LO 4.3.2: Calculate the present value and net present value (NPV) of uneven cash flows.

Question 1

What type of problems use the NPV calculation

Answer 1

Capital projects and long term investments.

Question 2

How is NPV calculated (conceptually)

Answer 2

• By discounting future cash flows at a given discount rate to determine their total PV
• NPV = PV of all future cash flows - Cost of investment

Question 3

What is the discount rate

Answer 3

The required rate of return

Question 4

How do you use the calculator to solve for NPV

Answer 4

• Enter all the cash flows (CF sub j 0 is the initial cost of the investment, negative #)
• The final cash flow is the expected cash flow + the sale proceeds
• I/YR is the required rate of return/discount rate
• SHIFT > NPV (PRC key)

Question 5

If NPV is positive

Answer 5

then the return is better than the discount rate/required rate of return.

Question 6

If NPV is negative

Answer 6

then the return is less than the required rate of return, and the investor probably shouldn’t do that.

Question 7

How do you use the calculator to solve for actual rate for return given a positive NPV

Answer 7

• You enter the cost of investment and all the cash flows
• Do not enter anything for I/YR, instead hit SHIFT > IRR/YR (CST key)
• The result is the actual rate of return (which will be higher than the discount rate).