Discounted Cash Flow Techniques-Net Present Value

andProfitability Index

ASEEM R.aseem128@gmail.com

Presented By,

Should we build thisplant?

• Introduction• Importance of investment decision• Classification of projects• Evaluation criteria• Net Present Value• Profitability Index• NPV Vs. PI• Conclusion

Contents

An efficient allocation of capital is the most important finance function in the modern times.

It involves decisions to commit the firms fund to the long term assets.

Capital budgeting or investment decisions are of considerable importance to the firm, since they tend to determine its value by influencing its growth, profitability and risk.

Introduction

Capital budgeting is the process of evaluating and selecting long-term investments that are consistent with the firm’s goal of maximizing owner wealth.

In other words Capital budgeting is the firms decision to invest its current funds most efficiently in the long term assets in anticipation of an expected flow of benefits over a series of year.

Capital Budgeting

Features of Investment decisions

The exchange of current fund for future benefits.

The funds are invested in long term asset.The future benefit will occur to the firm

over series of years.In investment analysis Cash flow is more

important than accounting profit.

Importance of investment decision1. They influence the firms growth in the long run.2. They affect the risk of the firm3. They involve commitment of large amount of funds.4. They are irreversible or reversible at substantial loss.5. They are among the most difficult decision to make.

Classification of Projects

• Mutually exclusive investments• Independent investments.• Contingent investment

Mutually exclusive investments

It serves the same purpose and compete with each other. If one investment is undertaken, others will have to be excluded.

An Example of Mutually Exclusive Projects

BRIDGE vs. BOAT to get products across a river.

Independent Investments Independent projects are projects whose cash

flows are unrelated to (or independent of) one another; the acceptance of one does not eliminate the others from further consideration.

Eg: If a heavy engineering company may be considering expansion of its plant capacity to produce additional products, or start a new production facility to manufacture a new product- light commercial vehicles. Depending on their profitability and availability of funds, the company can undertake both investments.

Contingent Investments

contingent investments are dependent projects, the choice of one investment necessitates undertaking one or more other investments.Eg: If a company decides to build a factory in remote, backward area, it may have to invest in house, roads, hospitals, schools etc. for the employees to attract the work force. Thus building of factory also requires investment in facilities for employees.

Evaluation Criteria

1. Discounted Cash flow criteriaa. Net Presented Value (NPV)b. Profitability Index (PI)c. Internal Rate of Return (IRR)

2. Non discounted cash flow criteriaa. Pay Back (PB)b. Accounting Rate of Return (ARR)

Net Present Value It is a modern method of evaluating

investment proposals.This method take into consideration the time

value of money and attempt to calculate the return on investment by introducing the factor of time element.

It recognises the fact that a rupee earned today is worth more than the same rupee earned tomorrow.

The net present value of all inflow and out flows of cash occurring during the entire life of the project is determined separately for each year.

Net Present Value

Steps for calculation of NPV

1. Cash flows of the investment project should be forecasted based on realistic assumption.

2. Appropriate discount rate should be identified to discount the forecasted cash flows. The appropriate discount rate is the project opportunity cost of capital, which equal to the required rate of return expected by the investors on investment of equivalent risk.

3. Present value of cash flows should be calculated using the opportunity cost of capital as the discount rate.

4. NPV should be found out by subtracting present value of cash out flows from present value of cash inflows.

Steps for calculation of NPV

Decision Rule:

· If NPV is positive, ACCEPT.· If NPV is negative, REJECT.

Advantages of NPV

• It recognises the time value of money and is suitable to applied in a situation with uniform cash outflows and uneven cash inflows or cash flows at different period of time.

• It take into account the entire earnings over life of the project and true profitability of the investment proposal can be evaluated.

• It take into consideration the objectives of maximum profitability.

Disadvantages of NPV

• It may not give good result while comparing projects with unequal lives as the project having higher Net Present Value but realised in a longer life span may not be desirable as a project having something lesser net present value achieved in a much shorter span of life of the asset.

• It may not easy to determine an appropriate discount rate.

Disadvantages of NPV

• It may not be give good result while comparing projects with unequal investment of funds.

From the following information calculate NPV of two projects and suggest which is the two projects should be accepted assuming discount rate is 10%

The profit before depreciation and after tax (cash flows) are follows.

Project A Project BInitial Investment 20,000 30,000

Estimated life 5 years 5 years

Scrap Value 1000 2000

Year 1 Year 2 Year 3 Year 4 Year 5Project X 5000 10,000 10,000 3,000 2,000Project Y 20,000 10,000 5,000 3,000 2,000Pv factor @ 10% 0.909 0.826 0.751 0.683 0.621

Profitability Index

It is the time adjusted method of evaluating the investment proposal.

This method is also called Benefit cost ratio. PI is the ratio of present value of cash inflows at

the required rate of return to the initial cash outflows of the investment.

PI = Present value of cash inflows

Present value of cash outflows

OR

PI = Present value of cash inflows

Cost of investment

Acceptance Rule

• Accept the project when PI greater than one PI>1

• Reject the project when PI less than one PI<1• May accept project when PI is equal to one

P=1

Advantages of PI

• PI tells about an investment increasing or decreasing the firm value.

• PI takes into consideration all cash flows of the project.

• PI takes time value of money into consideration.

• PI is also helpful in ranking and picking projects while rationing of capital.

Disadvantages of PI

• The PI of a firm might not, sometimes, provide the correct decision while being used to compare mutually exclusive project under consideration.

• It is not easy to determine an appropriate discount rate.

The initial cash outlay of a project is Rs.50,000 and it generates cash inflows of Rs.20,000, Rs. 15,000, Rs.25,000 and Rs.10,000 in four years . using present value index method appraise profitability of the proposed investment assuming 10% rate of discount.

Net Present ValueVs.

Profitability Index

• NPV and PI technics of capital investment decisions are closely related to each other, both provide the same result as far as accept-reject decision are concerned.

• Under NPV a proposal is acceptable if it gives positive net present value and under PI a proposal is acceptable it the PI is greater than one.

• However in case of mutually exclusive proposal having different scale of investment, ie, where the initial investment in the alternative proposal is not the same a conflict in NPV and PI rankings may occure.

Project A Project BPresent Value of Cash inflow 1,00000 50,000

Initial Investment 50,000 20,000

NPV 50,000 30,000

PI 2.00 2.50

• In case of mutually exclusive decisions, the NPV method should be preferred, because one should always select the project giving largest positive net present value using appropriate cost of capital or predetermined cutoff rate.

• The reason is that the objective of the firm is to maximize share holders wealth and the project with largest NPV is more reliable as compared to the IRR and PI.

• In fact NPV is the best operational criterion for ranking mutually exclusive proposals

Conclusion

Bibliography I M Pandey, Financial management. Vikas publishing house pvt

ltd, New Delhi, 2013.

M Khan, P K Jain. Financial Management. Tata McGraw-Hill publishing company ltd, New Delhi, 2005.

J. Van Horne, John M. Wachowiz, Fundamentals of Fianacial management. Pearson Education, New Delhi, 2014.

Shashi K Gupta, Neeti Gupta. Financial management. New central Agency, New Delhi, 2013

Thank You