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    CF-PGPM-session 9.

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    Aman Pratik
    The document discusses various investment evaluation criteria including discounted cash flow methods like net present value (NPV), internal rate of return (IRR), and profitability index (PI), as well as non-discounted methods like accounting rate of return (ARR) and payback period. It provides examples of calculating each method and outlines the advantages and disadvantages. The key methods are NPV, which accepts projects with positive NPV, and PI, which ranks projects based on the ratio of NPV to initial investment.

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    CF-PGPM-session 9.

    Uploaded by

    Aman Pratik
    24 views29 pages
    The document discusses various investment evaluation criteria including discounted cash flow methods like net present value (NPV), internal rate of return (IRR), and profitability index (PI), as well as non-discounted methods like accounting rate of return (ARR) and payback period. It provides examples of calculating each method and outlines the advantages and disadvantages. The key methods are NPV, which accepts projects with positive NPV, and PI, which ranks projects based on the ratio of NPV to initial investment.

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    The document discusses various investment evaluation criteria including discounted cash flow methods like net present value (NPV), internal rate of return (IRR), and profitability index (PI), as well as non-discounted methods like accounting rate of return (ARR) and payback period. It provides examples of calculating each method and outlines the advantages and disadvantages. The key methods are NPV, which accepts projects with positive NPV, and PI, which ranks projects based on the ratio of NPV to initial investment.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    24 views29 pages

    CF-PGPM-session 9.

    Uploaded by

    Aman Pratik
    The document discusses various investment evaluation criteria including discounted cash flow methods like net present value (NPV), internal rate of return (IRR), and profitability index (PI), as well as non-discounted methods like accounting rate of return (ARR) and payback period. It provides examples of calculating each method and outlines the advantages and disadvantages. The key methods are NPV, which accepts projects with positive NPV, and PI, which ranks projects based on the ratio of NPV to initial investment.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    of 29

    Session 9-12

    Net Present Value and Other


    Investment Rules
    Evaluation Criteria
     1. Discounted Cash Flow (DCF) Criteria
    ◦ Discounted payback period (DPB)
    ◦ Net Present Value (NPV)
    ◦ Internal Rate of Return (IRR)
    ◦ Profitability Index (PI)
     2. Non-discounted Cash Flow Criteria
    ◦ Accounting Rate of Return (ARR)
    ◦ Payback Period (PB)
    Average Accounting Return
    Average Net Income
    AAR =
    Average Book Value of Investment

     Another attractive, but fatally flawed,


    approach
     Ranking Criteria and Minimum Acceptance
    Criteria set by management
     Based on the following information
    calculate the ARR of the project:
    Purchase price of Rs. 80,000
    machinery
    Installation Charges Rs. 20,000
    Estimated salvage value at the Rs. 40,000
    end of the useful life
    Useful life 4 years
    Working capital required Rs. 10,000
    Annual earnings before Rs. 65,000
    depreciation and tax
    Tax rate 30%
    Average Accounting Return
     Disadvantages:
    ◦ Ignores the time value of money
    ◦ Uses an arbitrary benchmark cutoff rate
    ◦ Based on book values, not cash flows and
    market values
     Advantages:
    ◦ The accounting information is usually available
    ◦ Easy to calculate and understand
    ◦ Considers the entire profits over the life of
    project
    The Payback Period Method
     How long does it take the project to “pay
    back” its initial investment?
     Payback Period = number of years to
    recover initial costs
     Minimum Acceptance Criteria:
    ◦ Set by management
     Ranking Criteria:
    ◦ Set by management
    Example
     Assume that a project requires an outlay
    of Rs 50,000 and yields annual cash inflow
    of Rs 12,500 for 7 years. The payback
    period for the project is:

    Rs 50,000
    PB = = 4 years
    Rs 12,500
    Acceptance Rule
     The project would be accepted if its
    payback period is less than the maximum
    or standard payback period set by
    management.
     As a ranking method, it gives highest
    ranking to the project, which has the
    shortest payback period and lowest
    ranking to the project with highest
    payback period.
    Payback
    Example
    Examine the three projects and note the mistake
    we would make if we insisted on only taking
    projects with a payback period of 2 years or less.

    Payback
    Project C0 C1 C2 C3 NPV@ 10%
    Period
    A - 2000 500 500 5000
    B - 2000 500 1800 0
    C - 2000 1800 500 0
    Payback
    Example
    Examine the three projects and note the mistake
    we would make if we insisted on only taking
    projects with a payback period of 2 years or less.

    Payback
    Project C0 C1 C2 C3 NPV@ 10%
    Period
    A - 2000 500 500 5000 3 + 2,624
    B - 2000 500 1800 0 2 - 58
    C - 2000 1800 500 0 2 + 50
    The Payback Period Method
     Disadvantages:
    ◦ Ignores the time value of money
    ◦ Ignores cash flows after the payback period
    ◦ Requires an arbitrary acceptance criteria
    ◦ A project accepted based on the payback
    criteria may not have a positive NPV
     Advantages:
    ◦ Easy to understand
    ◦ Biased toward liquidity
    Evaluation Criteria
     1. Discounted Cash Flow (DCF) Criteria
    ◦ Discounted payback period (DPB)
    ◦ Net Present Value (NPV)
    ◦ Internal Rate of Return (IRR)
    ◦ Profitability Index (PI)
     2. Non-discounted Cash Flow Criteria
    ◦ Accounting Rate of Return (ARR)
    ◦ Payback Period (PB)
    The Discounted Payback Period
     How long does it take the project to “pay
    back” its initial investment, taking the time
    value of money into account?
     Decision rule: Accept the project if it pays
    back on a discounted basis within the
    specified time.
     By the time you have discounted the cash
    flows, you might as well calculate the NPV.
    Net Present Value Method

     The formula for the net present value can be


    written as follows:
     C1 C2 C3 Cn 
    NPV =  + 2
    + 3
    +L+ n  − C0
     (1 + k) (1 + k) (1 + k) (1 + k) 
    n
    Ct
    NPV = ∑ t
    − C0
    t =1 (1 + k )
    Why Use Net Present Value?
     Accepting positive NPV projects benefits
    shareholders.
    NPV uses cash flows
    NPV uses all the cash flows of the project
    NPV discounts the cash flows properly
     Reinvestment assumption: the NPV rule
    assumes that all cash flows can be
    reinvested at the discount rate.
    The Net Present Value (NPV) Rule
     Net Present Value (NPV) =
    Total PV of future CF’s - Initial Investment
     Estimating NPV:
    1. Estimate future cash flows: how much? and when?
    2. Estimate discount rate
    3. Estimate initial costs
     Minimum Acceptance Criteria: Accept if NPV > 0
     Ranking Criteria: Choose the highest NPV
    Calculating Net Present Value
     Assume that Project X costs Rs 2,500 now and is expected
    to generate year-end cash inflows of Rs 900, Rs 800, Rs 700,
    Rs 600 and Rs 500 in years 1 through 5. The opportunity cost
    of the capital may be assumed to be 10 per cent.
     Lets solve Q8 on pg 131
    Which projects have positive NPV?
    $1000
    NPVA = − $1000 + = −$90.91
    (1.10)

    $1000 $1000 $4000 $1000 $1000


    NPVB = − $2000 + + 2
    + 3
    + 4
    + 5
    = +$4,044.73
    (1.10) (1.10) (1.10) (1.10) (1.10)

    $1000 $1000 $1000 $1000


    NPVC = − $3000 + + + + = +$39.47
    (1.10) (1.10) 2 (1.10) 4 (1.10) 5
    Payback period
     Payback A = 1 year
     Payback B = 2 years
     Payback C = 4 years

     At 3 year payback…firm should choose..


     A and B
    Discounted payback period
    $1000
    PVA = = $909.09
    (1.10)1

     The present value of the cash inflows for Project A never


    recovers the initial outlay for the project, which is always the
    case for a negative NPV project.

     The present values of the cash inflows for Project B are


    shown in the third row of the table below, and the
    cumulative net present values are shown in the fourth row:

    C0 C1 C2 C3 C4 C5
    -2,000.00 +1,000.00 +1,000.00 +4,000.00 +1,000.00 +1,000.00
    -2,000.00 909.09 826.45 3,005.26 683.01 620.92
    -1,090.91 -264.46 2,740.80 3,423.81 4,044.73
     Since the cumulative NPV turns positive between year
    two and year three, the discounted payback period is:

    264.46
    2+ = 2.09 years
    3,005.26
    The present values of the cash inflows for Project C are shown in
    the third row of the table below, and the cumulative net present
    values are shown in the fourth row:

    C0 C1 C2 C3 C4 C5
    -3,000.00 +1,000.00 +1,000.00 0.00 +1,000.00 +1,000.00
    -3,000.00 909.09 826.45 0.00 683.01 620.92
    -2,090.91 -1,264.46 -1,264.46 -581.45 39.47

    Since the cumulative NPV turns positive between year four and year five,
    the discounted payback period is:
    581.45
    4+ = 4.94 years
    620.92
    The Profitability Index (PI)

    Total PV of Future Cash Flows


    PI =
    Initial Investent
     Minimum Acceptance Criteria:
    ◦ Accept if PI > 1, or if PI>0 ( if the formula is
    NPV/Initial Investment)

     Ranking Criteria:
    ◦ Select alternative with highest PI
    Profitability Index
     When resources are limited, the profitability
    index (PI) provides a tool for selecting among
    various project combinations and alternatives

     A set of limited resources and projects can yield


    various combinations.

     The highest weighted average PI can indicate


    which projects to select.
    Profitability Index
    Cash Flows (Rs. millions)
    Profitability Index
    Cash Flows (Rs. millions)

    NPV
    Profitability Index =
    Investment
    Profitability Index
    NPV
    Profitability Index =
    Investment
    Another Example
    We only have Rs.300,000 to invest. Which do we select?

    Proj NPV Investment PI


    A 230,000 200,000 1.15
    B 141,250 125,000 1.13
    C 194,250 175,000 1.11
    D 162,000 150,000 1.08
    Profitability Index
    Another Example - continued
    Proj NPV Investment PI
    A 230,000 200,000 1.15
    B 141,250 125,000 1.13
    C 194,250 175,000 1.11
    D 162,000 150,000 1.08

    Select projects with highest Weighted Avg PI


    WAPI (BD) = 1.13(125) + 1.08(150) + 0.0 (25)
    (300) (300) (300)
    = 1.01
    Profitability Index
    Another Example - continued
    Proj NPV Investment PI
    A 230,000 200,000 1.15
    B 141,250 125,000 1.13
    C 194,250 175,000 1.11
    D 162,000 150,000 1.08

    Select projects with highest Weighted Avg PI


    WAPI (BD) = 1.01
    WAPI (A) = 0.77
    WAPI (BC) = 1.12

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