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7/24/2019 Lecture(4.1) Financial Appraisal
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Financial Appraisal
7/24/2019 Lecture(4.1) Financial Appraisal
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Discounted cash flow methods
Net Present Value (NPV)is the sum of the present values of all cash
flows associated with the project. Future cash flows are discounted at
a certain hurdle rate to arrive at their present value. Higher NPV
indicates a better proposal in case the nitial nvestments are similar.
Benefit-Cost Analysis calculates the ratio of either Present Value ofbenefits to the nitial nvestment !"enefit #ost $atio "#$% or the Net
Present Value to nitial nvestment !Net "enefit #ost $atio N"#$%.
&he criterion is preferable to NPV criteria for comparing proposals
having widel' differing initial investments.
Internal Rate of Return (IRR)is the discount rate at which NPVof the project is (ero. Higher $$ indicates better proposal
irrespective of the amount of initial investment.
7/24/2019 Lecture(4.1) Financial Appraisal
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Discounted cash flow methods
Future cash flows are discounted to thepresent value and therefore can becompared to initial investment directl'.
All project cash flows for its entire lifeare considered in D#F evaluation
"oth profitabilit' of project during its
operations and recover' of initialinvestment are calculated in D#F anal'sis.
7/24/2019 Lecture(4.1) Financial Appraisal
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Net Present Value
&he net present valueof an income stream is the sum of
the present values of the individual amounts in the
income stream. )ach future income amount in the stream
is discounted* meaning that it is divided b' a numberrepresenting the opportunit' cost of holding capital from
now !'ear +% until the 'ear when income is received or
the outgo is spent. &he opportunit' cost can either be how
much one would have earned investing the rupee
someplace else* or how much interest one would have had
to pa' if one borrowed a rupee.
7/24/2019 Lecture(4.1) Financial Appraisal
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Net Present Value
Future Value = Present Value (1 +Interest Rate) n
The present value of a future incomeamount is the amount that, if we ha ittoa!, we coul invest an have it "row toe#ual the future income amount$
Present Value = (Future Value) % (1 +Interest Rate) n
7/24/2019 Lecture(4.1) Financial Appraisal
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Net Present Value
The &iscount Rate = The Interest Rate 'se in Reverse
,hen an interest rate is used in reverse li-e this* to
calculate how much 'ou need now to have a certain
amount later* economists conventionall' use the term
discount raterather than interest rate. &he two terms meanthe same thing. A reason for using the term discount rate
when 'ou calculate a present value is that 'ou are ta-ing a
larger number* the future value* and calculating from it a
smaller number* the present value. Present Value = (Future Value) (&iscount Rate) n
&iscount rate = 1 % (1 + interest rate) ,hen the discount rate goes up* present values go down. ,hen the
discount rate goes down* present values go up.
7/24/2019 Lecture(4.1) Financial Appraisal
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Net Present Value
Three properties of the net present value of an income streamare
/. Higher income amounts ma-e the net present value higher. 0ower
income amounts ma-e the net present value lower.
1. f profits come sooner* the net present value is higher. f profits
come later* the net present value is lower.2. #hanging the discount rate changes the net present value. For an
investment with the common pattern of having costs earl' and profits
later* a higher discount rate ma-es the net present value smaller.
7/24/2019 Lecture(4.1) Financial Appraisal
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Net Present Value
3ince NPV method gives Net value of returns in Present $upee
terms* NPV4s of different projects can be directl' added. &his helps
in deciding the projects that can be accepted amongst several
contenders under limited funds situation.
3ince NPV gives net value of returns in absolute $upee terms* itcannot be used to compare projects that re5uire different initial
investments.
$an-ing of projects b' NPV method is influenced b' nature of cash
flow patterns 6 discount rates. Projects with similar initial
investments give different ran-ings at different discount rates.
&he method also does not indicate the ris- margin available over
the hurdle rate or the cost of capital.
7/24/2019 Lecture(4.1) Financial Appraisal
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nternal $ate 7f $eturn
&he internal rate of return is the interest
rate that ma-es the present value of the
investment8s income stream 99 its costs andpa'offs 99 add up to +.
&he internal rate of return is a measure of
the worth of an investment. f the ris-s are
e5ual investments with higher internal rates
of return pa' better.
7/24/2019 Lecture(4.1) Financial Appraisal
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nternal $ate 7f $eturn
&he internal rate of return is nota goodwa' to evaluate an investment that hascosts later rather than just earlier. Ane:ample of that would be an investmentthat generates an environmental problemthat will re5uire a cleanup at the end of the
income stream. For some suchinvestments* the worseinvestments havehigher internal rates of return.
7/24/2019 Lecture(4.1) Financial Appraisal
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nternal $ate 7f $eturn
$$ indicates margin of safet' over costof capital.
$an-ing of projects can be done forprojects with different initial investments.
$an-ing of projects does not change withchange in cost of capital.
f cash flows change sign more than once*there can be multiple values for $$
7/24/2019 Lecture(4.1) Financial Appraisal
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N P V I R R
NPV method finds the present value of
future cash flows at the given rate of
discounting
$$ finds the rate of discounting at which
the NPV becomes ;ero.
#omputation of NPV is comparativel'
simple.
#omputation of $$ is a complicated
process as it involves trial 6 error
method with multiple computations to
arrive at the right value.
A project with positive value of NPV at
the rate of discounting e5uivalent to the
,A## is considered acceptable while theone with negative NPV is rejected.
A project with an $$ greater than
,A## is considered acceptable while the
one with a lower $$ is rejected
Value of NPV depends on the rate of
discounting used and therefore*
comparative ran-ing of projects ma'
change as discounting rate changes.
$$ is independent of the discounting
rate and therefore can give a direct
comparison between projects.
NPVs of different projects can be addedto find total addition in value of the firm.
$$s for different projects cannot followthe value additivit' principle.
NPV criterion can be used in case of
var'ing cost of capital i.e. rate of
discounting from 'ear to 'ear
$$ criterion cannot be used in case rate
of discounting changes from 'ear to 'ear.
7/24/2019 Lecture(4.1) Financial Appraisal
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Non Discounting #riteria
Pay Bac! Period is the length of time to recoverinitial cash outla' on the project. 3horter the pa'bac-
period* the more desirable the project. &his criterion
tends to shield the project from the ris- of futureuncertainties in the cash flows to certain e:tent.
Accountin" Rate of Return is a measure of projectprofitabilit' that relates income to investment* bothmeasured in accounting terms. t is generall'e:pressed as a ratio of Average ncome after &a: tonitial nvestment.
7/24/2019 Lecture(4.1) Financial Appraisal
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Drawbac-s of Non discounted cash flow
method
t ignores time value of mone'. t treats all present andfuture cash flows having same value.
t overloo-s cash flows be'ond pa'bac- period and
discriminates against projects that generate substantialcash flows in later 'ears.
"' focusing attention on capital recover'* it divertsattention from profitabilit'.
&hough it measures project4s li5uidit'* it does not
indicate firm4s li5uidit'. "' ignoring cash flows be'ond pa' bac- period* the
ris-s be'ond pa' bac- period are also ignored