Net Present Value (NPV) Net present value is the present value of net cash inflows generated by a project

including salvage value, if any, less the initial investment on the project. It is one of the most reliable measures used in capital budgeting because it accounts for time value of money by using discounted cash inflows. Before calculating NPV, a target rate of return is set which is used to discount the net cash inflows from a project. Net cash inflow equals total cash inflow during a period less the expenses directly incurred on generating the cash inflow. Calculation Methods and Formulas The first step involved in the calculation of NPV is the determination of the present value of net cash inflows from a project or asset. The net cash flows may be even (i.e. equal cash inflows in different periods) or uneven (i.e. different cash flows in different periods). When they are even, present value can be easily calculated by using the present value formula of annuity. However, if they are uneven, we need to calculate the present value of each individual net cash inflow separately. In the second step we subtract the initial investment on the project from the total present value of inflows to arrive at net present value. Thus we have the following two formulas for the calculation of NPV: When cash inflows are even: 1 (1 + i)-n NPV = R Initial Investment i In the above formula, R is the net cash inflow expected to be received each period; i is the required rate of return per period; n are the number of periods during which the project is expected to operate and generate cash inflows. When cash inflows are uneven: R1 R2 R3 NPV = + + + ... (1 + i)1 (1 + i)2 (1 + i)3

Initial Investment

Where, i is the target rate of return per period; R1 is the net cash inflow during the first period; R2 is the net cash inflow during the second period; R3 is the net cash inflow during the third period, and so on ... Decision Rule Accept the project only if its NPV is positive or zero. Reject the project having negative NPV. While comparing two or more exclusive projects having positive NPVs, accept the one with highest NPV. Examples Example 1: Even Cash Inflows: Calculate the net present value of a project which requires an initial investment of $243,000 and it is expected to generate a cash inflow of $50,000 each month for 12 months. Assume that the salvage value of the project is zero. The target rate of return is 12% per annum. Solution We have, Initial Investment = $243,000 Net Cash Inflow per Period = $50,000 Number of Periods = 12 Discount Rate per Period = 12% 12 = 1% Net Present Value = $50,000 (1 (1 + 1%)^-12) 1% $243,000 = $50,000 (1 1.01^-12) 0.01 $243,000 $50,000 (1 0.887449) 0.01 $243,000 $50,000 0.112551 0.01 $243,000 $50,000 11.2551 $243,000 $562,754 $243,000 $319,754 Example 2: Uneven Cash Inflows: An initial investment on plant and machinery of $8,320 thousand is expected to generate cash inflows of $3,411 thousand, $4,070 thousand, $5,824 thousand and $2,065 thousand at the end of first, second, third and fourth year respectively. At the end of the fourth year, the machinery will be sold for $900 thousand. Calculate the present value of the investment if the discount rate is 18%. Round your answer to nearest thousand dollars. Solution

PV Factors: Year 1 = Year 2 = Year 3 = Year 4 =

1 1 1 1

(1 (1 (1 (1

+ + + +

18%)^1 18%)^2 18%)^3 18%)^4

0.8475 0.7182 0.6086 0.5158

The rest of the problem can be solved more efficiently in table format as show below: Year Net Cash Inflow Salvage Value Total Cash Inflow Present Value Factor Present Value of Cash Flows Total PV of Cash Inflows Initial Investment Net Present Value 1 $3,411 $3,411 0.8475 $2,890.68 $10,888 8,320 $2,568 2 $4,070 $4,070 0.7182 $2,923.01 3 $5,824 $5,824 0.6086 $3,544.67 4 $2,065 900 $2,965 0.5158 $1,529.31

thousand

Advantage and Disadvantage of NPV Advantage: Net present value accounts for time value of money. Thus it is more reliable than other investment appraisal techniques which do not discount future cash flows such payback period and accounting rate of return. Disadvantage: It is based on estimated future cash flows of the project and estimates may be far from actual results. Internal Rate of Return (IRR) Internal rate of return (IRR) is the discount rate at which the net present value of an investment becomes zero. In other words, IRR is the discount rate which equates the present value of the future cash flows of an investment with the initial investment. It is one of the several measures used for investment appraisal. Decision Rule A project should only be accepted if its IRR is NOT less than the target internal rate of return. When comparing two or more mutually exclusive projects, the project having highest value of IRR should be accepted. IRR Calculation The calculation of IRR is a bit complex than other capital budgeting techniques. We know that at IRR, Net Present Value (NPV) is zero, thus: NPV = 0; or PV of future cash flows Initial Investment = 0; or CF1 CF2 CF3 + + + ... Initial Investment = 0 ( 1 + r )1 ( 1 + r )2 ( 1 + r )3 Where, r is the internal rate of return; CF1 is the period one net cash inflow; CF2 is the period two net cash inflow, CF3 is the period three net cash inflow, and so on ... But the problem is, we cannot isolate the variable r (=internal rate of return) on one side of the above equation. However, there are alternative procedures which can be followed to find IRR. The simplest of them is described below: 1. Guess the value of r and calculate the NPV of the project at that value. 2. If NPV is close to zero then IRR is equal to r. 3. If NPV is greater than 0 then increase r and jump to step 5. 4. If NPV is smaller than 0 then decrease r and jump to step 5. 5. Recalculate NPV using the new value of r and go back to step 2. Example Find the IRR of an investment having initial cash outflow of $213,000. The cash inflows during the first, second, third and fourth years are expected to be $65,200, $96,000, $73,100 and $55,400 respectively. Solution Assume that r is 10%. NPV at 10% discount rate = $18,372 Since NPV is greater than zero we have to increase discount rate, thus NPV at 13% discount rate = $4,521 But it is still greater than zero we have to further increase the discount rate, thus NPV at 14% discount rate = $204

NPV at 15% discount rate = ($3,975) Since NPV is fairly close to zero at 14% value of r, therefore IRR 14% Payback Period Payback period is the time in which the initial cash outflow of an investment is expected to be recovered from the cash inflows generated by the investment. It is one of the simplest investment appraisal techniques. Formula The formula to calculate payback period of a project depends on whether the cash flow per period from the project is even or uneven. In case they are even, the formula to calculate payback period is: Payback Period = Initial Investment Cash Inflow per Period

When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and then use the following formula for payback period: Payback Period = A + B C

In the above formula, A is the last period with a negative cumulative cash flow; B is the absolute value of cumulative cash flow at the end of the period A; C is the total cash flow during the period after A Both of the above situations are applied in the following examples. Decision Rule Accept the project only if its payback period is LESS than the target payback period. Examples Example 1: Even Cash Flows Company C is planning to undertake a project requiring initial investment of $105 million. The project is expected to generate $25 million per year for 7 years. Calculate the payback period of the project. Solution Payback Period = Initial Investment Annual Cash Flow = $105M $25M = 4.2 years Example 2: Uneven Cash Flows Company C is planning to undertake another project requiring initial investment of $50 million and is expected to generate $10 million in Year 1, $13 million in Year 2, $16 million in year 3, $19 million in Year 4 and $22 million in Year 5. Calculate the payback value of the project. Solution (cash flows in millions) Year Cash Flow 0 (50) 1 10 2 13 3 16 4 19 5 22 Payback Period = 3 + (|-$11M| $19M) = 3 + ($11M $19M) 3 + 0.58 3.58 years Advantages and Disadvantages Advantages of payback period are: 1. Payback period is very simple to calculate. 2. It can be a measure of risk inherent in a project. Since cash flows that occur later in a project's life are considered more uncertain, payback period provides an indication of how certain the project cash inflows are. 3. For companies facing liquidity problems, it provides a good ranking of projects that would return money early. Cumulative Cash Flow (50) (40) (27) (11) 8 30

Disadvantages of payback period are: 1. Payback period does not take into account the time value of money which is a serious drawback since it can lead to wrong decisions. A variation of payback method that attempts to remove this drawback is called discounted payback period method. 2. It does not take into account, the cash flows that occur after the payback period. Accounting Rate of Return (ARR) Accounting rate of return (also known as simple rate of return) is the ratio of estimated accounting profit of a project to the average investment made in the project. ARR is used in investment appraisal. Formula Accounting Rate of Return is calculated using the following formula: ARR = Average Accounting Profit Average Investment

Average accounting profit is the arithmetic mean of accounting income expected to be earned during each year of the project's life time. Average investment may be calculated as the sum of the beginning and ending book value of the project divided by 2. Another variation of ARR formula uses initial investment instead of average investment. Decision Rule Accept the project only if its ARR is equal to or greater than the required accounting rate of return. In case of mutually exclusive projects, accept the one with highest ARR. Examples Example 1: An initial investment of $130,000 is expected to generate annual cash inflow of $32,000 for 6 years. Depreciation is allowed on the straight line basis. It is estimated that the project will generate scrap value of $10,500 at end of the 6th year. Calculate its accounting rate of return assuming that there are no other expenses on the project. Solution Annual Depreciation = (Initial Investment Scrap Value) Useful Life in Years Annual Depreciation = ($130,000 $10,500) 6 $19,917 Average Accounting Income = $32,000 $19,917 = $12,083 Accounting Rate of Return = $12,083 $130,000 9.3% Example 2: Compare the following two mutually exclusive projects on the basis of ARR. Cash flows and salvage values are in thousands of dollars. Use the straight line depreciation method. Project A: Year Cash Outflow Cash Inflow Salvage Value Project B: Year Cash Outflow Cash Inflow Salvage Value Solution Project A: Step 1: Annual Depreciation = ( 220 10 ) / 3 = 70 Step 2: Year 1 Cash Inflow 91 Salvage Value Depreciation* -70 Accounting Income 21 2 130 -70 60 3 105 10 -70 45 0 -220 1 91 2 130 3 105 10

0 -198

1 87

2 110

3 84 18

Step 3: Average Accounting Income = ( 21 + 60 + 45 ) / 3 = 42 Step 4: Accounting Rate of Return = 42 / 220 = 19.1% Project B:

Step 1: Annual Depreciation = ( 198 18 ) / 3 = 60 Step 2: Year 1 Cash Inflow 87 Salvage Value Depreciation* -60 Accounting Income 27 2 110 -60 50 3 84 18 -60 42

Step 3: Average Accounting Income = ( 27 + 50 + 42 ) / 3 = 39.666 Step 4: Accounting Rate of Return = 39.666 / 198 20.0% Since the ARR of the project B is higher, it is more favorable than the project A. Advantages and Disadvantages Advantages 1. Like payback period, this method of investment appraisal is easy to calculate. 2. It recognizes the profitability factor of investment. Disadvantages 1. It ignores time value of money. Suppose, if we use ARR to compare two projects having equal initial investments. The project which has higher annual income in the latter years of its useful life may rank higher than the one having higher annual income in the beginning years, even if the present value of the income generated by the latter project is higher. 2. It can be calculated in different ways. Thus there is problem of consistency. 3. It uses accounting income rather than cash flow information. Thus it is not suitable for projects which having high maintenance costs because their viability also depends upon timely cash inflows. Discounted Payback Period One of the major disadvantages of simple payback period is that it ignores the time value of money. To counter this limitation, an alternative procedure called discounted payback period may be followed, which accounts for time value of money by discounting the cash inflows of the project. Formulas and Calculation Procedure In discounted payback period we have to calculate the present value of each cash inflow taking the start of the first period as zero point. For this purpose the management has to set a suitable discount rate. The discounted cash inflow for each period is to be calculated using the formula: Discounted Cash Inflow = Actual Cash Inflow (1 + i)n

Where, i is the discount rate; n is the period to which the cash inflow relates. Usually the above formula is split into two components which are actual cash inflow and present value factor ( i.e. 1 / ( 1 + i )^n ). Thus discounted cash flow is the product of actual cash flow and present value factor. The rest of the procedure is similar to the calculation of simple payback period except that we have to use the discounted cash flows as calculated above instead of actual cash flows. The cumulative cash flow will be replaced by cumulative discounted cash flow. Discounted Payback Period = A + B C

Where, A = Last period with a negative discounted cumulative cash flow; B = Absolute value of discounted cumulative cash flow at the end of the period A; C = Discounted cash flow during the period after A. Note: In the calculation of simple payback period, we could use an alternative formula for situations where all the cash inflows were even. That formula won't be applicable here since it is extremely unlikely that discounted cash inflows will be even. The calculation method is illustrated in the example below. Decision Rule If the discounted payback period is less that the target period, accept the project. Otherwise reject. Example

An initial investment of $2,324,000 is expected to generate $600,000 per year for 6 years. Calculate the discounted payback period of the investment if the discount rate is 11%. Solution Step 1: Prepare a table to calculate discounted cash flow of each period by multiplying the actual cash flows by present value factor. Create a cumulative discounted cash flow column. Year n 0 1 2 3 4 5 6 Cash Flow CF $ 2,324,000 600,000 600,000 600,000 600,000 600,000 600,000 Present Value Factor PV$1=1/(1+i)n 1.0000 0.9009 0.8116 0.7312 0.6587 0.5935 0.5346 Discounted Cash Flow CFPV$1 $ 2,324,000 540,541 486,973 438,715 395,239 356,071 320,785 Cumulative Discounted Cash Flow $ 2,324,000 1,783,459 1,296,486 857,771 462,533 106,462 214,323

Step 2: Discounted Payback Period = 5 + |-106,462| / 320,785 5.32 years Advantages and Disadvantages Advantage: Discounted payback period is more reliable than simple payback period since it accounts for time value of money. It is interesting to note that if a project has negative net present value it won't pay back the initial investment. Disadvantage: It ignores the cash inflows from project after the payback period. Profitability Index Profitability index is an investment appraisal technique calculated by dividing the present value of future cash flows of a project by the initial investment required for the project. Formula: Profitability Index Present Value of Future Cash Flows = Initial Investment Required =1+ Net Present Value Initial Investment Required

Explanation: Profitability index is actually a modification of the net present value method. While present value is an absolute measure (i.e. it gives as the total dollar figure for a project), the profitability index is a relative measure (i.e. it gives as the figure as a ratio). Decision Rule Accept a project if the profitability index is greater than 1, stay indifferent if the profitability index is zero and don't accept a project if the profitability index is below 1. Profitability index is sometimes called benefit-cost ratio too and is useful in capital rationing since it helps in ranking projects based on their per dollar return. Example Company C is undertaking a project at a cost of $50 million which is expected to generate future net cash flows with a present value of $65 million. Calculate the profitability index. Solution Profitability Index = PV of Future Net Cash Flows / Initial Investment Required Profitability Index = $65M / $50M = 1.3 Net Present Value = PV of Net Future Cash Flows Initial Investment Required Net Present Value = $65M-$50M = $15M. The information about NPV and initial investment can be used to calculate profitability index as follows: Profitability Index = 1 + (Net Present Value / Initial Investment Required) Profitability Index = 1 + $15M/$50M = 1.3