A. Suppose the company is considering a potential investment project to add to its portfolio. Calculate the following items: Before Home Depot calculates the net present value (NPV), internal rate of return (IRR), terminal value (TV), and modified internal rate of return (MIRR) of its newest potential investment project, the company must first calculate its free cash flows. The calculation begins by subtracting the operating costs and the 20% depreciation expenses from the cash flows derived from sales revenues. Next, the income tax (35%) is then subtracted from the resulting operating income to arrive at the company’s after-tax earnings before income tax. The final step is for Home Depot to add back the depreciation to the after-tax
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Similar to calculating the IRR, terminal value is also calculated in three ways: (1) perpetuity with growth approach, (2) the earnings before income taxes, depreciation, and amortization (EBITDA) approach, and (3) the perpetuity approach. The EBITDA approach is the easiest of the three methods, but resuls may lack accuracy and consistency. “The perpetual growth approach assumes that free cash flow will continue to grow at a constant rate in perpetuity” (Warnelid 2011). Since there is no constant growth rate for Home Depot’s investment, the forumula will not include that variable. Therefore, Home Depot’s terminal value is calculated with the following formula: TV = CF1 * (1 + I)^4 + CF2 * (1 + I)^3 + (CF3 * (1 + I)^2 + CF4 * (1 + IRR)^1 + CF5. After inserting the variables, TV = $20,475,000 * (1 + 0.08)^4 + $17,225,000 * (1 + 0.08)^3 + $30,550,000 * (1 + 0.16098)^2 + $23,225,000 * (1 + 0.16098)^1 + $4,225,000 and the resulting TV is $115,036,070.66 (Warnelid 2011) (Ehrhardt & Brigham …show more content…
NPV “is the aggregate of all present value of the cash flows of an asset immaterial of positive or negative” while IRR “is the discount rate at which NPV = 0” (S 2015). In addition, the utilization of NPV enables companies to make financial decisions more easily as it focuses on how the investment adds and subtracts investor wealth. On the other hand, IRR is compared to the break-even point as the percentage results in a zero NPV. Unfortunately, IRR is not best suited for helping facilitate the decision-making process. One of the key differences between IRR and MIRR is what is utilized for in calculations. IRR “implies a method of reckoning the discount rate considering internal factors” while MIRR “calculates the rate of return taking into account cost of capital” (S 2017). The IRR percentage is the rate that helps bring the NPV to zero while the MIRR percentage is multiplied to the terminal value to equal the PV. In addition, the MIRR percentage is utilized more often than the IRR percentage due to its higher accuracy (S 2015) (S
Similar to calculating the IRR, terminal value is also calculated in three ways: (1) perpetuity with growth approach, (2) the earnings before income taxes, depreciation, and amortization (EBITDA) approach, and (3) the perpetuity approach. The EBITDA approach is the easiest of the three methods, but resuls may lack accuracy and consistency. “The perpetual growth approach assumes that free cash flow will continue to grow at a constant rate in perpetuity” (Warnelid 2011). Since there is no constant growth rate for Home Depot’s investment, the forumula will not include that variable. Therefore, Home Depot’s terminal value is calculated with the following formula: TV = CF1 * (1 + I)^4 + CF2 * (1 + I)^3 + (CF3 * (1 + I)^2 + CF4 * (1 + IRR)^1 + CF5. After inserting the variables, TV = $20,475,000 * (1 + 0.08)^4 + $17,225,000 * (1 + 0.08)^3 + $30,550,000 * (1 + 0.16098)^2 + $23,225,000 * (1 + 0.16098)^1 + $4,225,000 and the resulting TV is $115,036,070.66 (Warnelid 2011) (Ehrhardt & Brigham …show more content…
NPV “is the aggregate of all present value of the cash flows of an asset immaterial of positive or negative” while IRR “is the discount rate at which NPV = 0” (S 2015). In addition, the utilization of NPV enables companies to make financial decisions more easily as it focuses on how the investment adds and subtracts investor wealth. On the other hand, IRR is compared to the break-even point as the percentage results in a zero NPV. Unfortunately, IRR is not best suited for helping facilitate the decision-making process. One of the key differences between IRR and MIRR is what is utilized for in calculations. IRR “implies a method of reckoning the discount rate considering internal factors” while MIRR “calculates the rate of return taking into account cost of capital” (S 2017). The IRR percentage is the rate that helps bring the NPV to zero while the MIRR percentage is multiplied to the terminal value to equal the PV. In addition, the MIRR percentage is utilized more often than the IRR percentage due to its higher accuracy (S 2015) (S