Discounting/Modern methods of capital budgeting

Prepared by:Saleekha Varamangalath

Discounting methods

• The value of money received in future is not equivalent to the value of money invested today.

• In another words, a rupee in hand now is more valuable than a rupee to be received in future because cash in hand can be invested

elsewhere and interest can be earned on it.

Discounting or modern methods of Capital Budgeting

1. Discounted Payback method2. Net Present value method3. Profitability Index/Benefit Cost 4. Internal Rate of return5. Net Terminal value method

Discounted pay back method

• A Major shortcoming of the conventional pay back period method is that it does not take in to account the time value of money.

• To overcome this limitation the discounted payback method is suggested. In this modified method, cash flows are first converted into to their present values and then added to ascertain the period of time required to recover the intial outaly on the project.

Net Present Value Method

This method is used only when the rate of return on investment is predetermined by the

management. The difference between the present value of cash inflows and cash outflow is called the

net present value.

Advantages of NPVIt takes into account the time value of moneyIt considers the cash flow stream over the entire life of the projectIt focuses attention on the objective of maximization of the wealth of the firm.This method is most suitable when cash inflows are not uniform.This method is generally preferred by economists.

Disadvantages of NPVThe method may not provide satisfactory results in case of two projects having different useful lives.For a project with a higher NPV may not be desirable, because it may involve huge initial capital outlay.Different discount rates will give different present values. It involves complicated calculations.

Profitability Index

Two projects having different investment outlay cannot be compared by ne present value method

because it indicates the NPV in absolute terms. For example projects X and Y are having initial

investment of Rs.50,000 and Rs.1,00,000 respectively. Their NPV is as under:

Advantages of PI

It is very scientific and logicalIt considers the fair rate of returnIt is based upon the real profitability of the projectsIt is very useful to compare the projects having different investments.

Disadvantages of PI

This method is not in accordance with accounting principles and conceptsIt is comparatively difficult to understand &followIt is difficult to estimate the effective life of a projectIt cannot be used for comparing those projects having unequal lives.

Comparison of NPV and PIThe NPV is an absolute measure of a project’s

acceptability, Whereas PI is a relative measure. But, as far as the selection of a project is

concerned, both NPV and PI will arrive at the same decision. If PI is =1 then NPV =0

If PI IS greater than one, then NPV will be positive. If it is less than one NPV will be

negative.

Internal Rate of Return

NPV method indicate the net present value of the cash flows of a project at a predetermined interest rate, but it does not the rate of return

of the project. It is the rate where the NPV becomes zero. Accept when IRR is greater than

one.

Advantages of IRR

It considers all the cash flows over the entire life of the projectIt takes into account the time value of moneyCost of capital need not be calculatedIRR gives a true picture of the profitabilityProjects having different degrees of risk can easily be compared

Disadvantages of IRR

The IRR method is difficult to understand and use in practice because it involves complicated calculationsConditions of irregular cash flows, IRR may give two or more answers.Sometimes it may yield negative rate or multiple rate which is rather confusing.

Comparison between NPV and IRR

Both consider time value of moneyBoth lead to the same acceptance or rejection

decision rule when there is a single project

Differences

NPV• The minimum desired rate

of return( cost of capital) is assumed to be known

• It implies that the cash inflows are invested at the rate of firms cost of capital

• It give absolute return• The NPV of different

projects can be added

IRR• The minimum desired rate

of return is to be determined

• It implies that the cash inflows are reinvested at the IRR of the project

• It give %return• The IRR s of different

projects cannot be added

Net Terminal Value Method

• This method is based on the assumption that annual cash inflows is received at the end of the year and is reinvested in another asset at a certain rate of return from the moment it is received till the termination of the project

• The excess of the present value over the cost of the project is the Net Terminal Value( NTV )

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