684):.
1. A table is prepared to provide the cash flows for each year of the proposed investment.
2. Present value of each cash flow is calculated using a hurdle rate, or the cost to acquire the capital.
3. Net present value is then calculated by adding the present values.
4. If the net present value is positive, then the proposal can be accepted; if negative, the proposal should be rejected.
Based on the low demand projections for Canadian Bikes, the NPV results in a negative $26,740 by the end of the five year timeframe. As a result, this does not appear to be a sound investment as it would be awhile, if ever, before Competition Bikes earned any return on this proposal.
With the moderate demand projections, the NPV results in a positive $2,243 by the end of the five year timeframe. This could easily slip into the negative if the company experienced even the slightest decline in demand.
Internal Rate of Return.
According to Hilton (2011), the internal rate of return is the "true economic return earned by the asset over its life" (p. 685). Examining an investment proposal using internal rate of returns helps the company decide whether or not to accept the proposal if it is greater than the hurdle rate, or the organization's cost of capital.
Despite an initial investment of $600,000, the cash flow is only expected to be $540,532 after five years in the low demand projections. This results in an IRR of only 8.7%, slightly lower than the 10% hurdle rate. Analyzing the moderate projections results in a 10.1% IRR. This barely meets the 10% hurdle rate, so any slight declines in demand could cause the IRR to easily drop under. .
Recommendation.
This investment proposal would not be in the company's best interest based on the NPV and IRR results. The NPV ranges from negative $26,740 for the worst case scenario to positive $2,243 for the moderate projections, meaning that actual results will be within that range.
