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Sovraj Gautam
One change of signs. Cost (negative CF) followed by a series of positive cash inflows.
Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs,then cost to close project. Example: Nuclear power plant, strip mine.
Discounting Criteria
NPV
BCR
IRR
PBP
ARR
MIRR
DPBP
The NPV method can be used to select between mutually exclusive projects; the one with the higher NPV should be selected.
Since it considers the investment in the project, it is considered to be preferable to NPV method. Disadvantages of BCR method:
It does not provide for a means through which a number of smaller projects can be combined to be compared to a bigger project.
CF0
Cost
CF1
CF3
IRR is the rate of return that equates PV of cash inflows with investment outlay of a project . This is the same as forcing NPV = 0.
t !1 n t !1
Ct (1 r )t Ct C0 ! 0 t (1 r )
Ct = cash flow at the end of year t n = Life of the project r = discount rate C0 = Initial investment 1 / (1 + r )t = known as discounting factor or PVIF i.e present value interest factor.
CALCULATION OF IRR
Level or even Cash Flows: Let us assume that an investment would cost Rs 20,000 and provide annual cash inflow of Rs 5,430 for 6 years. The IRR of the investment can be found out as follows: NPV ! Rs 20,000 + Rs 5,430(PVAF6,r ) = 0
Rs 20,000 ! Rs 5,430(PVAF6, r ) Rs 20,000 PVAF6, r ! ! 3.683 Rs 5,430 IRR = 16% approx.( Refer to PVAF table @ 3.685 for 6 yrs
NPV 1 2 ,5 8 0 7 ,5 6 1 3 ,6 4 9 550 0 ( 1 ,9 4 2 ) ( 3 ,9 7 4 )
IR R
F ig u r e 8 .1 N P V P r o f ile
CALCULATION OF IRR
Uneven or non normal Cash Flows: Calculating IRR by Trial and Error The approach is to select any discount rate to compute the present value of cash inflows. If the calculated present value of the expected cash inflow is lower than the present value of cash outflows, a lower rate should be tried. On the other hand, a higher value should be tried if the present value of inflows is higher than the present value of outflows. This process will be repeated unless the net present value becomes zero.
CALCULATION OF IRR
A project costs Rs.16000 and is expected to generate cash inflows of Rs. 8000, Rs.7000 & Rs.6000 at the end of each year for next 3 years.
Cash Flows (Rs.) Project X Y Co -100 100 C1 110 -110 IRR 10% 10% NPV at 15% -4.3 4.3
A project may have both lending and borrowing features together. IRR method, when used to evaluate such non-conventional investment can yield multiple internal rates of return because of more than one change of signs in cash flows.
Discount Rate
Discount Rate
2.4
3 80 50
60 100 -30 0
= 2.375 years
Weaknesses of Payback: 1. 2. 3. Ignores the time value of money. Ignores CFs occurring after the payback period. It is a measure of capital recovery & not profitability.
CFt PVCFt
-100 -100
10 9.09 -90.91
60 49.59 -41.32
80 60.11 18.79
It is very simple to understand. Dependency on accounting data which is readily available. Shows the profitability of the project.
It is based on accounting profit rather than cash flows. Time value of money is ignored. It is inconsistent in the sense that the numerator represents the profit belonging to equity and preference shareholders whereas the fixed assets used in denominator rarely if ever represents contribution equal to equity & preference shareholders.