Discounted cash flow analysis is the term employ to describe the technique whereby the value of future cash flows is discounted back to a present value so that the monetary values of all cash flows are equivalent regardless of their timing. The logic for concession is that the value of money declines over time for the reason that of individual time preferences and the impact of inflation in eroding spending power. People value money received sooner somewhat than later because as soon as cash is received they can increase consumption or reinvest the capital. NPV uses discounting to compute the present value of all cash flows associated with a project. The current value of cash outflows is then compared with the present value of cash inflows to obtain a net present value (NPV). If cash out exceed cash in then the NPV will be negative and vice versa. The extent of the NPV is dependent upon the cash flow pattern and the rate of discount which is applied.
The common rule is that a company will discount the forecast cash flows at a rate equal to its cost of capital. The cause for this is that if a company has an overall cost of capital of example 12% it is necessary that the rate of return exceeds 12% or the funding costs will not be covered.
Therefore if the cash flows are discounted at the cost of capital and the project yields a positive NPV this implies that the return exceeds the cost of capital. When using NPV for investment appraisal next a simple rule is applied invest if NPV is positive and don't invest if it is negative.
IRR uses discounting in a somewhat different way to determine the profitability of an investment. The Internal Rate of Return is described as the discount rate at which the net present value equals zero. For instance an investment may yield a forecast NPV of $15000 when the cash flows are discounted at 10%. If the rate of discount is increased the net present value will fall and the IRR represents the effective break even discount rate for the investment. Presume for instance that the IRR is 15% this figure can then be used to establish a decision rule for investments. An IRR of 15% signifies that if the cost of capital exceeds 15% then the investment would generate a negative NPV. If the company at present has to pay 12% on its investment funds then it knows that it can afford to see its cost of capital rise by 3% before the investment will become financially non-viable. As long as the IRR go beyond the cost of capital then the company should invest and so as a general rule the higher the IRR the better.
NPV and IRR measures may occasionally contradict one another when used in relation to either mutually exclusive investments or projects which have multiple yields. An instance of the ambiguity which can occur when choosing between mutually exclusive decisions is when one of the investments has a higher NPV than the other and consequently is preferable on that basis, but at the same time it has a lower IRR.
When NPV and IRR give conflicting results the preferred alternative is the project with the highest NPV. In the condition of projects with multiple yields caused by cash flows which change from positive to negative and vice versa on several occasions there may be more than one IRR. In these circumstances it is once again preferable to use NPV as the decision criteria.
In conclusion afterwards although both NPV and IRR use discounted cash flows as a method of arriving at an investment decision the results that they generate need to be interpreted with care and they don't always yield the same investment decisions. NPV is the preferred criteria where the two approaches give ambiguous results.
ii) If the laptops replacement take place every year
NPV of one replacement cycle = $(2400) + 1200/1.14 = $(1,347.37)
Equivalent Annual Cost = $1,347/0.877 = $1,536.34
If replacement take place every two years
NPV of one replacement cycle = $(2,400) + 800/1.142 + (75)/1.14 = ($1,850.21)
Equivalent Annual Cost = $1,850·21/1.647 = $1,123.38
If replacement takes place every three years
NPV of one replacement cycle = $(2,400) + 300/1.143 + (150)/1.142 + (75)/1.14 = ($2,378.72)
Equivalent Annual Cost = $2,378·72/2.322 = $1,024.43
Conclude: The best possible cycle for replacement is each three years. Other factors which require to be taken into account are the non-financial aspects of the alternative cycle choices. For instance computer technology and the associated software is changing very rapidly and this could signify that failure to replace annually would leave the salesmen unable to utilise the most up to date systems for recording monitoring and implementing their sales. This could have a force on the company's competitive position. The company needs to as well consider the compatibility of the software used by the laptops with that used by the in-house computers and mainframe. If system improvements are made within the main business which renders the two computers incompatible then rapid replacement of the laptops to regain compatibility is essential.