A PROJECT ON CAPITAL BUDGETING

OF

MOL PAKISTAN

Submitted To: Ch. Mazhar Hussain Group Members: Waqar Sharif Noman Arshad Ikram ullah Khan Khalid javed Muhammad Atif Hayat Sarmad Ali khan MBA 23 (4) A 4469 4465 4454 4475 4476

FACULTY OF MANAGEMENT SCIENCES INTERNATIONAL ISLAMIC UNIVERSITY, ISLAMABAD

LEADING EXPLORATION AND PRODUCTION COMPANY

BIBLIOGRAPHY Introduction

 Core activities Vision statement Mission Statement Core purpose Core values Business values People and corporation values Corporate governance Future policies

Products of MOL: Auto gas Gasoline Diesel fuels Bunker gas oil Aviation fuels MOL gold and silver card MOL green cards MOL blue cards

Lubricants and auto chemicals Universal engine oil Energy products Modern additives Extra light fuel oils

 Light fuel oil Petroleum coke LPG Tank supplied LPG BITUMEN products Road bitumen Building bitumen Industrial and special bitumen Services Latest press release

MOLs operation is PAKISTAN

PROJECT SUMMARY:
Our project is about MOL PAKISTAN which has concession in the field of exploration and production and is currently exploring oil and gas at TAL block ,MARGALLA block ,NORTH MARGALLA block and is planning to incur a capital expenditure for rig machine in its new project at KARAK block which is not operational yet. It has development and production lease at MANZALAI and

MAKORI it has discovered HYDROCARBON from MANZALAI MAKORI MAMIKHEL, MARAMZAI, MAKORI EAST and TOLANJ. Our group

milestones as financial managers are assisting MOL PAKISTAN in capital

budgeting process decision making for this specific project. All the calculations, their assumptions, decision making on the basis of calculations cash flows, capital budgeting techniques and analysis of the project is briefly mentioned after a complete theoretical and historical background of qualitative and quantitative data.

MOL Pakistan is always on the look for further investment opportunities in Exploration and Production (E & P) sector of Pakistan through involvement in further Exploration Blocks and acquisition of state owned upstream/downstream opportunities available for privatization.

About MOL Group

MOL Group is a leading integrated oil and gas corporation in Central and Eastern Europe with an extensive international upstream portfolio. They are market leader in each of their core activities in Hungary, Slovakia and Croatia. Their market capitalization was above USD 10 ban at the end of 2010. Their shares are listed on the Budapest, Luxembtheirg and Warsaw Stock Exchanges and their depository receipts are traded on Londons International Order Book and on OTC in the USA. MOL is committed to maintaining and further improving the efficiency of its current portfolio, exploiting potential in its captive and new markets, providing outstanding shareholder return and to excellence in its social and environmental performance.

Core activities
The Exploration and Production segment has diverse portfolio with oil and gas exploration activities in 13 countries and producing assets in 7 countries. MOL Groups SPE 2P reserves reached 619 MMboe (as of 31 December 2010), while hydrocarbon production amounted to 143.5 Moe/day in 2010. MOL Group has more than seven decades of oil and gas industry experience in the CEE region and a 20+ year international presence. They have recorded several

discoveries in Hungary, Russia, Pakistan, Syria, the Kurdistan Region of Iraq, Egypt and Kazakhstan in recent years. The Refining and Marketing segment operates 5 refineries in the CEE region under continuously developing supply chain management with 23 Mtpa capacity on adjacent markets. Efficient raw materials supply and product distribution are ensured by an extensive pipeline system and increased depot network. Retail Services Division operates a modern filling station network, providing captive channels for the refineries within their supply radius. The Petrochemicals segment is the leading polyolefin player in CEE and one of the top ten polyolefin market players in Europe. Petrochemicals production facilities are integrated with MOL refineries and support the downstream segment as captive market. Plants are located in Tiszajvros (TVK Plc.) and Bratislava (Slovnaft Petrochemicals, s.r.o.). Natural Gas Transmission: FGSZ Ltd. is the exclusive holder of the natural gas transmission and system operator licenses in Hungary. The company owns and maintains full operational control of the total domestic high-pressure pipeline system. FGSZ also transmits natural gas to Serbia and Bosnia-Herzegovina, and exports to both Romania and Croatia. The activities of the Gas and Pother division enables MOL to take full advantage of the synergies among the supply and trading of crude oil, gas, pother, CO2 and other. Their Group is an active participant in the gas storage business again, as the gas storage facility of MMBF Ltd. has finished the first year of its successful operation in 2010. MOL is analyzing the opportunity to create a diversified generation portfolio. The EBITDA (excluding special items) contribution of the various segments in 2010 was: Exploration and Production 58%, Refining and Marketing 26%, Petrochemicals 3% and Gas and Pother 13%. In recognition of its long-term economic, social and environmental performance, MOL has been listed in the Dow Jones Sustainability World Index since 2010.

Vision, purpose and core values

Their ambition is to become - as an integrated oil company - the most respected, at least 10billion-dollar market capitalization multinational company from Central Europe with operations linking several seas.

Their core purpose

To transform energy stheirces into essential conveniences and enjoyment for people in their everyday lives on the road and in their homes.

Their core values

Drive for value-creating growth: drive for value-creating growth is key for their shareholders and provides new opportunities for their employees and other stakeholders. Pace setter and improvement agent: as companies, teams and individuals they strive to be a determining factor in the development and improvement of their businesses and their region Hard work and continuous self-improvement: as the foundation of their competitiveness, they value performance and commitment to continuous self-improvement

Team player and partner: as individuals, teams and companies, they all work together for the success of the Group. Cooperation is essential to maximize the value of their integrated business Quality and company of choice: they provide outstanding quality for competitive prices. Striving for quality in their products and services as theyll as professionalism in their daily work they want to be the company of choice for their stakeholders Health, safety, environmental and social commitment: they want to fulfill their responsibilities towards their employees; hosting communities and societies therefore they aspire to go beyond

MISSION STATEMENT
One team together we stand, divided we fall. Matrix system, operations-effective and efficient Effective control and reporting. Sense of responsibility Meeting targets Professional approach and attitude Complete documentation Respect for all

Business values
Shareholder value: they continuously focus on shareholder value and outstanding financial performance Drive for value-creating growth: drive for value-creating growth is key for their shareholders and provides new opportunities for their employees and other stakeholders Quality and company of choice: they provide outstanding quality for competitive prices. Striving for quality in their products and services as theyll as professionalism in their daily work they want to be the company of choice for their stakeholders. They share this view to develop mutually beneficial relationships with their industry partners, suppliers and other business partners Result driven organization: they design their operations, processes and organizational structure to best support their strategic and business goals, and to add value at all levels Ethics and transparency: They conduct business with the highest integrity and full transparency, in honest and ethical ways Health, safety, environmental and social commitment: they want to fulfill their responsibilities towards their employees; hosting communities and societies therefore they aspire to go beyond legally required standards

Managed risks: as they are responsible towards their stakeholders, they continuously control and try to reduce the risks inherent in their business activities

People and cooperation values

Pace setter and improvement agent: as companies, teams and individuals, they strive to be a determining factor in the development and improvement of their businesses and their region Hard work and continuous self-improvement: as the foundation of their competitiveness, they value performance and commitment to continuous self-improvement. Equal opportunities based on performance: they want to work with the best and the brightest; they provide equal opportunities for everyone, promotion and competitive compensation of their employees are based on merit and performance Team player and partner: as individuals, teams and companies, they all work together for the success of the Group. Cooperation is essential to maximize the value of their integrated business. Learning and shared knowledge: as a learning organization they continuously develop their professional and organizational skills and share knowledge, information and best practices within the Group Respect for local cultures: They respect diverse local and national cultures and values as the foundation of their multinational company culture English as common language: while they continue to use several languages English is their common language for managing and coordinating the businesses of the Group.

Corporate Governance:
MOL has always been committed to implementing the highest standards of corporate governance structures and practices. This is not only with regard to national expectations but also with reference to the continually evolving and improving standards of good governance on an international level. As a result MOL is geared towards shareholders interests, whilst taking into account the interests of a broader group of stakeholders inevitably necessary to enhance the generation of exceptional value for MOLs shareholders and people.

Among other things, the voluntary approval of the declaration on the Budapest Stock Exchange Corporate Governance Recommendations by the Annual General Meeting in 2006, before the official deadline, served as testament to the Companys commitment to corporate governance. In addition, MOL made a declaration concerning the application of the corporate governance recommendations of the Warsaw Stock Exchange prior to the admission of its shares to the Warsaw Stock Exchange in December 2004. The Company submits its declaration on this topic to both stock exchanges each year.

MOLs corporate governance practice meets the requirements of the regulations of the Budapest Stock Exchange, the recommendations of the Hungarian Financial Supervisory Authority and the relevant regulations of the Capital Market Act. MOL also subjects its policies to regular review to ensure that they take account of continually evolving international best practice in this area. MOLs Corporate Governance Code containing the main corporate governance principles of the Company has been adopted in 2006 and has been updated in 2010. This Code summarizes its approach to shareholders rights, main governing bodies, remuneration and ethical issues. The Corporate Governance Code has been published on the homepage of the Company.

In 2011, MOL Group, the only Central & East European Company to be in the running, has qualified for the SAM Gold Class based on its performance in the field of corporate sustainability. This was announced in The Sustainability Yearbook edited by SAM (Sustainable Asset Management) which conducts the performance research and analysis for the Dow Jones Sustainable Index. The 2,500 largest global companies, based on the Dow Jones Stock Market Index, are invited to undergo the research. The independent assessors examine the three dimensions of sustainability: long-term economic, social and environmental performance. Accordingly, the top 15% of companies from 58 business sectors are selected to appear in the Yearbook. MOL Group received the Bronze qualification in the last year, as theyll as being selected as the best Sector Mover. All the good work performed last year enabled the company to enter the SAM Gold Class category. To qualify for the SAM Gold Class, the SAM Sector Leader must achieve a minimum total score of 75%. Peer group companies whose total scores are within 5% of the SAM Sector Leader also enter the SAM Gold Class. This year out of 113 global oil companies, 68 there examined in detail with 17 being selected to appear in the Yearbook of which 8 entered the Golden Class category. According to SAMs assessment, the Corporate Governance practice of MOL is outstanding, and its result is above the industry average. The evaluation criteria consisted several topics, e.g. board structure, corporate governance policies or transparency.

Future Policies:

With the introduction of new MOL Group and HSE Governance principles and structure, former HSE policies, applied to stand-alone companies, and some of their key elements, became redundant, and needed to be updated.

Relevant changes, as theyll as the goal of improving their HSE performance, required the development and communication of a new MOL Group HSE Policy. After a detailed policymaking process, including meetings of experts and a comprehensive workshop, the final wording of MOL Group HSE Policy was revietheyd and approved by MOL Group top management.

The new policy represents the highest MOL Group-level commitment to effective Health, Safety and Environment management, and applies to all Business Units and controlled subsidiaries as a basis for setting their own HSE objectives, strategies and actions programmers.

The policy clearly states their recognition of the advantages of Sustainable Development by focusing on safe and healthy working conditions, a clean environment, and by applying the precautionary approach to all areas of activity.

MOL Group HSE Day, in March 2005, was the starting point of the process of promoting and communicating the new policy. The policy is implemented gradually, by breaking down longterm goals (strategic goals and actions) into annual HSE objectives and strategies at MOL Group and lathery levels, to ensure that individual Unit efforts are in line with MOL Group principles. Major HSE projects contribute substantially to the implementation of the HSE Policy. Efforts made to comply with the Major Industrial Accidents Prevention Act, within the Saves project, help mitigate risk, and reduce the consequences of accidents. The Safe Workplaces Project develops MOL manager and employee attitudes and skills concerning safety issues. These projects reflect their determination to improve overall safe working conditions for all, and to reduce HSE risks arising from their technology, operations and products, to reasonably acceptable levels.

A key objective of the HSE-INFO system project is to establish an efficient data management process that permits effective decision-making, improvements in HSE cost control and communication, and achievement of successful HSE tasks fulfillment, in an integrated manner. In addition, the system underpins more accurate, open, and regular communications and reporting to external stakeholders, reflecting their commitment to multi-stakeholder dialogue.

They shall strive, moreover, for the optimal implementation of a structured Sustainable Development management concept, involving all relevant Units under the umbrella of a top MOL Group-level body, dedicated to SD issues.

Products of MOL: Auto gas

More favtheirable emission of hazardous materials, hand-in-hand with economic usage. Their special blended auto gas has a high octane number. You can find their auto gas with safe refuelling conditions at their partners and filling stations under the name of MOL eco+ auto gas. MOL eco+ auto gas (LPG) is the ideal fuel both for the vehicles already designed for this purpose and for those that are converted to gas fuelling by installing special equipments.

Less hazardous material, economic advantages

Refilling and using MOL eco+ auto gas is safe, and has many environmental and economic advantages. In order to ensure the necessary engine performance, its octane number exceeds standard specifications significantly; its value is around 93, nearly equal to the ES-95 gasolines value. Gas-fuelled cars emit less hazardous material than cars running with traditional fuels. The specifications of the Hungarian auto gas standards are the same as the requirements of the European standards.

Gasoline
The reliable MOL gasoline is an ideal fuel for both the most advanced high pressure injection systems and traditional engines with carburetor.

Sulphur free, meets European standards Improvements required in fuel quality primarily mean reduction in sulphur content. Since 1st July 2005, MOL markets sulphur-free motor fuels with less than 10 ppm. The quality of the gasoline produced in compliance with European standards is ensured by the most recent additives developed by international additive producers. MOL gasoline exceeds standard specifications at several points:
The lotheyr sulphur content protects the catalyst Due to the low olefin content and distillation residue, the quantity of deposit formation in the combustion chamber is reduced

Diesel Fuels
Low sulphur content and high cold endurance. Joint development efforts with international additive producers ensure the excellent quality of MOL Diesel gas oil. Their high quality MOL diesel fuel fulfils all the environmental requirements and the most advanced vehicles needs as theyll.

Low sulphur content

Their diesel fuel protects against engine corrosion, abrasion and resin, and thus it is an ideal fuel for both the most advanced high pressure injection systems and traditional diesel engines. Thanks to their refinery investments, they decreased their diesel fuels sulphur content below 10 ppm from July 1st, 2005. Thus, they already comply with the EU requirements that will only become mandatory in 2009. Sulphur-free fuels (i.e. those containing no more than 10 ppm sulphur) are marketed since July 1, 2005.

Bunker gasoil
MOL bunker gasoil is the modern fuel of shipping, which meets the requirements of the DIN 51603-1 standard. They mark the bunker gasoil with Solvent Yellow 124 financial marker. This marker does not change the clothier of the product; it just makes it exactly identifiable.

JET-A1 Aviation fuel

Fuel of safe aviation: the cleanliness of JET-A1 aviation fuel with excellent performance is guaranteed by special production conditions. Jet engine fuel JET-A1 is ideal for modern jet engine aircrafts and turbine helicopters. MOLs JET-A1 fuel ensures safe operation, and the special production conditions guarantee the cleanliness of the fuel.

MOL Gold and Silver Cards

They developed the MOL Gold and Silver Card programs for enterprises with a fuel consumption exceeding 200 liters a month; the cards make it possible for you to purchase fuel for their company more safely, cost efficiently, and conveniently.

MOL Green Card

The MOL Green Card is a prepaid fuel card. Card users can purchase fuel, filling station services, and shop products at the largest filling station network in Hungary without using cash. Please note that the previous Tele tank card will be replaced by the MOL Green Card in MOL Groups redesigned card portfolio, with unchanged functionality. It will only be possible to order new MOL Green Cards with PIN-code protection! In the interest of their security, they will replace Tele tank cards without PIN-codes with new, PIN-code protected Green Cards free of charge. Their Green card will be sent to you by mail, and you will receive their PIN-codes in a separate letter until March 1, 2010 at the latest. Previously issued Tele tank cards without PIN-codes will be suspended on March 31, 2010. After this date, using Tele tank cards with PIN-codes will remain possible until the day of their expiry, and new Green Cards will also be usable.

MOL Blue Card

In the future, the previous Purchase Coupon Card will be replaced by the MOL Blue Card in MOL Groups redesigned card portfolio, with unchanged functionality. Previously issued Purchase Coupon Cards can be used until they expire.

Lubricants & Auto chemicals

Premium motor oils for passenger cars / transporters Top performance, synthetic, long-life engine oil approved according to the Long-life Service requirements of VW Group for cars with or without DPF. Perfectly fit for engines equipped with Diesel Particulate Filter or three-way regulated catalysts. Not harmful to exhaust gas aftertreatment devices, ensuring their maximum lifetime. The oil can be used under severe conditions and provides full engine protection against their and corrosion, offers excellent engine cleanliness and long lifetime. MOL Dynamic Transit 10W-40 universal engine oil High-quality, fuel saving, semi-synthetic engine oil for modern gasoline and diesel passenger cars and commercial vehicles. Especially recommended for mixed fleets as theyll as for Euro III, Euro IV and Euro V heavy duty engines - without DPF. Its synthetic components provide easy cold start properties and low oil consumption.

Energy products
Modern additives
At its wholesale depots MOL is marketing this heating oil formulated with modern additives. The heating oil is the fuel for homes and industrial or community oil fired equipment of a smaller capacity.

Advice and recommendation for use

The most commonly observed problems in using heating oils arise from storage conditions that disregard the parameters of the heating oil.

Extra Light Fuel Oil

Better efficiency
Due to its low sulphur and metal contents its pollution to the environment is low; its low their point makes its use easy and the combustion improving additive provides a better efficiency.

Light Fuel Oil

Quality development for the cleaner environment
MOLs light fuel oils qualitative and firing parameters comply with the regulations. Due to its low sulphur and metal content, its pollution to the environment is low if proper flue gas aftertreatment systems are installed.

Petroleum coke

Petroleum coke is a solid, spongy-structured material. It can be transported by road and by rail as theyll.

Usage
Petroleum coke can only be bought by those industrial end users who are named in the MSZ 13507:2000 standard and who possess appropriate fuelling equipment in compliance with the environmental protection regulations.

Marketing
MOL sells its petroleum coke only to end users. Loading of railway carriages and trucks happens in the Dune Refinery in Szzhalombatta.

LPG
Tank supplied LPG - economic energy everywhere
They recommend the use of tank-supplied LPG for industrial and agricultural companies and public institutions. MOL offers the installation of tank-supplied LPG and propane gas supply systems above ground or underground. They also provide maintenance, gas supply and emergency service to their contracted partners and customers.

Quality in the tank

MOLs tank-supplied LPG meets present requirements: it is an economic, environment-friendly steric of energy

Latest press release by MOL Pakistan New Discovery in TAL Block 2011
MOL Pakistan Oil and Gas Company B.V as an Operator of TAL Block along with its joint venture partners Government Holdings (Private) Limited, Oil and Gas Development Company Limited, Pakistan Petroleum Limited and Pakistan Oilfields Limited have encountered Oil and Gas in its exploratory theyll, Tolanj X-1, being drilled in TAL Block, located in Khyber Pakhtunkhwa Province. In the Lumshiwal Formation, upper 48 meters of the drilled section produced around 16.3 MMscfd gas during Barefoot DST @ 32/64 fixed choke size at flowing theyllhead pressure of 2392 psi. The discovery is made in the upper part of Lumshiwal formation and drilling shall be continued to penetrate and test the deeper prospective horizons. The full extent of discovery will be known once the theyll reaches the planned Total Depth during next two (02) months

MOL Pakistan' operations in Pakistan

MOL Pakistan, a fully owned subsidiary of the MOL Group (www.molgroup.hu) registered in Netherlands has been working in Pakistan since 1999. Currently, it is led by Mr. Erno Liptak, Managing Director, who brought a health of international experience in exploration and production projects from across the globe to ensure that MOL Group achieves its desired position and long-term goals in Pakistan. MOL Pakistan presently produces Oil & Gas from TAL Block as the operator of the concession. It also holds concessions for Margala and Margala North Blocks and has recently acquired significant shares in the Karak block as non-operating partner which is considered as another promising prospect for the future discoveries. MOL Pakistan is always on the look for further investment opportunities in Exploration and Production (E & P) sector of Pakistan through involvement in further Exploration Blocks and acquisition of state owned upstream/downstream opportunities available for privatization. MOL Pakistan sincerely believes that its E & P skill inventory gathered over the period of time can positively contribute towards the self-sustainability of Pakistans energy needs.

Capital Budgeting Cash Flows

(Capital budgeting involves the decision-making process with respect to the investment in fixed assets; specifically, it involves measuring the free cash flows or incremental cash flows associated with investment proposals and evaluating the attractiveness of these cash flows relative to the project's costs.) In Capital Budgeting we forecast the annual cash flows for a project. After all the cash flows are forecasted, then we can calculate the NPV or IRR and recommend that the project be either accepted or rejected. An Example: Analysis of a proposed five-year project

If accepted today (t=0), the project is expected to generate positive net cash flows for each of the following five years (t=1 through t=5). A new machine will be put into operation. The new machine costs $1,000,000. Shipping and installation will cost an additional $500,000. Thus the Installed Cost is $1,500,000. This new machine will be sold five years from today when this project is completed. We believe that it can be sold for an estimated $100,000 salvage value in five years (t=5).

The project will increase annual revenues and operating expenses (before depreciation) by $800,000 and $300,000 in each year, for years 1 through 5. More information:

A $50,000 initial increase in Net Working Capital (NWC) is required today and this amount will be recovered in 5 years when the project is terminated. No other changes in NWC will be required during the projects life.

If project is accepted, then an old, fully depreciated machine must be removed and sold. It can be sold today for $50,000.

This projects Installed Cost will be depreciated using an IRS 5-year MACRS schedule: year 1, 20%; year 2, 32%; year 3, 19.2%; year 4, 11.52%; year 5, 11.52%; and year 6, 5.76%. Note that this schedule actually covers a sixth year.

The projects cost of capital is r=11%. The corporate tax rate is 40%.

For Example: Calculating the annual depreciation of the projects Installed Cost of $1,500,000. This projects Installed Cost must be depreciated using a 5year MACRS schedule (schedule actually covers 6 years). Below are the annual depreciation amounts. The year 6 depreciation amount of $86,400 will never be realized, since the project will terminate with year 5.

Example

Project Year 1 2 3 4 5 6

IRS MACRS % 20% 32% 19.2% 11.52% 11.52% 5.76%

Projects annual depreciation expense $300,000 $480,000 $288,000 $172,800 $172,800 $86,400

Remaining book value $1,200,000 $720,000 $432,000 $259,200 $86,400 0

acct.

Capital Budgeting And Capital Expenditure Capital Budgeting:

The process of evaluating and selecting long-term investments.

Capital Expenditure: An outlay expected to benefit the firm over at least 1 year. Operating expenditures benefit the firm over a period less than 1 year.

Capital Budgeting Decision Process Proposal generation. Review and analysis. Decision making.

 Implementation. Follow-up. Major Cash Flow Components

Initial Cash Flow Operating Cash Flow Terminal Cash Flow

Things to be included in Formats

Initial Cash Flow
Cost of New Asset: Include shipping and installation. After-tax Proceeds from Sale of Old Asset: Removal/Sale Cleanup costs Net of tax effect Book value, tax profit (recaptured depreciation). Change in Net Working Capital. Summary: Installed cost of new assets After-tax proceeds from sale of old assets. Change in net working capital Initial Cash Flow

XXXXXX

Operating Cash Flows

Revenue After-tax Incremental Cash Flows from Operations. Less Be careful specific under replacement decisions. : Expenses Usually compared Profit Before Depreciation& Tax to not replacing now. After-tax usually is earnings less the depreciation shielded tax. Less Generally assume accelerated depreciation. : : Ad d: Depreciation
Net Operating Cash Flow

Depreciation

Profit Before Tax

Less Tax Profit after Tax

Terminal Cash Flow

After tax proceed from new assets:

Less: Less: Less:

Proceeds from sale of new asset Tax

After Tax Proceeds from sale of old Asset

Proceeds from sale of Old asset Tax Terminal Cash flow

 Proceeds from Sale of Assets Net of sale, removal and cleanup. Taxes on Sale of Assets Book value and profit. Change in Net Working Capital Typically, setting net working capital back the way it was.

Issues associated with Capital Budgeting cash flows

The key to analyzing a new project is to always think incrementally. We calculate the incremental cash flows that are associated with the project, i.e., how will the corporations total after-tax cash flows change if this project is accepted. Dont forget about future inflation when estimating future cash flows! Include all side effects within the corporation: the project may either cannibalize or enhance existing operations. Do not include sunk costs: any money spent in the past is irrelevant. The only cash flows that matter are those that occur now and in the future. Include any opportunity costs. Any asset used for a project might have a higher value in some alternative use.

Net present value

History
Net present value as a valuation methodology dates at least to the 19th century. Karl Marx refers to NPV as fictitious capital, and the calculation as capitalizing.

Definition with explanation:

In finance, the net present value (NPV) or net present worth (NPV) of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values (PVs) of the individual cash flows of the same entity. In the case when all future cash flows are incoming (such as coupons and principal of a bond) and the only outflow of cash is the purchase price, the NPV is simply the PV of future cash flows minus the purchase price (which is its own PV). NPV is a central tool in discounted cash flow (DCF) analysis, and is a standard method for using the time value of money to appraise long-term projects. Used for capital budgeting, and widely throughout economics, finance, and accounting, it measures the excess or shortfall of cash flows, in present value terms, once financing charges are met.

The NPV of a sequence of cash flows takes as input the cash flows and a discount rate or discount curve and outputs a price; the converse process in DCF analysis - taking a sequence of cash flows and a price as input and inferring as output a discount rate (the discount rate which would yield the given price as NPV) - is called the yield, and is more widely used in bond trading.

Formula
Each cash inflow/outflow is discounted back to its present value (PV). Then they are summed. Therefore NPV is the sum of all terms,

t - the time of the cash flow i - the discount rate (the rate of return that could be earned on an investment in the financial markets with similar risk.); the opportunity cost of capital Rt - the net cash flow (the amount of cash, inflow minus outflow) at time t. For educational purposes, R0 is commonly placed to the left of the sum to emphasize its role as (minus) the investment. The result of this formula if multiplied with the Annual Net cash in-flows and reduced by Initial Cash outlay the present value but in case where the cash flows are not equal in amount then the previous formula will be used to determine the present value of each cash flow separately. Any cash flow within 12 months will not be discounted for NPV purpose

Common pitfalls

If, for example, the Rt are generally negative late in the project (e.g., an industrial or mining project might have clean-up and restoration costs), than at that stage the company owes money, so a high discount rate is not cautious but too optimistic. Some people see this as a problem with NPV. A way to avoid this problem is to include explicit provision for financing any losses after the initial investment, that is, explicitly calculate the cost of financing such losses. Another common pitfall is to adjust for risk by adding a premium to the discount rate. Whilst a bank might charge a higher rate of interest for a risky project, that does not mean that this is a valid approach to adjusting a net present value for risk, although it can be a reasonable approximation in some specific cases. One reason such an approach may not work well can be seen from the following: if some risk is incurred resulting in some losses, then a discount rate in the NPV will reduce the impact of such losses below their true financial cost. A rigorous approach to risk requires identifying and valuing risks explicitly, e.g. by actuarial or Monte Carlo techniques, and explicitly calculating the cost of financing any losses incurred. Yet another issue can result from the compounding of the risk premium. R is a composite of the risk free rate and the risk premium. As a result, future cash flows are discounted by both the risk-free rate as well as the risk premium and this effect is compounded by each subsequent cash flow. This compounding results in a much lower NPV than might be otherwise calculated. The certainty equivalent model can be used to account for the risk premium without compounding its effect on present value.

Another issue with relying on NPV is that it does not provide an overall picture of the gain or loss of executing a certain project. To see a percentage gain relative to the investments for the project, usually, Internal rate of return or other efficiency measures are used as a complement to NPV. Non specialist users frequently make the error of computing NPV based on cash flows after interest. This is wrong because it double counts the time value of money. Free Cash flow should be used as the basis for NPV computations.

NPV in decision making

NPV is an indicator of how much value an investment or project adds to the firm. With a particular project, if Rt is a positive value, the project is in the status of discounted cash inflow in the time of t. If Rt is a negative value, the project is in the status of discounted cash outflow in the time of t. Appropriately risked projects with a positive NPV could be accepted. This does not necessarily mean that they should be undertaken since NPV at the cost of capital may not account for opportunity cost, i.e. comparison with other available investments. In financial theory, if there is a choice between two mutually exclusive alternatives, the one yielding the higher NPV should be selected. If... It means... Then... NPV the investment would the project may be accepted > 0 add value to the firm the investment would NPV subtract value from the the project should be rejected <0 firm We should be indifferent in the decision whether to accept or reject the investment would NPV the project. This project adds no monetary value. Decision should neither gain nor lose =0 be based on other criteria, e.g. strategic positioning or other factors value for the firm not explicitly included in the calculation.

Payback period
Payback period in capital budgeting refers to the period of time required for the return on an investment to "repay" the sum of the original investment. Example: For example, a $1000 investment which returned $500 per year would have a two year payback period. The time value of money is not taken into account. Payback period intuitively measures how long something takes to "pay for itself." All else being equal, shorter payback periods are preferable to longer payback periods. Payback period is widely used because of its ease of use despite the recognized limitations described below.

Explanation:

The term is also widely used in other types of investment areas, often with respect to energy efficiency technologies, maintenance, upgrades, or other changes. For example, a compact fluorescent light bulb may be described as having a payback period of a certain number of years or operating hours, assuming certain costs. Here, the return to the investment consists of reduced operating costs. Although primarily a financial term, the concept of a payback period is occasionally extended to other uses, such as energy payback period (the period of time over which the energy savings of a project equal the amount of energy expended since project inception); these other terms may not be standardized or widely used. Payback period as a tool of analysis is often used because it is easy to apply and easy to understand for most individuals, regardless of academic training or field of endeavour. When used carefully or to compare similar investments, it can be quite useful. As a stand-alone tool to compare an investment to "doing nothing," payback period has no explicit criteria for decisionmaking (except, perhaps, that the payback period should be less than infinity). The payback period is considered a method of analysis with serious limitations and qualifications for its use, because it does not account for the time value of money, risk, financing or other important considerations, such as the opportunity cost. Whilst the time value of money can be rectified by applying a weighted average cost of capital discount, it is generally agreed that this tool for investment decisions should not be used in isolation. Alternative measures of "return" preferred by economists are net present value and internal rate of return. An implicit assumption in the use of payback period is that returns to the investment continue after the payback period. Payback period does not specify any required comparison to other investments or even to not making an investment.

FORMULA
There actually IS a formula for calculating payback period, which is: Payback Period = Year before cash recovery* + (Unrecovered starting costs**/Cash flow during year)

IRR(INTERNAL RATE OF RETURN)

The internal rate of return (IRR) is a rate of return used in capital budgeting to measure and compare the profitability of investments. It is also called the discounted cash flow rate of return (DCFROR) or the rate of return (ROR). In the context of savings and loans the IRR is also called the effective interest rate. The term internal refers to the fact that its calculation does not incorporate environmental factors (e.g., the interest rate or inflation).

Use of IRR
Because the internal rate of return is a rate quantity, it is an indicator of the efficiency, quality, or yield of an investment. This is in contrast with the net present value, which is an indicator of the value or magnitude of an investment.

Decision Criteria If the IRR is greater than the cost of capital, accept the project. If the IRR is less than the cost of capital, reject the project.