NPV IRR

PREMCHAND 12ME1E0020

“The term capital budgeting generally refers to acquiring inputs with long term returns”

Richards & Greenlaw

The finance function has to deal with one of the most important decisions regarding:

The amount to be invested in fixed assets.

The decision is technically in the form of “Capital Budgeting”

Generation

Evaluation

Selection

Execution

Identification of investment proposals Screening the proposals

Evaluation of various proposals

Fixing prioritiesFinal Approroval

Implementation of proposalsPerformance review

Accounting rateOf returns

Traditional Techniques

Pay Back Period indicates the period within which the cost of the project will be completely recovered.

It indicates the period within which the total cash inflows equal to the total cash outflows.

Accept/Reject rules:

ACCEPT : calculated PBP < standard PBPREJECT : calculated PBP > standard PBPCONSIDER : calculated PBP = standard PBP

Year before fully recovered + unrecovered amt of investment

Pay Back Period = ------------------------------------------------- cash flows during the period of final recovery

ARR is used to measure the profitability of investment proposals

ARR is computed by dividing the average profits after depreciation and taxes by net investments in the project.

MODERN TECHNIQUES

Net Present Value is a method of calculating present value of each inflows and cash outflows in an investment project, by using cost of capital as the discounting rate.

Accept/reject Rule :◦ NPV > 0 will be accepted◦ NPV < 0 will be accepted◦ NPV = 0 will be consider

NPV = Discounted Cash Inflows – Discounted Cash Outflows

Internal Rate of Return (IRR) is that rate at which the discounted cash inflows match with discounted cash outflows.

Thus IRR may be called as the “break even rate” of borrowing for the company.

In simple words IRR indicates that discounting rate at which NPV is zero.

IRR > Cost of Capital ---- Accept IRR < Cost of Capital -----Reject IRR = Cost of Capital -----Consider

It is the ratio between total discounted cash inflows and total discounted cash outflows. Thus profitability index can be computed as follows.

Acceptance Rule PI > 1 will be accepted PI < 1 will be reject PI = 1 will be consider

It is also called as PROFITABILITY INDEX The excess present value index is calculated by

dividing the net present value of cash inflow by initial net investment cost

PV of cash inflow

Pay Back Period = ------------------------------------- Initial cash out lay

Thank You

K PREMCHAND12ME1E0020