Time value of money

Which would you prefer -- $1000 today or $1000 in 4 years?

Certainly, $10,00 today.
Your response motivated y the !"ime value of money#
You already reco$ni%ed that there is "&'( )*+,( "- '-.(Y//
Significance of TIME
Why is "&'( such an important element in your decision?
"&'( allows you the opportunity to postpone consumption and earn &."(0(1"
Interest
&nterest is a return on a deposit. &nterest paid on the principal orrowed is simple
interest. &nterest paid on any previous interest, as well as on the principal orrowed is
compound interest.
Simple Interest
*ssume that you deposit $10,000 in an account earnin$ 23 simple interest for 4 years.
"he accumulated interest at the end of the 4nd year can e calculated usin$ the formula5
1& 6 7
0
8i9 8n9
1&5 1imple &nterest
705 :eposit today 8t609
i5 &nterest 0ate per 7eriod
n5 .umer of "ime 7eriods
1& 6 $10,000 80.029 849 6 $4,000
"he simple interest on the deposit of $10,000 for 4 years ; 23 is $4000.
Compound Interest
<ow is compound interest different from simple interest? 1hierly Winters deposits
$10,000 ; compounded interest rate of 23 per annum for 4 years. 1he wants to =now
how much it will ecomes after 4 years.
FV FV
4 4
0 1 2 3 4
$10,000 $10,000
5%
1he earned $200 interest on your $10000 deposit over the first year. "his is the same
interest you would earn under simple interest. &n the second year the interest would e
>)1 6 70 81?i91 6 $10,000 81.029 6 $10,200
>)4 6 >)1 81?i91
6 70 81?i981?i9 6 $10,00081.02981.029
6 70 81?i94 6 $10,00081.029
4
6 $11,042
&n the second year she earned an interest of 0s.242 as interest. "he (@"0* $42 is the
compound interest over simple interest. *ccordin$ly, the future value at the end of the 4
th
year would e
6 7081?i981?i981?i981?i9 6 $10,00081.02981.02981.02981.029
"his is eAuivalent to 70 81?i9
4
6 $14,122
6 $10,000 81.029
4
6 $14,122
"he formula is5 >) 6 7)81?i9
n
<er deposit of $10000 $rows to $14122 at the end of the fourth year.
SIMPLE AND COMPOUND INTEREST
0
2000
4000
6000
8000
10000
12000
14000
16000
18000
20000
1 5 10 15 YEAR
I
N
T
E
R
E
S
T

(
$
)
SIMPLE INTEREST @ 5%
COMPOUND INTEREST @ 5%
COMPOUND INTEREST @ 7%
&n the fi$ure notice the difference in the simple and the compound interest depicted y the
first two ars for the 23 rate of interest.
The Rule-of-72
<ow lon$ does it ta=e to doule $10,000 at a compound rate of 143 per year 8approB.9?
Approx. Years to Double 6 C4 C4 D i3
C4 C4 D 143 6 6 Years 6 Years
E*ctual "ime is F.14 YearsG
Time value
& $ive you 1000 dollars. You deposit in a an=. Han= will $ive you 23 interest per
annum. *fter 4 years, it ecomes $1104.20. "he Present Value is $ 1000 and Future
Value will e $1104.20.
"he difference etween the present value and the future value is !time value of money#.
'oney loses value with the passa$e of time due to factors such as inflation. Inflation is a
phenomenon, characterised y risin$ prices in the economy. &nflation is principally
caused y the mismatch etween $eneration of incomes and production of $oods and
services in the economy.
"he time value of money has the followin$ possiilities5
7resent value of a sin$le amount
>uture values of a sin$le amount
>uture )alue of an ,neven Cash >low
7resent value of an annuity
>uture value of an annuity
!resent value of single amount
1hierly Winters wants to =now how lar$e of a deposit to ma=e so that the money will
$row to $42,000 in 4 years at a interest rate of C3.
"he $eneral formula for calculatin$ 7resent )alue is 5
n n
i
FV PV
9 1 8
1
+

where
7) is the present value
>)n is the future value of the investment in the year !n#
i is the rate of interest and
n is the numer of years
6 42,200 D 81?0.0C9
4
6 $1I,0C4
1hierly Winters need to deposit $1I0C4 now to reali%e $42000 after 4 years. "he $1I0C4
is the present value of the future sum of $42000.
$25,000 $25,000
Year 0 1 2 3 4
PV ? PV ?
7%
"uture value of a single amount5
.ow 1hierly Winters deposits $10000 for a period of F years ; J3 per annum. <ow
much she $et on maturity of the deposit?
n
i PV FV 9 1 8 +
Where,
>)n is the future value in the year !n#
7) is the present value
i is the rate of interest and
n is the numer of years
>)F 6 $ 10000 81 ? 0.0J9
F
6 $ 12JFI
1hierly Winter#s deposit will e worth $12JFI at the end of the F
th
year.
!resent #alue of Cash "lo$
1hierly Winters calculates that she will receive a set of cash flows for the neBt F years.
1he wants to =now what it is worth now? 1he can proved she =nows the rate of interest.
*ssumin$ a rate of J3 the worth can e calculated.
Year Cash >low
1 4200
4 1200
K 4200
4 1J00
2 4000
F 4400
"he future earnin$s are converted to their respective present values y discountin$ them
y the discount factor.
"he discountin$ is done as follows5
+ + + + + +
F 2 4 K 4 1
0J . 1
1
4400
0J . 1
1
4000
0J . 1
1
1J00
0J . 1
1
4200
0J . 1
1
1200
0J . 1
1
4200 PV
6 $I,F2F.
"he present worth of her earnin$s is $I,F2F.
Year
Cash
>low
:iscount
>actor
7resent
)alue
8>)9
8df9
8>) B df9
1D81?&9
n
1 4200 0.IK 4K14.J1
4 1200 0.JF 14JF.01
K 4200 0.CI 1IJ4.2J
4 1J00 0.C4 1K4K.02
2 4000 0.FJ 1KF1.1C
F 4400 0.FK 1KJF.KC
7resent )alue %&'&())
"uture #alue of Cash "lo$
1hierly Winters plans to deposits her yearly savin$s for the neBt 2 years in a an=. 1he
wants to =now what her investment will e worth at the end of 2 years?
Year 1avin$s $
1 1000
4 1200
K 4000
4 4400
2 4200
"o =now the future value, each year#s savin$s has to e converted to their respective
future value. >or eBample $1000 of 1
st
year has to e compounded to the 2
th
year.
i.e.
6 1000 L 81 ? 0.0J9M2
6 1000 L 81.4C9
6 14C0
Year
Cash
>low
Compoundin$
>actor
>uture )alue
87)9 87) B df9
81?&9
n
1 1000
1.4FI 14FI.K
4 1200
1.KF0 4040.C
K 4000
1.4F0 421I.4
4 4400
1.1FF 42FF.1
2 4200
1.0J0 4C00.0
>uture )alue
114I2.F
"herefore, after 2 years, she will have $114I2.F. "hat is the future value of her cash flow.
Effective Interest Rate
)ery often people are carried away with the stated interest rate when they avail a loan. &n
fact a loan carryin$ 143 interest for a housin$ loan may e cheaper than a loan carryin$
an interest of 11.423. &t depends on the freAuency of compoundin$. "herefore, to assess
the actual cost of a loan, one should calculate the effective interest rate. "he effective
interest rate is the actual interest rate that the orrower pays for his loan or receives for
his deposit. "he effective interest rate is different from the nominal interest rate. "he
nominal interest rate is specified for the loan.
1hierly Winters has $2,000 to invest for 4 Years at an annual interest rate of J3. "he
tale shows the effective interest for different freAuencies of compoundin$ for a nominal
interest of J3.
Year &nterest *mount
(ffective 0ate of
&nterest 839
*nnual 400.00 J.00
Hiannual 40J.00 J.1F
Nuarterly 414.1F J.44
'onthly 412.00 J.K0
:aily 41F.KI J.KK
"he effective interest rate is calculated usin$ the formula $iven elow5
1 1
1
]
1

+
m
m
i
Where,
i is the rate of interest
m is the freAuency of compoundin$ durin$ a year
1hierly winters will receive $2,400 if the interest is compounded annually and $2,414.1F
if compounded Auarterly. "he effective interest for Auarterly compoundin$ of J.443 is
arrived at usin$ the formula5
44 . J 1
4
0J . 0
1
4

1
]
1

+
*nnuity
*nnuity is a series of eAual payments or receipts occurrin$ over a specified numer of
eAuidistant periods. Car +oan 7ayments, &nsurance 7remiums, 'ort$a$e 7ayments and
0etirement 1avin$s are some of the eBamples of annuity.
!resent value of an annuity
1hierly after reviewin$ her ud$et decides that she can pay $ 1400 a month for a period
of K years towards purchase of a new car. Car loans are availale from 'Ds. *uto 'art
which offers car loans at J3 interest. 1hierly would li=e to =now how much she can
orrow so that she can decides which car to uy.
7rolems such as these, involve decidin$ the present value of the future annuity
payments, which in 1hirley#s case is $1400 per month. "he formula for calculatin$ the
present value of an annuity is5
r
r
Annuity PV
n
+

9 1 8 1

,
_

0J . 0
9 0J . 0 1 8 1
14 L 1400
K
PV
6 $KC,110.40
1hierly can avail a loan of $KC,110.10. .ow, she can decide which car to uy. 1hierly y
payin$ $1400 per month is amorti%in$ a loan of $KC,110.10 over the period of the three
years.
"uture value of an annuity
1hierly is savin$ at the rate of $200 per month for a period of 12 years for her retirement.
"he interest on the deposit is 103. <ow much will she receive on maturity of her
deposit?
You plan to uy a car costin$ $42000 and approach a finance company who offers you a
loan on the condition you ma=e a down payment of 403 and the alance will e advanced
; I3, reducin$ alance interest, over a period of 4J months. What will the eAuate monthly
interest e?
$ 214.42
"his otained y sustitutin$ the values in the formula
r
r
Annuity PV
n
+

9 1 8 1
and solvin$ for *nnuity.
1ince 1hierly is depositin$ money every month, the first instalment earns interest for 1J0
months, second instalment earns interest for 1CI months and so on. "o =now the future
value of her deposit the formula is5
r
r
Annuity FV
n
1 9 1 8 +

<er annuity is the monthly contriution. "he rate of interest !r# which is usually
eBpressed per annum, in this case 10 per cent has to e converted to each period in to
which the year is divided. &n this case it is 14. "herefore, the monthly interest would e
0.10D14 6 0.00JKK per cent. "his rate is used in the formula aove.
6 200 B 881 ? 0.00JKK9
1J0
O 19 D 0.00JKK
6 200 B 414.K4
6 $ 40C12I
"he maturity value of 1hirley#s deposit will e $40C12I.
1uppose the interest is calculated on the deposit once in siB months, rather than every
month, then appropriate chan$es have to e made in the interest rate, the annuity amount
and the numer of periods of the deposit. 1ince the year is divided into two periods, the
interest rate has to e divided y two and the period has to e multiplied y two, and the
deposits has to e a$$re$ated for siB months. "hus, !r# will e 2 per cent, !n# will e K0
and annuity will e $K000.
6 K000 B 881 ? 0.029
K0
O 19 D 0.02
6 K000 B FF.44
6 $ 1IIK1F.24
If the interest is compounded +uarterly, $hat is the maturity value-
The maturity value $ill .e / 020%17(2)
3 4')) 5 64 7 )()2'8
&)
9 48 : )()2'
3 4')) 5 40'(%%
3 / 2)0%17(2)
Capital ;udgeting
1hirley Winters decides to start a HoutiAue in her nei$horhood as there isn#t one close y and
therefore she thin=s that it has a $ood chance of succeedin$. With the help of her friend who
has eBperience in runnin$ a outiAue she estimated the cost of settin$ it up and finds it reAuires
an investment of $ 1J000 which she could ill afford. While discussin$ her plans with a friend,
she was told if she could estalish the financial soundness of the investment, she has a $ood
chance of $ettin$ a loan from a financial institution. .ow she has to prove the worth of her
investment. "his can e done throu$h capital ud$etin$.
Capital Hud$etin$ *nalysis is a process of evaluatin$ investments in capital assets to
determine whether future enefits of this proPect e lar$e enou$h to Pustify the investment
$iven the ris= involved.
1hirley Winters must =now the cost of otainin$ funds to ma=e the lon$-term investments in
new product lines, new eAuipment and other assets. Cost of Capital represents the rate a
usiness must pay for each source of funds.
Why use the Cost of Capital?
Hecause we =now the 1hierly wouldnQt do the proPect, which earns profits elow the cost
of capital. 1he would lose money. <opefully 1hirley#s HoutiAue would earn much more
than the cost of capital. "he cost of capital is the minimum acceptale rate of return for
lon$-term investments. "he discount rate is usually the cost of capital i.e. interest rate.
"he "hree 1ta$es of Capital Hud$etin$ *nalysis
We must focus much of our attention on present values so that we can understand how
eBpenditures today influence values in the future. *n approach to loo=in$ at present values of
proPects is the is!ounte !ash flo" #DCF$ techniAue. Capital Hud$etin$ involves three
sta$es5
:ecision *nalysis 8for Rnowled$e Huildin$9
-ption 7ricin$ 8to (stalish 7osition9
:iscounted Cash >low 8:C>9 8for ma=in$ the &nvestment :ecision9
"hese processes helps to reduce the uncertainty in the investment decision.
4( <ecision *nalysis
:ecision-ma=in$ in the e$innin$ of the proPect for 1hirley is compleB ecause of uncertainty
li=e capital reAuirements, ris=s, taB considerations and eBpected rates of return. 1he has to
understand the eBistin$ mar=ets to forecast proPect revenues, assess competitive impacts of the
proPect, and determine the life cycle of the proPect. &f our capital proPect involves production,
we have to understand operatin$ costs, additional overheads, capacity utili%ation, and start-up
costs. ConseAuently, we cannot mana$e capital proPects y simply loo=in$ at the numers. We
must assess all relevant variales and outcomes within an analytical hierarchy.
2( =ption !ricing
"he second sta$e is to consider all options for the proPect. "herefore, efore employin$
discounted cash flow techniAue we need to uild a set of options into our proPect for mana$in$
uneBpected chan$es. 1hirley must consider options which she could easily ta=e up lest her
ori$inal proPect fails.
0( <iscounted Cash "lo$s
:iscounted Cash >low techniAues is concerned with the present values of assets. 1ince capital
proPects li=e 1hirley#s HoutiAue provide enefits into the future and to determine the present
value of the proPect, we discount the future cash flows of a proPect to the present.
:iscountin$ refers to ta=in$ a future amount and findin$ its value today. >uture values differ
from present values ecause of the time value of money. >inancial mana$ement reco$ni%es the
time value of money ecause5
1. Inflation reduces values over timeS i.e. $ 1,000 today will have less value five years from
now due to risin$ prices 8inflation9.
2. >ncertainty in the futureS i.e. we thin= we will receive $ 1,000 five years from now, ut a
lot can happen over the neBt five years.
3. =pportunity Costs of moneyS $ 1,000 today is worth more to us than $ 1,000 five years
from now ecause we can invest $ 1,000 today and earn a return.
Capital ;udgeting Techni+ues
"he Capital Hud$etin$ "echniAues are
a9 7roPect (valuation and 1election
9 7otential :ifficulties
c9 Capital 0ationin$
d9 7roPect 'onitorin$
a8 !ro?ect Evaluation@
"he methods of 7roPect (valuation are
19 .et 7resent )alue 8.7)9
49 &nternal 0ate of 0eturn 8&009
K9 7ayac= 7eriod 87H79
49 7rofitaility &ndeB 87&9
Aet !resent #alue 6A!#8
&n order to assess the worth of 1hirley#s proPect, she must determine its present worth.
"he future cash flows have to e converted into its present worth, called .et 7resent
Worth. Hy findin$ out the net present worth of the &nvestment in the HoutiAue 1hierly
will convince the financer whether it is economically viale or not. 1hirley sumits two
proposals one for the HoutiAue and another for a 0estaurant to Trow U 7rosper >inance
Company
"he finance company is evaluatin$ two investment proposals. "heir respective
investment and cash flows are here5
;outi+ue Restaurant
Year
&nvestment
8$9 Cash >low Year
&nvestment
80s9 Cash >low
1 420000 40000 1 K00000 F0000
4 20000 4 J0000
K J0000 K J0000
4 100000 4 100000
2 100000 2 100000
"he interest for the loan is 14 per cent per annum i.e. the cost of capital.
"he .7) of the two proPects is shown elow5
Year
&nvestment
8$9
Cash
>low .et >low
:iscount
factor
n
r9 1 8
1
+
7resent
)alue
;outi+ue
1 420000 40000 -410000 0.JCC4 -1J4411
4 20000 20000 0.CFI2 KJ4CK
K J0000 J0000 0.FC20 2KIIJ
4 100000 100000 0.2I41 2I40J
2 100000 100000 0.21I4 21IKC
.7) -V 1I402
Restaurant
1 K00000 F0000 -440000 0.JCC4 -41024F
4 J0000 J0000 0.CFI2 F122C
K J0000 J0000 0.FC20 2KIIJ
4 100000 100000 0.2I41 2I40J
2 100000 100000 0.21I4 21IKC
.7) -V 1F1C4
"he cash flow is the returns over the cost. "he net flow is the difference etween the cash
flow and the total investment cost. "he discount factors are calculated usin$ the formula
n
r9 1 8
1
+
5
Where, !r# is 0.14 and !n# ta=es values 1,4,K,4 and 2
and presented in column 2 of the tale. "he present values are derived y multiplyin$ the
net flow y the correspondin$ discount factor and shown in the last column of the tale.
"hen the present values are added to otain the .et 7resent )alue.
>or Trow U 7rosper >inance Company to e satisfied aout the feasiility of the
7roPects they should have a positive .7). When it comes to choosin$ etween the two
investment proposals, the proPect with the hi$her .7) will e preferred Hetween the two
7roPects oth proPects are economically viale since oth have positive .7)s. "he
investment in the HoutiAue is preferred over 0estaurant ecause of its hi$her .et 7resent
)alue of the two.
Internal rate of return
1hirley is happy that her HoutiAue meets the reAuirement of .et 7resent Worth ut wants to
=now what return the proPect yields in percenta$e terms. "his will e =nown if she calculates
the &nternal 0ate of 0eturn. &nternal 0ate of 0eturn 8&009 is the amount of profit you $et y
investin$ in a certain proPect. &t is eBpressed as a percenta$e. *n &00 of 103 means you ma=e
103 profit per year on the money invested in the proPect. &00 is a popular economic criteria
for evaluatin$ capital proPects, since investors li=e 1hirley Winters can easily identify with
rates of return. &00 is calculated y findin$ the discount rate wherey the .et &nvestment
amount eAuals the total present value of all cash inflows. "he &00 is a discount rate that ma=es
the .et 7resent )alue 6 0. "his can e seen from the eBample elow5 Reep chan$in$ the &00
y small amounts till the ri$ht hand side eAuals the +eft <and 1ide. "hat happens at a rate of
1J.23. "his ecomes the &00.
n
n
I%%
CF
I%%
CF
I%%
CF
I%%
CF
IC
9 1 8
. . . . .
9 1 8 9 1 8 9 1 8
0
K
K
4
4
1
1
+
+ +
+
+
+
+
+

2 4 K 4 1
9 1J2 . 0 1 8
100000
9 1J2 . 0 1 8
100000
9 1J2 . 0 1 8
J0000
9 1J2 . 0 1 8
20000
9 1J2 . 0 1 8
40000
42000 $
+
+
+
+
+
+
+
+
+

"his is how the &00 is arrived at.

"he tale $ives the details of investments and returns of two proPects. "he cost of capital for
oth the proPects is 143 per annum and the deposit rate is 103.
;outi+ue
Year
&nvestment
8$9 Cash >low .et >low
:iscount
factor
;1J.23
7resent
)alue
1 420000 40000 -410000 0.J4KI -1CC44K
4 20000 20000 0.C144 K2F10
K J0000 J0000 0.F010 4J0JK
4 100000 100000 0.20C4 20C4K
2 100000 100000 0.44J1 44J0F
.7) -V 0
Restaurant
Year
&nvestment
8$9 Cash >low .et >low
:iscount
factor
;1C.2K3
7resent
)alue
1 K00000 F0000 -440000 0.J20I -40440C
4 J0000 J0000 0.C440 2CI1J
K J0000 J0000 0.F1F0 4I4J0
4 100000 100000 0.2441 2441K
2 100000 100000 0.44F0 442IF
.7) -V 0
&f the &00 is hi$her than 143, then we would accept the proPect.
&n our eBample, the &00 1J.23 for 7roPect-* and 1C.2K3 for 7roPect-H. 1ince the &00 is
hi$her than the cost of capital, we can invest in oth the proPects, ut 7roPect-* is superior to
7roPect-H.
-ne of the prolems with &00 is the so-called reinvestment rate assumption. "his means the
amount $K2F10D- which is surplus of the 4
nd
year is reinvested in the proPect at 1J.23,
eAuivalent to the &00. "his assumption need not e true as the surplus may e deployed at a
different rate. We will correct this distortion y modifyin$ our &00 calculation 8'&009.
"he '&00 can e calculated usin$ the (Bcel function5
6'&008W&et Flo"'()is!ount rate'()reinvestment rate'9.
&n order to eliminate the reinvestment rate assumption, we will modify the &00 incorporate
chan$es in the reinvestment rate. *ccordin$ly, the '&00 for the 7roPect-* is 12.4C3 and
7roPect-H is 14.223, at reinvestment rate of 103, which are still hi$her than the cost of capital
and hence economically viale.
&f y some coincidence, the rate of discount and the internal rate of return coincide,
what will the net present value of the investment e? "he .7) will e %ero since the &00 is that rate of discount, which eAuates the present
worth of enefits and costs.
!ay.acB !eriod
1hirley is =een on $ettin$ rid of the loan as soon as possile and would li=e to =now how
lon$ it will ta=e to do so. "he 7ayac= period is the periods for the investment to e
recovered from the net cash flow of the proPect. &t is usually undiscounted and calculated
y deductin$ the investment cost from each year#s net cash flow until the entire
investment is recovered. "he time ta=en to recover the investment is called the !payac=
period#. &t is demonstrated for the two proPects discussed earlier.
;outi+ue
Year
&nvestment
8$9
.et Cash
>low
"otal Cash
>low
.et >low
8K-49
*nnual
recovery of
investment
:iscount
factor
;143
7resent
)alue
82 B F9
*nnual
recovery
8discounted9
819 849 8K9
8Ka9
849 829 8F9 8C9 8J9
1 420000 6.8 40000
40000
-410000 -410000 0.JCC4 -1J4411 -1J4411
4 20000
I0000
20000 -1F0000 0.CFI2 KJ4CK.KJ -142CKC
K 6a8 J0000
1C00006c8
J0000 -J0000 0.FC20 2KIIC.C4 -I1CKI.4
4 100000
4C0000
100000 6d8 40000 0.2I41 2I40J.0K -K42K1.4
2 100000
KC0000
100000 140000 0.21I4 21IKF.JC 1I402.4C
&t can e calculated in a strai$htforward manner usin$ the formula.
7H7 6 a ? 8 - c 9 D d
Where , 7H7 is pay ac= period,
a is the year last year of ne$ative recovery
is the investment
c is the total cash flow upto year !a#
d is the net flow in the year followin$ year !a#
6 K ? 8420000 - 1C00009 D 100000
6 K.I Years 8rounded to sin$le decimal9
Restaurant
Year
&nvestment
8$9
.et Cash
>low
"otal Cash
>low
.et >low
8K-49
*nnual
recovery of
investment
:iscount
factor
;143
7resent
)alue
82 B F9
*nnual
recovery
8discounted9
819 849 8K9
8Ka9
849 829 8F9 8C9 8J9
1 K00000 F0000
F0000
-440000 -440000 0.JCC4 -41024F -41024F
4 J0000
140000
J0000 -1F0000 0.CFI2 F122C.4 -14JIFI
K J0000
4400006c8
J0000 -J0000 0.FC20 2KIIC.C4 -I4IC1.4
4 100000
K40000
100000 40000 0.2I41 2I40J.0K -K2CFK.4
2 100000
KC0000
100000 140000 0.21I4 21IKF.JC 1F1CK.C
&n proPects * and H, the annual capital recovery is shown in column 829. With the data
from the tale, the payac= for oth the proPects has een computed and found to e at
K.I years. Hoth the proPects have the same payac= period.
!rofita.ility Inde5
7rofitaility indeB is the ratio of the 7resent Worth of the net cash flows of the 7roPect to
the &nitial Cash -utflow. "his can e illustrated with the help of the HoutiAue eBample.
"he cash in-flow of the proPect is $40000, $20000, $J0000, $100000 and $100000,
respectively for the first to the fifth year. "he cost of capital is 103, which is ta=en as the
discount rate and the calculations are shown.
n
n
r
CF
r
CF
r
CF
r
CF
&PW
9 1 8
. . . . .
9 1 8 9 1 8 9 1 8
K
K
4
4
1
1
+
+ +
+
+
+
+
+

2 4 K 4 1
9 10 . 0 1 8
100000
9 10 . 0 1 8
100000
9 10 . 0 1 8
J0000
9 10 . 0 1 8
20000
9 10 . 0 1 8
40000
4FJ1J2 $
+
+
+
+
+
+
+
+
+

"he 7resent Worth of the .et cash outflows is $4FJ1J2 while the &nitial cash outlay or
the investment is $4,20,000.
"he 7rofitaility &ndeB is 6 4FJ1J2D 4200006 1.0C
1hould the HoutiAue 7roPect e accepted?
Yes since the ratio is $reater than one, the proPect is viale as it can cover the cost of
orrowin$.
"he measures of proPect worth help 1hirley Winters evaluate and select the proPects. 1he
should continually try to spot potential difficulties so as to overcome them from time to
time.
Capital rationin$ occurs when the capital is constrained durin$ a particular period. &f
1hirley Winters can raise only a part of her proPect cost, then the selection will have to
ased on the criteria that maBimises shareholders value y investin$ the part of the
capital. >inally a post completion audit has to e carried out to compare the actual costs
and returns with those that were proPected. "his will help in identifyin$ the wea=nesses so
that corrective action can e ta=en and etter decisions ta=en in future.