Financial Management : Assignment

Submitted To, Submitted By,Akhil SabuMBA TT 15-17

School Of Management Studies SMS CUSAT

Contents

1. DISCOUNTED CASH FLOW1. NET PRESENT VALUE2. INTERNAL RATE OF RETURN3. PROFITABILITY INDEX

2. NON DISCOUNTED CASH FLOW 1. PAYBACK 2. DISCOUNTED PAYBACK 3. ACCOUNTING RATE OF RETURN

Net Present Value

• 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.

To discount you go to the left from FV and calculate the PV, this is called discounting.

Net Present Value

• 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.

Calculation Methods and Formulas

Net Present Value

• When cash inflows are even:

• NPV = R × 1 − (1 + i) -n − Initial Investment i Investment • 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.

Thus we have the following two formulas for the calculation of NPV:

Net Present Value

• When cash inflows are uneven:

NPV = R1 + R2 + R3 + ... −Initial Investment

(1 + i) 1 (1 + i) 2 (1 + i)3

• 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 ...

NPV = R1 + R2 + R3 + ... − Initial Investment

(1 + i) 1 (1 + i) 2 (1 + i)3

Net Present Value

• 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.

NPV = R1 + R2 + R3 + ... − Initial Investment

(1 + i) 1 (1 + i) 2 (1 + i)3

Net Present Value

• 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.

Profitability Index

An Investment Appraisal Technique

Definition 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 Flow

Initial Investment Required

Present Valueinitial Investment Required1+=

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 one and don't accept a project if the profitability index is below 1.

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.

Advantages of PI It considers time value of money.It takes into account the cash inflows and outflows

throughout the economic life of the project.Though PI method is almost similar to NPV method

and has got the same advantages, the former is still a better measure because PI measures the relative profitability and NPV, being an absolute measure.

PI ascertains the exact rate of return of the project.

Disadvantages of PI

It is difficult to understand interest rate or discount rate.It is difficult to calculate profitability index if two projects having

different useful life.

Internal Rate of Return (IRR)

Meaning :• Internal rate of returns is that rate at which the sum of

discounted cash inflow equals the sum of discounted cash outflow. In other words it is the rate which discounts the cash flow to zero.

Accept/reject criterion• The acceptance and rejection is done on the basis of

the IRR rate.

Comparison of IRR with NPV NPV IRR

a) It take interest as a known a) It take interest as a-factor unknown factor

b) It calculates the exact b) It calculates maximum amt. of investment rate of interest

Conflicts :• The project require different cash outlay.• The project have unequal lives.• The project have different pattern of cash flows.

Merits &demerits:• Consider the time value of money.• Take the amount of expenses &revenue.• Gives more value to the present money value.

• It is very difficult.• Reinvestment presumption.

Accounting Rate of Return

Definition• 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:

Average Accounting Profit• ARR =

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.

Payback• Payback Analysis: Components • This calculation must take into account Incomes, Expenses and Taxes:

– The shorter the payback period, the better; – The longer the payback period, the longer funds are locked up and the riskier the project probably is. • Note: Depreciation should not be included in the calculation.

• Payback Analysis: Calculation • Payback period = When cumulative net cash flow reaches breakeven • Payback period = (Last year that will show a negative cash flow)

+ (Absolute cumulative net cash flow for that year / Total net cash flow in the following year)

Discounted Payback Period • What is the 'Discounted Payback Period'• A capital budgeting procedure used to determine the profitability of a

project. In contrast to an NPV analysis, which provides the overall value of an project, a discounted payback period gives the number of years it takes to break even from undertaking the initial expenditure. Futurecash flows are considered are discounted to time "zero." This procedure is similar to a payback period; however, the payback period only measure how long it take for the initial cash outflow to be paid back, ignoring the time value of money.