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Evaluation of Investment
Proposals
1. Time Value of money
2. Net present value (NPV)
3. Graphical representation of NPV
4. Internal rate of return (IRR)
5. An economic rationale for IRR rule
6-1
Future uncertainty
Sacrifice present consumption or preference
for higher consumption in future period
Alternative investment opportunities i.e.
opportunity cost.
Sacrifice of cash holding preference
Inflation
6-3
Terminologies
Present value: The value of today that is
obtained by discounting a future cash flow
or a series of cash flows by the opportunity
cost of fund as discount rate.
Future value: The amount or value will be
obtained at a certain time point in future of
a cash flow or a series of cash flows by
compounding at a given interest rate or
opportunity cost over a certain time period.
6-4
Terminologies
Discounting: The process of finding the
present value of a cash flow or a series
of cash flows by using a given discount
rate.
Compounding: The arithmetic process of
determining the final value of a cash
flow or a series of cash flows by using a
certain interest rate
6-5
Terminologies
Terminologies
Terminologies
Definition of capital
investment techniques
1. NPV: NPV is defined as the summation of the
present values of cash flows after tax in each
year over the project or investment period
minus the summation of present values of net
cash outflows in each year during that period.
2.
graphical presentation of
relationship between a projects and the firms
cost of capital or discount rate is called NPV
profile. A graph that plots a projects NPV
against the discount rates is defined as the
projects NPV profile.
NPV
Profile:
The
6-9
Definition
3. IRR: The discount rate that makes equal the present
value of a projects future cash inflows to the present
value of its total costs. Equivalently the rate that
forces the net present value to equal zero is internal
rate of return.
4. Modified IRR: The discount rate at which the present
value of a projects cost is equal to the present value
of its terminal value, where the terminal value is
found as the sum of the future values of cash inflows,
compound at the firms cost of capital.
6-10
Definition
5. Net Terminal Value: When terminal amount of any
Example
An asset can be purchased for Tk.7,50,000 that will
provide net benefits Tk.1,00,000; Tk.3,00,000;
Tk.2,10000 & Tk.280000 in years 1, 2, 3 & 4
respectively. Reinvestment rate is 8% and cost of
capital is 10.5%.Would it be wise to purchase the
asset under the following techniques?
(i) NPV
(ii) IRR (iii) PI
(iv) MIRR
(v) NTV
6-12
6-14
30056
4
Payback
=3
years
Discoun
ted
payback
=4
years
(apprx)
6-18
Problems
1. What will be present value of Tk.500000 will be
received 8 years from now at 15% discount rate?
2. Find the present value of Tk.20000, Tk.25000,
Tk15000 and Tk.30000 will be received in years 0, 1,
2
&
3
respectively
by
considering
discount/compound rate is 10%.
Problems
5. You have a choice of receiving 15 payments of
Tk.50000 a year, with the first payment to be
received just now, or Tk.600000 at a time today. If
your opportunity cost is 15% which would you prefer?
Problems
Problems
6-24
Homework
Questions & problems:
3.5, 3.6, 3.12 & 3.14
6-25