You work for the CFO of our company, and he asks you to calculate the financial

Question

You work for the CFO of our company, and he asks you to calculate the financial aspects of a new acquisition/merger. You do the due diligence, calculate the cash flows that are all normal, determine the initial purchase costs, and decide to utilize the NPV valuation process in your analysis over the 30-year life of the investment. When you finish, you find the answer to be $140M, positive, calculated at a WACC of 10%. Your CFO says, great! But, what does that mean in terms of a percentage return? You tell him that:

a. you tell him that, based on your calculations, the percentage return (IRR) is definitely greater than the 10% WACC, and that the project should be done.

b. you calculated the IRR at the value it would take to achieve a NPV of $140M, and found that it is the same as the WACC of 10%, so the project should be done.

c. the IRR is 8%, since there is risk in the cash flows.

d. the IRR is 10%, since the assumption is that the cash flows are reinvested at the weighted average cost of capital rate when calculating the internal rate of return.

e. because the possibility exists of two different percentages when calculating the IRR, that this would not be a good technique to base the go/no-go decision on.

Explanation / Answer

Net present value is a capital budgeting strategy use to decide whether a project should be undertaken or not, it is done by calculating the present value of cash inflow and outflow. A positive NPV means the project can be undertaken. In this we have got NPV of $140 m and WACC is 10% in percentage terms it means you tell him that, based on your calculations the percentage return is definitely greater than the 10% WACC and that the project should be done.

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