Welcome back to our course, Decision Making and Scenarios.

I'm Professor Rick Lambert of the Wharton School and we're going to be continuing

Module Four where we're talking about analyzing a new product venture.

In this lecture, we're going to talk about how to calculate the NPV and

IRR of the project.

This is what we've been doing all the setup to be able to come to

the calculation of, is this a valuable project or not?

So we've talked about setting up the spreadsheet,

forecasting out the financial statements into the future.

The forecasted future cash flows and now we are going to talk about

using those future cash flows to calculate the NPV of the project.

So, we're going to take the forecasted future cash flows from before.

So we started with trying to calculate the operating cash flows.

Started with net income, added back the depreciation expense, adjusted for

changes in working capital that gave us our operating cash flows,

then we're also going to consider the investing cash flows.

These are the investments at the beginning during the initial period and

also the disposal costs at the very end.

Put those into the bottom line, the net cash inflow or outflow.

And now, we've got both the timing and the magnitudes of the cash flows.

We need to calculate a present value.

To do that, we need a discount rate.

So, the discount rate is intended to represent the opportunity cost of our

capital.

This is the rate we could earn on our next best use of capital of equivalent risk.

We said that we would use 6% for purposes of our example.

Now we could calculate the present value cash flow by cash flow, brute force or

we can use the functions that Excel already has set up to do this.

So the NPV function is the one that's going to calculate a net present value,

but remember that the NPV function assumes that

the first cash flow is one period out.

In our example, the first cash flow is now.

So, just applying the NPV function to all the cash flows will mess it up.

So instead, we want to calculate the first cash flow by itself.

That's the $70,000 initial outlay and

then take the remaining value of the present cash flows.

If we do that, those have a present value of 96,624.

And our overall NPV is then positive 26,624.

The internal rate of return or IRR, also has a built in function for

Excel, we can apply that to the stream of cash flows in total and

that's going to say, 11.5%.

So, what do those numbers mean?

Well, let's start with the NPV calculation.

NPV of 26,624.

This is the economic value that the new product

venture is going to add to the firm.

This considers both the timing and the magnitude of the inflows, and

outflows of cash, and

it should also reflect the riskiness associated with the cash flows as well.

That is the discount rate is supposed to reflect the riskiness.

So this is saying, this project adds $26,624 of value.

What does the IRR mean, 11.5%?

This means that the money that we've invested in a new product venture is

going to earn a rate of return of 11.5%.

Again, this takes into consideration both the timing and

the magnitude of the inflows and the outflows.