NPV Method
NPV Method
NPV Method
3.0 INTRODUCTION
The value of any particular asset is not easy to determine as the value of any asset is
determined by the present value of the future cash flows associated with the assets
which itself are uncertain in nature. The managers are continually faced with decisions
regarding the various alternative investments scenarios. In this unit we look at the
various types of capital investment decisions which the finance manager takes we are
also going to look at the ways and means to estimate the costs and benefits associated
with these decisions.
3.1 OBJECTIVES
After going through this unit, you should be able to:
The value of a firm is the present value of all its future cash flows and the source of
these future cash flows are:
36
• Assets that are already in place Investment Appraisal
Methods
• Future investment opportunities.
Future cash flows are re-discounted at a rate which takes into consideration the risk
and uncertaininty of these cash flows. Cash flow risk comes from two basic sources:
• Sales risk, which is the degree of uncertainty related to the number of units that
will be sold and the price realised.
• Operating risk, which is the degree of uncertainty concerning cash flows that
arises from the particular mix of fixed and variable operating costs of sales.
Risk is associated with general economic conditions prevailing in the markets
in which goods and services are sold, whereas the operating risk is determined
by the product itself and is related to the sensitivity of operating cash flows to
changes in sales. The combination of these two risks is business risks.
The discount rate (the rate of return required to compensate the suppliers of capital) is
a function of business risk associated with the project. From the investors perspective
the discount rate is the required rate of return (RRR) and from the firm’s perspective,
the discount rate is the cost of capital.
Stage 1: Investment Screening and Selection − Projects consistent with the corporate
strategy are identified by the various functional units (production, marketing, research
and development) of the firm. Once the projects are identified, projects are evaluated
and screened by an investment committee comprising of senior managers. The main
focus of this process is to estimate how the investment proposal will affect the future
cash flows of the firm and hence the value of the firm.
Stage 2: Capital Budgeting Proposal − Once the investment proposal survives the
scrutiny of the investment committee, a capital budget is proposed for the project. The
capital budget lists the amount of investment required for each investment proposal.
This proposal may start with estimates of expected revenue and costs. At a later stage
inputs from marketing, purchasing engineering, production and accounting and
finance functions are put together.
Stage 4: Project Tracking − Once the project is approved the next step is to execute it.
The concerned managers periodically report the progress of the project as well as any
variances from the plan. The managers also report about time and cost overruns. This
process of reporting is known as project tracking
• Physical decoration
• Obsolescence
• The degree of competition in the market for a product.
The economic life of an asset is an estimate of the length of time that the asset would
provide benefits to the firm. After its useful life, the revenues generated by the assets
decline rapidly and expenses on the assets increase in a disproportionate manner.
Investment decisions are vital and crucial for any company and merit special attention
because of the following reasons:
Growth: Investment decisions affect the growth rate of the firm. A firm’s decisions
to invest in long-term assets will have a bearing on the rate and direction of its future
growth. The assumptions on which capital investment decisions are based have to be
estimated with a fair degree of precision; otherwise this may lead to the creation of
excessive capacity and simultaneous increase in interest and other costs. On the other
hand inadequate investments would lead to a loss of market share.
Risk: The risk complexion of the firm may also change with long- term commitment
of funds for capital assets. The capital assets are financed by a mix of internal
accruals, long-term borrowings and issue of fresh equity. The firms using borrowings
to finance capital projects become more risky as the future cash flows associated with
the capital projects are uncertain.
Funding: Investment decisions generally require large amount of funds, which make
it imperative for the firms to plan their investment programame very carefully and
make an advance arrangement for procuring finances internally or externally.
38
Irreversibility: Most of the capital investments are irreversible or reversible at very Investment Appraisal
Methods
significant costs. Once the funds are committed for a capital project it becomes
imperative for the firm to complete the project, abandoning it mid way would cause
heavy losses to the firm as it is difficult to find a market for such custom made plant
and machinery.
Complexity: Investment decisions are among the firm’s most difficult decisions. The
reasons for the complexity of these decisions are that they involve estimating the
future cash flows of an investment, decisions, which in turn are depended on
economic, political, social and technological variables.
39
Financial Management These types of investment decisions involve choosing among different
and Decisions alternatives. Choosing one alternative will exclude all other alternatives. For
example, for capital power generation a company may either choose between a
gas based or coal based power generator. Choosing any one of the alternatives
will automatically exclude all the other available alternatives.
40
A firm invests only to increase the value of their ownership interest. A firm will have Investment Appraisal
Methods
cash flows in the future from its past investment decisions. When it invests in new
assets, it expects the future cash flows to be greater than without the new investment.
Incremental Cash Flows
The difference between the cash flows of the firm with the investment project and the
cash flow of the firm without the investment project both over the same period of
time-is referred to as the projects incremental cash flows.
A more useful way of evaluating the change in value of the firm is the break down of
the project’s cash flow into two components:
1) The present value of the cash flows from the projects operating activities
(revenue minus operating expenses), referred to as the project’s operating cash
flow (OCF); and
2) The present value of the investment cash flows which are the cash flow
associated with the expenditure needed to acquire the projects asset and any
cash flow associated with the disposal of the asset.
The present value of a project’s operating cash flow are generally positive and the
present value of the investment cash flows is typically negative.
In addition to these factors two other factors viz., sunk cost and the opportunity cost
should be factored in the analysis of new projects.
Sunk cost is any cost that has already been incurred that does not affect future cash
flows of the firm, e.g., Research and Development cost of new products.
In case the new project uses already existing assets (generating cash flows) the cash
flows foregone to use the above said assets represents the opportunity cost that must
be included in the analysis of the new project. However, these foregone cash flows are
not asset acquisition cash flows, but they represent operating cash flows that could
have occurred but will not because of the new project, they must be considered part of
the project’s future operating cash flows.
Asset Disposal
At the end of the useful life of an asset the firm may be able to sell it or pay someone
to diamantal and haul it away. If a firm is making replacement decision the cash flow
from disposal of the asset must be factored in since this cash flow is relevant to the
acquisition of the new assets. For the disposal of an existing asset whether at the end
of the useful life or when it is replaced, two types of cash flows must be considered:
1) The firm receives or pays in disposing off the asset
2) The tax consequences resulting from the disposal.
Cash flow from disposing assets = proceeds or payments from disposal of assets –
Taxes from disposing assets.
41
Financial Management
and Decisions
The tax on disposal would depend upon three factors:
1) The expected sales price.
2) The book value of the asset for tax purpose. The book value of an asset is
(Original cost of acquisition – Accumulated depreciation). The book value is
also referred to written Down Value (WDV).
3) The tax rate at the time of disposal.
If a firm sells the asset for more than its book value but for less uses than its original
cost, the difference between the sales price and the book value for taxable purposes
(called the tax basis) is a gain taxable at ordinary tax rates. If the firm sells the asset
for more than its original cost than the gain is broken into two parts:
1) Capital Gain: The difference between the sales price and original cost.
2) Recapture of Depreciation: The difference between the original cost and the
written down value.
The capital gains are taxed at special rates usually lower than the ordinary rates. The
recapture of depreciation is taxed at the ordinary rate. If a firm sells off asset for less
than its book value, the result is capital loss. The capital loss can be offset against
capital gains.
The operating cash flows cannot be predicted accurately for the future but an effort
must be made to estimate the input for future planning. These estimates depend upon
research, engineering analysis, operation research, competitor’s analyses and
managerial experience.
Cash Flows
In capital budgeting decisions, the costs and benefits of a proposal are measured in
terms of cash flows. Clash flows refer to cash revenue minus cash expenses or cash
oriented measures of return generated by a proposal. The costs are denoted as cash
outflows whereas the benefits are denoted as cash inflows. The cash flows associated
with a proposal, usually, involves the following three types of cash flows:
• Cost of New Asset to purchase land, building, machinery etc. including expenses
on insurance, freight, loading and unloading, installation cost etc.
• Opportunity Cost, if the new investment makes use of some existing facilities for
example, if a firm proposes to invest in a machine to be installed on some surplus
land of the firm, the opportunity cost of this land would be its selling price.
• Additional Working Capital i.e., excess of current assets over current liabilities
required to extend additional credit, to carry additional inventory, and to enlarge
its cash balances.
The computation of cash outflows has been shown in the following Table:
Rs.
Purchase Price of the Asset (including duties and taxes, if any) ……….
Add : Insurance, Freight and Installations costs ……….
Add : Net Opportunity Cost (if any) ……….
Add : Net increase in working capital required ……….
……….
Less : Cash Inflows in the form of scrap of salvage value of the old ……….
assets (in case of replacement decisions)
Initial Investment or Cash Outlay ……….
The initial investment or cash outflows are expected to generate a series of cash
inflows in the form of cash profits by the project. These cash inflows may be the same
every year throughout the life of the project or may vary from one year to another.
These annual cash inflows are not accounting profits, because accounting profits are
affected by accruals, provisions for future losses and non-cash transactions such as
depreciation, preliminary expenses etc. Therefore, cash inflows that are related to
capital budgeting decisions are the after tax cash inflows. In other words, net annual
cash inflow refers to the annual net income (profits) before depreciation and after tax.
For the calculation of these cash inflows, first of all income before tax is calculated by
deducting all cash operating expenses and depreciation from the sales revenues. After
deducting the tax, the amount of depreciation is added to the income after tax. The
balance is the net cash inflows from the project which can also be calculated as
follows:
Rs.
(A) Estimated Saving
Estimated Savings in direct wages ……….
Estimated Savings in Scrap ……….
Total Savings (A) ……….
(B) Estimated Additional Costs
………..
Additional cost of maintenance
………..
Additional cost of supervision
………..
Add: Cost of indirect material ………..
Additional depreciation ………..
Total Additional Costs (B)
Net Savings before tax (A−B) ………..
Less : Income Tax ………..
Net Savings after tax ………..
………..
Add: Additional depreciation
.
Net Savings after tax or Cash Inflows ………..
Initial Investments Co
Payback period = =
Annual Cashflows C
Example 3.1:
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Investment Appraisal
Initial Investment Project X Project Y Methods
Year (1,00,000) (1,00,000)
Solution:
In this example project Y would be selected as its payback period of three years is
shorter than the four years payback period of Project X.
Example 3.2: Project A costs Rs. 200000 and Project B Costs Rs. 3000000 both have
a ten-year life. Uniform cash receipts expected are A Rs. 40,000 p.a. and B
Rs. 80,000 p.a. Calculate the payback period.
Solution:
Under traditional payback
Rs. 2,00,000
Project A = = 5 years
Rs. 40,000
Rs.3,00,000
Project B = = 3.75 years
Rs.80,000
45
Financial Management An alternative way of expressing payback period is “payback period reciprocal”
and Decisions which is expressed as
1
× 100
Payback Period
Thus, if a project has a payback period of 5 years then the payback period reciprocal
would be
1
× 100 = 20%
5
Average Income
ARR =
Average Investment
∑ EBIT (1 − T ) / n
n
t =1
(I0 + I n ) / 2
Here average income is adjusted for interest. Of the various accounting rate of return,
the highest rate of return is taken to be the best investment proposal. In case the
accounting rate of return is less than the cost of capital or the prevailing interest rate
than that particular investment proposal is rejected.
Year Rs.
1 40,000
2 80,000
3 90,000
4 30,000
Solution :
Rs.5,00,000 + 0
i.e., = Rs.2,50,000
2
Note: If the residual value is not zero but say Rs. 60,000 then the average investment
would be,
Rs. 5,00,000 + Rs. 60,000
= Rs. 2,80,000
2
46
Rs. 60,000 Investment Appraisal
The accounting rates of return = × 100 = 24% Methods
Rs. 2,50,000
This percentage is compared with those of other projects in order that the investment
yielding the highest rate of return can be selected.
Year Rs.
1 20,000
2 40,000
3 30,000
4 15,000
5 5,000
These estimates are of profits before depreciation. You are required to calculate the
return on capital employed.
Solution:
Total profit before deprecation over the life of the machine = Rs. 1,10,000
Rs. 1,10,000
Average profit p. a. = = Rs. 22,000
5 years
Total depreciation over the life of the machine = Rs. 80,000 − Rs. 10,000 = Rs 70,000
Rs. 70,000
Average depreciation p.a. = = Rs. 14,000
5 years
Average annual profit after depreciation = Rs. 22,000 − Rs. 14,000 = Rs. 8,000
Original investment required = Rs. 80,000
Rs.8,000
Accounting rate of return = × 100 = 10%
80,000
Return on average investment:
80,000 + 10,000
Average investment = = Rs. 45,000
2
8,000
Therefore, accounting rate of return = × 100 = 17.78%
45,000
Merits of ARR
• It is easy to calculate
• It is not based on cash flows but on profits
• It takes into consideration all the years involved in the life of the project.
Demerits of ARR
47
Financial Management • It does not take into consideration time value of money
and Decisions • Change in depreciation policy may bring inconsistency in results
• This method fails to distinguish the size of the investment
• It is biased against short term projects
• Acceptance and rejection decisions are based on subjective management
targets.
Year 1 2 3 4
Expenses (Rs.)
Advertisement 1,00,000 75,000 60,000 30,000
Others 50,000 75,000 90,000 1,20,000
Variable costs of producing and selling a unit would be Rs. 250. Additional
48
fixed operating costs to be incurred because of this new products is budgeted at
Rs. 75,000 per year. The management expects a discounted return of 15%
(after tax) on investment in the new product. You are required to work out an initial Investment Appraisal
Methods
selling price per unit of the new product that may be fixed with a view to
obtaining the desired return on investment. Assume a tax rate of 40% and use of
straight-line method of depreciation for tax purpose.
2 12.50 7.50
3 10.00 7.50
4 7.50 12.50
5 - 12.50
6 - 10.00
7 - 8.00
Required: (i) Calculate for each project (a) Net present value of Cash flows
(b) Internal rate of return (ii) Recommend with reasons, which of the two
projects should be undertaken by the Company.
Present value of Re. 1
C1 C2 C3 Cn
NPV = + + + ... − C0
(1 + k ) (1 + k ) 2
(1 + k ) 3
(1 + k ) n
∑
Cn
NPV = − C0
t =1 (1 + k ) t
Example 3.5: A firm can invest Rs. 10,000 in a project with a life of three years.
Year Rs.
1 4,000
2 5,000
3 4,000
Solution:
Firstly the discount factors can be calculated based on Rs. 1 received in with r rate of
interest in 3 year
1
(1 + r ) n
Re .1 Re .1
Year 1 = = = 0.909
(1.10 / 100) (1.10)
Re .1 Re .1
Year 2 = = = 0.826
(1 + 10 / 100) 2 (1.10) 2
Re .1 Re .1
Year 3 = = = 0.751
(1 + 10 / 100) 3 (1.10) 3
In this chapter, the tables given at the end of the block are used wherever possible.
Obviously, where a particular year or rate of interest is not given in the tables it will
be necessary to resort to the basic discounting formula.
Since the net present value is positive, investment in the project can be made.
Example 3.6: Machine A costs Rs. 1,00,000 payable immediately. Machine B costs
Rs. 1,20,000 half payable immediately and half payable in one year’s time. The cash
receipts expected are as follows:
50
Year (at the end) A B Investment Appraisal
Methods
1 20,000
2 60,000 60,000
3 40,000 60,000
4 30,000 80,000
5 20,000
Solution:
Machine A
Machine B
Since Machine B has the higher NPV, our decision should be to select Machine B.
∑
Ct
C0 = − C0 = 0
t =1 (1 + r ) t
The IRR equation is the same as the one used for the NPV method. The only
difference is that in the NPV method, the required rate of return k is known while in
the IRR method the value of r has to be determined at which the net present value
becomes zero.
A project is accepted if the internal rate of return is higher than the cost of capital.
Example 3.7: A company has to select one of the following two projects:
Project A Project B
Cost 11000 10000
Cash inflows
Year 1 6000 1000
2 2000 1000
3 1000 2000
4 5000 10000
Using the internal rate of return method suggest which project is preferable.
Solution:
The cash inflow is not uniform and hence the internal rate of return will have to be
calculated by the trial and error method. In order to have an approximate idea about
such a rate, it will be better to find out the Factor. The factor reflects the same
relationship of investment and cash inflows in case of payback calculation:
F I/C
Where F Factor to be located
I Original investment
C Average cash inflow per year
The factor in case of Project A would The factor in case of Project B would be:
be:
11,000 10,000
F= = 3.14 F= = 2.86
3,500 3,500
The factor thus calculated will be located in the table given at the end of the unit on
the line representing number of years corresponding to estimated useful life of the
asset.
This would give the expected rate of return to be applied for discounting the cash
inflows, the internal rate of return.
In case of Project A, the rate comes to 10% while in case of Project B it comes to
15%.
Project A
The internal rate of return is thus more than 10% but less than 12%. The exact rate
may be calculated as follows. Difference calculated in present
Project B
Since present value at 15% adds up to Rs. 8,662, a lower rate of discount should be
taken. Taking a rate of 10% the following will be the result.
Example 3.8: The project cash flows from two mutually exclusive Projects A and B
are as under:
Solution:
(i) Project selection based on internal rate of return.
Project A
Since the original investment in Project A is Rs. 22,000 its IRR will fall between 19%
and 20%.
Rs.
P.V. of cash inflows at 19% 22,260
P.V. of cash inflows at 20% 21,600
Difference 660
54
Now, IRR of Project A is calculated as follows, by applying the formula for Investment Appraisal
Methods
interpretation:
22,260 − 22,000
IRR = 19 + ×1 = 19.4% (approx )
660
Project B
Since the original investment in project B is Rs. 27,000, its IRR will fall between 17%
to 18%.
Rs.
P.V. of cash inflows at 17% 27,440
P.V. of cash inflows at 18% 26,670
Difference 770
27,440 − 27,000
IRR = 17 + ×1 = 17.6% (approximately)
770
Selection of Project:
The IRR of Project A and Project B are 19.4% and 17.6% respectively. A project can
be selected because of its higher IRR over the other Projects. Hence Project A is to be
preferred as it has a higher IRR of 19.4%.
(i) Calculation of IRR of Project B whose cash flow from the Project is for 8 years
instead of 7 years
Discount factor P.V. factor for Cash inflow each P.V. of cash
8 years Rs. year Rs. inflows
15% 4.49 7,000 31,430
16% 4.34 000 30380
17% 4.21 7,000 29470
18% 4.08 7000 28,560
19% 3.95 7,000 27,650
20% 3.84 7,000 26,880
Since, the original investment in Project B is Rs. 27, 000, its IRR will fall between
19% to 210%.
Rs.
P.V. of cash inflows at 19% 27650
P.V. of cash inflows @ 20% 26880
Difference 770
27,650 − 27,000
IRR 19 + × 1 = 19.8% (approximately )
770
Selection of Project:
With the change in cash inflow of Project B from, 7 years to 8 years, its IRR is also
improved from 17.6% to 19.8% and it is also higher than the IRB of Project A (i.e.,
19.4%). Hence, Project B can be selected (based on its 8 years of cash inflows).
55
Financial Management Example 3.9: Two investment projects are being considered with the following cash
and Decisions flow projections:
Project 1 Project 2
Initial outlay
Cash inflows
Year 1 10 120
Year 2 30 90
Year 3 210 50
Year 4 50 10
Required:
(a) Prepare on a single graph present value profiles for each project. Use interest
rates from 0% to 20% at 5% intervals.
(b) Using the graph paper determine the IRR for each of the projects
(c) State for which range of costs of capital Project 1 would be preferred to
Project 2.
Solution:
Workgroups
Project 2
0 200 1.000 200 1.000 200 1.000 200 1.000 200
1 120 0.952 114.2 0.909 109.1 0.870 104.4 0.833 100.0
2 90 0.907 87.6 0.826 74.3 0.756 68.0 0.694 62.5
3 50 0.864 43.2 0.51 37.6 0.657 32.9 0.579 29.0
4 10 0.823 8.2 0.683 6.8 0.572 5.7 0.482 4.8
70 47.2 27.8 11.0 3.7
(i) IRR Project 1 15% (to nearest %)
(ii) IRR Project 2 19% to nearest %)
Year end %
1 8
2 8
3 8
57
Financial Management Solution:
and Decisions
First of all, it is necessary to calculate of the total compounded sum which will be
discounted to the present value.
Now, we have to calculate the present value of Rs. 12,984 by applying the discount
rate of 10%
(1+i)n
12,984
= = Rs.9,755 = 12984 × 0.7513 = Rs,9,755
(1.10) 3
Here, since the present value of reinvested cash flows i.e Rs. 9,755 is greater than the
original cash outlay of Rs. 8,000, the project would be accepted under the terminal
value criterion.
Example 3.12: XYZ Ltd. is implementing a project with a initial capital outlay of
Rs. 7,600. Its cash inflows are as follows:
Year Rs.
1 6,000
2 2,000
3 1,000
4 5,000
The expected rate of return on the capital invested is 12% p.a calculate the discounted
payback period of the project.
Solution:
The discounted payback period of the project is 3 years i.e., the discounted cash
inflows for the first three years (i.e., Rs. 5358 +Rs. 1594 + 712) is equivalent to the
initial capital outlay of Rs. 7600.
(b) Identify the preferred option, giving reasons for your choice.
2,78,000
Option 1 = = 2.78 years
1,00,000
8,05,000
Option 2 = = 3.32 years
2,50,000
Option 1
59
Financial Management Option 2
and Decisions
Annual depreciation 8,05,000 − 1,50,000 Rs. 1,31,000
5
Annual Profit Rs. 1,19,000 Rs. 2,50,000 cash flow-
Rs. 1,31,000 depreciation
Average investment 8,05,000 + 1,50,000 Rs. 4,77,500
2
Accounting rate of 1,19,000 25%
return × 100
4,77,500
Option 1
Year 0 (2,78,000)
Year 1-5 (1,00,000 × 3.353) 3,35,300
Year 5 (28,000 × 0.497) 13,900
71,200
NPV
Option 2
7,40,000
Approx cumulative discount factor (5 year) = = 2.96 = 20%
2,50,000
NPV at 20% (Rs.)
Year 0 (8,05,000)
Year 1-5 (2,50,000 × 3.353) 8,38,300
Year 5 (1,50,000 × 0.497) 74,500
NPV 1,07,800
Year 0 (2,78,000)
Year 1-5 (1,00,000x 2.689) 2,68,900
Year 5 (28,000 x 0.328) 9,200
NPV 100
IRR 25%
Option 2
7,40,000
Approx cumulative discount factor (5 years) = 2.96 = 20%
60 2,50,000
NPV at 20% : Investment Appraisal
Methods
Year 0 (8,05,000)
Year 1-5 ( 2,50,000 × 2.991) 7,47,700
Year 5 (1,50,000 × 0.402) 60,300
NPV 3,000
⎛ 1,07,800 ⎞
IRR = 15% + ⎜ 5 × ⎟ = 20.1% ∴ IRR 20%
⎝ 1,04,800 ⎠
Both projects are indicated as being worthwhile when the discounted cash flow
returns are compared with the cost of capital. The payback period, accounting rate of
return, and internal rate of return calculations all points to option 1 being preferred.
The net present value calculation, on the other hand, favours option 2.
The basic reason for the different ranking provided by the NPV method is an absolute
money measure which takes into account the scale of the investment as well as the
quality. The other three appraisal methods provide measure, which express returns
relative to the investment. Investments of comparable relative quality will have the
same returns regardless of scale. For example, an annual profit of Rs. 20 on an
investment of Rs. 100 will have the same relative return as an annual profit of
Rs. 2,00,000 on an investment of Rs. 10,00,000. If one is concerned especially with
quality then the relative measures would provide the required ranking. However, if the
objective is to maximise wealth, investment worth should be measured by the surplus
net present value generated, over and above the cost of the capital.
In the situation in the question the differential between option 1 and option 2 provides
an internal rate of return of 18% as follows:
NPV at 18%
Year 0 (5,27,000)
Year 1-5 (1,50,000 × 3.127) 4,69,100
Year 5 (1,22,000 × 0.437) 53,300
NPV 4,600
Finally, it should be recognised that both the payback method and the accounting rate
of return method have deficiencies. They do not provide an adequate measure of
investment worth. The percentage return including the accounting rate of return
calculations is not comparable with the cost of the capital.
The PI method is a conceptually sound method. It takes into consideration the time
value of money. It is also consistent with the value maximisation principle. Like NPV
and IRR methods the PI method also requires estimations of cash flows and discount
rate. In practice, the estimation of discount rates and cash flows is difficult.
61
Financial Management
and Decisions
) Check Your Progress 2
1) Precision Instruments is considering two mutually exclusive Project X and Y:
Following details are made available to you.
Project X Project Y
Project Cost 700 700
Cash inflows: Year 1 100 500
Year 2 200 400
Year 3 300 200
Year 4 450 100
Year 5 600 100
Total 1,650 1,300
Assume no residual values at the end of the fifth year. The firm’s cost of
capital is 10% required, in respect of each of the two projects: (i) Net present
value, using 10% discounting (ii) Internal rate of return: (iii) Profitability
index.
Present Value of Re.1
2) XYZ Ltd. Has decided to diversity its production and wants to invest its surplus
funds on a profitable project. It has under consideration only two projects. “A”
and “B”. The cost of Project “A” is Rs. 100 Lakhs and that of “B” is Rs. 150
Lakhs. Both projects are expected to have a life of 8 years only and at the end
of this period “A” will have a salvage value of Rs 4 Lakhs and “B” Rs. 14
Lakhs. The running expenses of “A” will be Rs. 35 Lakhs per year and that of
“B” Rs. 20 Lakhs per year. In both case the company expects a rate of return of
10%. The company tax rate is 50%. Depreciation is charged on a straight-line
basis. Which project should the company take up?
Note: Present value of annuity of Re. 1 for eight years at 10% is 5.335 and
present value of Re. 1 received at the end of the eight-year is 0.467.
The projects are mutually exclusive and the company is considering the
selection of one of the two projects. Cash flows have been worked out for both
the projects and the details are given below. “X” has a life of 8 years and “Y”
has a life of 6 years. Both will have zero salvage value at the end of their
operational lives. The company is already making profits and its tax rate is
62 50%. The cost of capital of the company is 15%.
Investment Appraisal
Methods
At the end of the year Project “X” Project “Y” Preset value of
(In Lakhs of rupees) rupee at 15%
1 25 40 0.870
2 35 60 0.756
3 45 80 0.685
4 65 50 0.572
5 65 30 0.497
6 55 20 0.432
7 35 - 0.36
8 15 - 0.327
3.5 SUMMARY
Capital investment decisions are complex decisions as they involve estimating future
cash flows associated with that particular investment. There are broadly two
techniques which are used for appraising the worth of an investment project:
(i) Discounted cash flow criteria
(ii) Non discounted cash flow criteria.
The basic difference between these two techniques is that the former uses the concept
of the time value of money, whereas in the latter technique absolute returns are used.
6) Distinguish clearly between Average rate of return and Internal rate of return.
7) Explain the operation of any two techniques (one a discounting method and
another a none-discounting one for evaluation of investment decisions.
10) Can the payback period method of evaluating projects identify the ones that will
maximise wealth? Explain.
63
Financial Management 11) Consider two projects, AA and BB, that have identical, positive net present
and Decisions values, but project BB is riskier than AA. If these projects are mutually
exclusive, what is your investment decision?
12) Can the net present value method of evaluating projects identify the ones that
will maximise wealth? Explain.
13) The decision rules for the net present value and the profitability index
methods are related. Explain the relationship between these two sets of
decision rules.
14) What is the source of the conflict between net present value and the
profitability index decision rules in evaluating mutually exclusive projects?
15) Suppose you calculate a project’s net present value to be Rs.3,000, what does
this mean?
16) Suppose you calculate a project’s profitability index to be 1.4. What does this
mean?
17) The internal rate of return is often referred to as the yield on an investment.
Explain the analogy between the internal rate of return on an investment and
the yield-to maturity on a bond.
18) The net present value method and the internal rate of return method may
produce different decisions when selecting among mutually exclusive
projects. What is the source of this conflict?
19) The modified internal rate of return is designed to overcome a deficiency in the
internal rate of return method. Specifically, what problem is the MIRR designed
to overcome?
20) Based upon our analysis of the alternative techniques to evaluate projects,
which method or methods are preferable in terms of maximising owners’
wealth?
21) You are evaluating an investment project, Project ZZ, with the following cash
flows?
0 100,000
1 35,027
2 35,027
3 35,027
4 35,027
0 100,000
1 43,798
2 35,027
3 35,027
4 35,027
27) You are evaluating an investment project, Project XX with the following cash
flows:
0 200,000
1 65,000
2 65,000
3 65,000
4 65,000
5 65,000
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Financial Management
and Decisions
28) Suppose you are evaluating two mutually exclusive projects, Project/Item 1
and Project/Item 2 with the following cash flows:
End of Year Cash Flows
Year Item 1 Item 2
Rs. Rs.
2000 10,000 Rs.10,000
2001 3,293 0
2002 3,293 0
2003 3,293 0
2004 3,293 14,641
(a) If the cost of capital on both project, is 5% which project, if any, would
you choose? Why?
(b) If the cost of capital on both projects is 8% which project, if any, would
you choose? Why?
(c) If the cost of capital on both projects is 11% which project, if any, would
you choose? Why?
(d) If the cost of capital on both projects is 14% which projects, if any,
would you choose? Why?
(e) At what discount rate would you be indifferent between choosing Item 1
and Item 2?
(f) On the same graph, draw the investment profiles of Item 1 and Item 2.
Indicate the following terms:
• Crossover discount rate
• NPV of Item 1 if the cost of Capital is 5%
• NPV of Item 2 if cost of Capital is 5%
• IRR of Item 1
• IRR of Item 2
29) Consider the results after analysing the following five projects:
Projects Outlay NPV
Rs. Rs.
AA 300,000 10,000
BB 400,000 20,000
CC 200,000 10,000
DD 100,000 10,000
EE 200,000 -15,000
Suppose there is a limit on the capital budget of Rs.600,000. Which projects
should we invest in, given our capital budget?
30) Consider these three independent projects?
Period FF GG HH
Rs. Rs. Rs.
0 100,000 200,000 300,000
1 30,000 40,000 40,000
2 30,000 40,000 40,000
3 30,000 40,000 40,000
4 40,000 120,000 240,000
Cost of Capital 5% 6% 7%
66
(a) If there is no limit on the capital budget, which projects would you Investment Appraisal
Methods
choose? Why?
(b) If there is a limit on the capital budget of Rs.300,000, which projects
would you choose? Why?
3.7 SOLUTIONS/ANSWERS
Check Your Progress 1
1) Working notes:
(i) Calculation of Depreciation per annum
IRR
2.51
Project AXE = 16 + × 4 = 16+5.23 = 21.23%
2.51 − 0.59
4.46
Project BX = 16 + × 8 = 16+4.73 = 20.73%
4.46 + 3.08
(ii) Analysis:
The IRRs of both projects AXE and BXE are very similar, with barely one-half
% separating them from each other. In such a case of marginal difference, it
would be necessary to re-validate key assumptions and use sensitivity analysis
to determine impact upon project returns to changes in key variables. The
project that is less sensitive to such variations may be preferred. Also while
NPVs and IRRs may provide a basis for financial decision-making, it is very
important to check whether either project is in line with corporate strategy. The
one more in tune with such strategy may be preferred even if the financial
numbers are not the highest among the competing proposals.
69
Financial Management
and Decisions 5 600 100 0.621 372.60 62.10
Net Present value 461.35 365.50
(ii) Internal Rate of Return (IRR)
Project X (Rs. In lakhs)
3.70
IRR = 27 + × 1 = 27+0.205 = 27.21%
3.70 + 14.35
5.10
IRR = 37 + × 1 = 37+0.63 = 37.63%
5.10 + 3.00
Analysis:
Under the NPV analysis of Projects, Project B has higher NPV. Hence,
Project B is suggested for implementation.
Project “Y”
End Cash Deprec- PBY Tax PAT Net C.F. Discount P.V
of flow iation (PAT+De factor @
year prn.) 15%
1 40 20 20 10 10 30 0.870 26.40
2 60 20 40 20 20 40 0.56 30.24
3 80 20 60 30 30 50 0.658 32.90
4 50 20 30 15 15 35 0.572 20.02
5 30 20 10 5 5 25 0.497 12.43
6 20 20 - - - 20 0.432 8.64
PV of cash 130.33
inflows
Less: Initial 120.00
investment
Net Present 10.33
value
As Project “Y” has a higher Net Present Value. It should be taken up.
72