NPV IRR PI PB DISCOUNTED PAYBACK ARR

1. Financial Management : Assignment
Submitted To, Submitted By,
Akhil Sabu
MBA TT 15-17
School Of Management Studies
SMS CUSAT

2. Contents
1. DISCOUNTED CASH FLOW
1. NET PRESENT VALUE
2. INTERNAL RATE OF RETURN
3. PROFITABILITY INDEX
2. NON DISCOUNTED CASH FLOW
1. PAYBACK
2. DISCOUNTED PAYBACK
3. ACCOUNTING RATE OF RETURN

3. 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.

4. 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

5. 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:

6. 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

7. 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

8. 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.

9. Profitability Index
An Investment Appraisal Technique

10. 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.

11. Formula
Profitability Index=
Present value of Future Cash Flow
Initial Investment Required
Present Value
initial Investment Required
1+=

12. 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).

13. 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.

14. 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.

15. 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.

16. 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.

17. Internal Rate of Return
(IRR)

18. 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.

19. Accept/reject criterion
• The acceptance and rejection is done on the basis of the IRR
rate.

20. 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

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

22. 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.

23. Accounting Rate of Return

24. 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.

25. Formula
• Accounting Rate of Return is calculated using the following formula:
Average Accounting Profit
• ARR =
Average Investment

26. 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.

27. 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.

28. • 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)

29. 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.