents the net benefit over and above the compensation for time and risk. It tells the senior managers that if the NPV is positive, accept the project and reject if NPV is negative.
The internal rate of return (IRR) of a project is the discount rate which makes its net present value equal to zero. In IRR calculation, we set the net present value equal to zero and determine the discount rate which satisfies this condition. It tells the senior managers that higher the IRR, better the project and is acceptable.
Sensitivity analysis helps to assess a capital project\'s risk and return through providing a business estimates what will happen to the project if the assumptions and estimates turn out to be unreliable. Sensitivity analysis involves changing the assumptions or estimates in a calculation to see the impact on the project\'s finances. In this way, it prepares the business\'s managers in case the project doesn\'t generate the expected results, so they can better analyze the project before making an investment.
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Explain the concepts of net present value and internal rate of return.docx
1. Explain the concepts of net present value and internal rate of return analysis. What do the results
of net present value and internal rate of return analysis tell senior managers of an organization?
Would sensitivity analysis be a useful tool for assessing this capital project’s risk and return?
Solution
The net present value of a project is equal to the sum of the present values of all the cash flows
after teh appropriate discount rate (to reflect the risk) is employed to the expected future cash
flows.The net present value represents the net benefit over and above the compensation for time
and risk. It tells the senior managers that if the NPV is positive, accept the project and reject if
NPV is negative.
The internal rate of return (IRR) of a project is the discount rate which makes its net present
value equal to zero. In IRR calculation, we set the net present value equal to zero and determine
the discount rate which satisfies this condition. It tells the senior managers that higher the IRR,
better the project and is acceptable.
Sensitivity analysis helps to assess a capital project's risk and return through providing a
business estimates what will happen to the project if the assumptions and estimates turn out to be
unreliable. Sensitivity analysis involves changing the assumptions or estimates in a calculation to
see the impact on the project's finances. In this way, it prepares the business's managers in case
the project doesn't generate the expected results, so they can better analyze the project before
making an investment.
