Monday, August 24, 2020

FINANCIAL APPRAISAL

 

  • FINANCIAL APPRAISAL 

    FINANCIAL ANALYSIS OF THE PROJECT
    PROJECT MANAGEMENT
  • DR SHASHI AGGARWAL
  • FINANCIAL APPRAISAL
  1. MEANING
  2. METHODS OF FINANCIAL APPRAISAL
  3. TRADITIONAL AND DISCOUNTED METHODS
  • SYLLABUS COVERED UNDER GROUP 1
  • COVERED

a)    CONCEPT OF PROJECT AND PROJECT MANAGEMENT

b)    PROJECT LIFE CYCLE

c)    ROLE OF PROJECT MANAGER

d)    PROJECT PLANNING

e)    WORK BREAKDOWN STRUCTURE

f)     PROJECT APPRAISAL

g)    TECHNICAL APPRAISAL

 

  • UNCOVERED
  1. ECONOMIC FEASIBILITY
  2. COST PLANNING AND ESTIMATING
  3. TIME PLANNING TOOLS AND TECHNIQUES
  4. FINANCIAL EVALUATION
  5. APPRAISAL UNDER RISK AND UNCERTAINTY
  • FINANCIAL APPRAISAL
  1. A PROJECT SHOULD EARN SUFFICIENT RETURN ON INVESTMENT
  2. PROJECTS SPONSORED BY THE GOVERNMENT MAY TAKE INTO CONSIDERATION SOCIAL COST BENEFITS

  1. ENABLE AN ORGANIZATION TO EVALUATE OBJECTIVELY THE COST OF IMPLEMENTING A PROJECT OR INVESTMENT AND THE RETURN THAT COULD BE EARNED FROM THE PROJECT

  1. FINANCIAL APPRAISAL HELP THE ORGANIZATION TO CHOOSE THE MOST PROFITABLE FROM A POOL OF NUMEROUS PROJECTS
  2. SELECTION OF THE RIGHT PROJECT IS HIGHLY CRITICAL FOR THE FINANCIAL WELL BEING OF ANY ORGANIZATION.
  • FINANCIAL APPRAISAL METHODS
  1. NON DISCOUNTED CASH FLOW TECHNIQUES : TIME VALUE OF MONEY IS NOT CONSIDERED
  2. DISCOUNTED CASH FLOW TECHNIQUES :- TIME VALUE OF MONEY IS CONSIDERED.
  • TECHNIQUES OF EVALUATION
  • TRADITIONAL OR NON DISCOUNTED CASH FLOW CRITERIA
  1. PAYBACK
  2. DISCOUNTED PAYBACK
  3. ACCOUNTING RATE OF RETURN

·         DISCOUNTED CASH FLOW (DCF) CRITERIA

  1. NET PRESENT VALUE( NPV)
  2. (IRR) INTERNAL RATE OF RETURN
  3. PROFITABILITY INDEX(PI)
  • PAYBACK
  1. NUMBER OF YEARS REQUIRED TO RECOVER THE ORIGINAL CASH OUTLAY INVESTED IN PROJECT
  2. IF THE PROJECT GENERATES CONSTANT ANNUAL CASH INFLOWS THEN THIS METHOD IS USED
  3. PB= INITIAL INVESTMENT/ANNUAL CASH INFLOW
  4. ANNUAL CASH INFLOW MEANS NET PROFIT BEFORE DEPRECIATION AND AFTER TAXES
  5. A PROJECT COST 50,000 AND YIELD AN ANNUAL CASH FLOW OF RS 10,000 FOR 8 YEARS
  6. PB=50,000/10,000=5 YEARS
  • EXAMPLE
  1.  A PROJECT COST RS 10,000,00 AND YIELD ANNUAL PROFIT OF 1,60,000  AFTER DEPRECIATION 12% PER ANNUM BUT BEFORE TAX OF 50%
  • SOLUTION
  1. DEPRECIATION=10,00,000X12/100=1,20,0000
  2. PROFIT BEFORE TAX=1,60,000
  3. TAX = 80,000
  4. PROFIT AFTER TAX=1,60,000-80,000=80,000
  5. PROFIT AFTER TAX BUT BEFORE DEPRECIATION=80,000+120,000=2,00,000
  6. PAY BACK PERIOD = 10,00,000/2,00,000=5 YEARS
  • UNEQUAL CASH INFLOWS
  •  WHERE THE ANNUAL CASH INFLOWS ARE UNEQUAL THEN PAYBACK PERIOD CAN BE FOUND BY ADDING UP THE CASH INFLOWS UNTIL THE TOTAL IS EQUAL TO THE INITIAL  CASH OUTLAY OF THE PROJECT
  1. CONSIDER A PROJECT WHICH REQUIRE INITIAL INVESTMENT OF RS 20,OOO AND  PRODUCE CASH INFLOW OF 4,000,8000,6000, AND 4,000 IN THE FIRST,SECOND,THIRD AND FOURTH YEAR RESPECTIVELY
  • UN EQUAL CASH INFLOWS

  • ACCEPTANCE RULE
  1. COMPARISON OF  PROJECT’S PAY BACK PERIOD WITH PREDETERMINED STANDARD PAYBACK PERIOD
  2. ACCEPTED IF ITS PAYBACK PERIOD IS LESS THAN MAXIMUM OR STANDARD PAYABACK PERIOD
  3. HIGHEST RANKING TO THE PROJECT WHICH HAS THE SHORTEST PAY BACK PERIOD
  4. AND LOWEST TO HIGH PAYBACK PERIOD
  • ADVANTAGE
  1. SIMPLE TO UNDERSTAND AND EASY TO CALCULATE
  2. COST EFFECTIVE
  3. PROJECT WITH SHORTER PAY BACK PERIOD IS PREFERRED TO THE ONE HAVING A LONGER PAY BACK PERIOD,IT REDUCES THE LOSS THROUGH OUTDATEDNESS AND SUITABLE TO DEVELOPING NATIONS
  4. STRESS IS ON THE EARLY RECOVERY O THE INVESTMENT AND SO FUNDS RELEASED CAN BE PUT TO OTHER USES
  • DISADVANTAGE
  1. DOES NOT TAKE INTO ACCOUNT THE CASH INFLOWS EARNED AFTER PAY BACK PERIOD AND  TRUE PROFITABILITY CAN NOT BE ASSESSES
  2. IGNORES THE TIME VALUE OF THE MONEY AND DOES NOT CONSIDER THE MAGNITUDE AND  TIMING OF CASH INFLOWS AND IT TREATS ALL CASH FLOWS OCCUR IN DIFFERENT PERIOD. IGNORE THE FACT CASH RECEIVED TODAY IS MORE IMPORTANT THAN THE SAME AMOUNT OF CASH RECEIVED AFTER SOME PERIOD
  3.  DOES NOT CONSIDER THE COST OF CAPITAL INTO ACCOUNT
  4. DIFFICULT TO DETERMINE THE MINIMUM ACCEPTABLE PAYBACK PERIOD
  5. IT DOES NOT CONSIDER ALL THE CASH INFLOWS YIELDED BY THE PROJECT
  6. NOT CONSISTENT WITH THE OBJECTIVE OF  MAXIMIZING THE WEALTH OF THE SHAREHOLDERS,
  7. SHOULD BE USED WITH DCF TECHNIQUES . SCREENING OF THE PROJECT.
  • ACCOUNTING RATE OF RETURN
  1. ALSO KNOWN AS THE RETURN ON INVESTMENT
  2. USES ACCOUNTING INFORMATION AS REVEALED BY FINANCIAL STATEMENTS TO MEASURE THE PROFITABILITY OF AN INVESTMENT
  3. THIS METHOD TAKES INTO ACCOUNT THE EARNINGS EXPECTED FROM THE INVESTMENT OVER THEIR WHOLE LIFE.
  4. HERE ACCOUNTING CONCEPT OF PROFIT ( NET PROFIT AFTER DEPRECIATION AND AFTER TAX IS USED INSTEAD OF CASH FLOWS
  • ACCOUNTING RATE OF RETURN
  • ACCEPTANCE RULE:
  • AS AN ACCEPT OR REJECT CRITERION,THIS METHOD WILL ACCEPT ALL THOSE PROJECTS WHOSE ARR IS HIGHER THAN THE MINIMUM RATE ESTABLISHED BY THE MGMT
  • REJECT THOSE PROJECTS WHICH HAVE ARR LESS THAN THE MINIMUM RATE
  • RANK A PROJECT HIGH NUMBER ONE IF IT HAS HIGHEST ARR AND LOWEST RANK THE ONE HAVING LOWEST ARR

 

  • METHODS
  • AVERAGE RATE OF RETURN METHOD=  (AVERAGE ANNUAL PROFITS/NET INVESTMENT IN THE PROJECT) X100
  • LIKE A PROJECT REQUIRES AN INVESTMENT OF RS 4,00,000 AND HAS A SCRAP VALUE OF 20,000 AFTER FIVE YEARS AND IS EXPECTED TO YIELD PROFIT AFTER DEPRECIATION AND TAXES DURING THE FIVE YEARS

 

  • PROFIT AFTER TAX AND DEPRECIATION
  • 1 ST YEAR=30,000
  • 2ND YEAR=50,000
  • 3 RD YEAR =60,000
  • 4TH YEAR=40,000
  • 5TH YEAR=20,000
  • TOTAL=2,00,000

 

  • SOLUTION
  • AVERAGE PROFIT =2,00,000/5=40,000
  • NET INVESTMENT IN THE PROJECT=4,00,000-20,000=3,80,000
  • AVERAGE RATE OF RETURN= (40,000/3,80,000)X100=10.53%

 

  • RETURN PER UNIT OF THE INVESTMENT METHOD=
  • (TOTAL PROFITS AFTER DEP AND TAXES/(NET INVESTMENT IN THE PROJECT))X100
  • = ( 2,00,000/3,80,000)X100= 52,63%
  • RETURN ON AVERAGE INVESTMENT METHOD
  •  THE RETURN ON AVERAGE INVESTMENT METHOD=
  • TOTAL PROFITS  AFTER DEPRECIATION  AND TAXES/(AVERAGE INVESTMENT IN THE PROJECT))X 100
  • AVERAGE INVESTMENT = NET INVESTMENT/2= 3,80,000/2=1,90,000
  • = (2,00,000/1,90,000) X100= 105.26%

 

  • AVERAGE RETURN ON AVERAGE INVESTMENT METHOD
  • AVERAGE RETURN ON AVERAGE INVESTMENT=
  • = (AVERAGE ANNUAL PROFIT/AVERAGE INVESTMENT) X100
  • = (40,000/ 1,90,000) X 100= 21.052%
  • MERITS
  1. SIMPLE  TO CALCULATE
  2. CAN BE READILY CALCULATED FROM HE ACCOUNTING DATA. NO ADJUSTMENTS ARE REQUIRED
  3. IT TAKES INTO ACCOUNT THE ENTIRE EARNING OF A PROJECT
  4. COMMONLY UNDERSTOOD BY ACCOUNTANT AND USED AS  PERFORMANCE MEASURE
  • DEMERITS
  1. THE AVERAGING OF INCOME IGNORES THE TIME VALUE OF THE MONEY AND THIS METHOD GIVE MORE WEIGHTAGE TO DISTANT RECEIPTS
  2. DOES NOT TAKE INTO CONSIDERATION THE CASH FLOWS WHICH ARE MORE IMPORTANT THAN ACCOUNTING PROFITS
  3. IT IGNORES THE PERIOD IN WHICH THE PROFITS ARE EARNED AS 25% RATE OF RETURN IN  3 YEARS MAY BE BETTER THAN 18 % RATE OF RETURN FOR 13 YEARS
  4. CAN NOT BE APPLIED TO A SITUATION WHERE INVESTMENT IN PROJECTS TO BE MADE IN PARTS
  • ACCOUNTING RATE OF RETURN
  • METHOD IS USED AS PERFORMANCE EVALUATION AND CONTROL MEASURE IN PRACTICE BUT ITS USE AS INVESTMENT CRITERION IS CERTAINLY UNDESIRABLE AND IT MAY LEAD TO UNPROFITABLE ALLOCATION OF CAPITAL
  • DISCOUNTED METHODS
  • TIME ADJUSTED OR DISCOUNTED CASH FLOW METHODS
  • PAY BACK PERIOD METHOD AND ACCOUNTING RATE OF RETURN METHODS SUFFER FROM THE LIMITATION OF  GIVING EQUAL WEIGHTAGE TO PRESENT AND FUTURE FLOW OF INCOME METHODS AND IGNORE THE TIME VALUE OF MONEY
  • THE TIME ADJUSTED OR DISCOUNTED CASH FLOW METHODS TAKE INTO ACCOUNT THE PROFITABILITY AND ALSO THE TIME VALUE OF THE MONEY
  • ALSO CALLED MODERN METHODS
  1. NET PRESENT VALUE
  2. INTERNAL RATE OF RETURN
  3. PROFITABILITY INDEX
  4. TERMINAL VALUE METHOD

 

  • TIME ADJUSTED OR DISCOUNTED CASH FLOW METHODS
  • ALSO
  • NET PRESENT VALUE METHOD
  1. IS A MODERN METHOD OF EVALUATING INVESTMENT PROPOSAL. IT TAKES INTO CONSIDERATION THE TIME VALUE OF MONEY.IT RECOGNIZE THE FACT THAT RUPEE EARNED TODAY IS MORE IMPORTANT THAN IN THE FUTURE.
  2. IT CORRECTLY ASSUMES THAT CASH FLOWS ARISING AT DIFFERENT TIME PERIODS DIFFER IN VALUE AND ARE COMPARABLE ONLY WHEN THEIR EQUIVALENTS PRESENT VALUES ARE FOUND OUT
  3. CASH FLOWS OF THE INVESTMENT PROJECTS ARE FORETASTED ON REALISTIC ASSUMPTIONS

 

 

  1. NET PRESENT VALUE METHOD
  2. IDENTIFICATION OF APPROPRIATE DISCOUNT RATE. THE APPROPRIATE RATE OF DISCOUNT IS THE PROJECT’S OPPORTUNITY COST OF CAPITAL WHICH IS EQUAL TO REQUIRED RATE OF RETURN EXPECTED BY INVESTOR ON THE INVESTMENT OF EQUIVALENT RISK

 

 

 

  • NET PRESENT VALUE METHOD
  1. PRESENT VALUES OF CASH FLOWS SHOULD BE CALCULATED USING THE OPPORTUNITY COST OF CAPITAL AS THE DISCOUNT RATE
  2. NET PRESENT VALUE SHOULD BE FOUND OUT BY SUBTRACTING PRESENT VALUE OF CASH OUTFLOWS FROM THE PRESENT VALUES OF CASH INFLOWS
  3. THE PROJECT SHOULD BE ACCEPTED AS IF NPV IS POSITIVE ( NPV>0)
  4. WHY NPV
  5. FUNDS AVAILABLE WITH COMPANY CAN BE EITHER INVESTED IN PROJECTS OR GIVEN TO SHAREHOLDERS
  6. SHAREHOLDERS CAN INVEST FUNDS DISTRIBUTED TO THEM IN FINANCIAL ASSETS
  7. SO DISCOUNT RATE IS THE OPPORTUNITY COST OF INVESTING IN PROJECTS RATHER THAN IN CAPITAL MARKETS
  8. OPPORTUNITY COST MAKES SENSE WHEN FINANCIAL ASSETS ARE OF EQUIVALENT RISK AS COMPARED TO THE PROJECT
  • WHY NPV
  • AN ALTERNATE INTERPRETATION OF THE POSITIVE NET PRESENT VALUE OF AN INVESTMENT IS THAT IT REPRESENT THE MAXIMUM AMOUNT OF A FIRM WOULD BE READY TO PAY FOR PURCHASING THE OPPORTUNITY OF MAKING INVESTMENT OR THE AMOUNT AT WHICH FIRM WOULD BE WILLING TO SELL THE RIGHT TO  INVEST WITH OUT BEING FINANCIALLY WORSE OFF.
  • ACCEPTANCE RULE
  1. ACCEPT THE PROJECT WHEN NPV IS POSITIVE NPV > 0. POSITIVE NET PRESENT VALUE CONTRIBUTES TO THE NET WEALTH OF THE SHAREHOLDERS WHICH SHOULD RESULT IN THE INCREASED PRICE OF  FIRM’S SHARE. THE POSITIVE NET PRESENT VALUE WILL RESULT ONLY WHEN THE  PROJECT GENERATES THE CASH INFLOWS AT A RATE HIGHER  THAN OPPORTUNITY COST OF CAPITAL
  2. MAY ACCEPT THE PROJECT WHEN THE NPV= 0 BECAUSE OF THE REASON THAT PROJECT GENERATES CASH FLOWS AT A RATE JUST EQUAL TO  THE OPPORTUNITY COST OF CAPITAL
  3. REJECT THE PROJECT WHEN THE NPV IS LESS THAN 0
  • SUITABILITY
  • CAN BE USED TO SELECT THE BETWEEN MUTUALLY EXCLUSIVE PROJECTS THE ONE WITH THE HIGHER NPV SHOULD BE SELECTED
  • RANKING OF THE PROJECTS ON THE BASIS OF NPV. FIRST RANK WILL BE GIVEN TO PROJECTS WITH HIGHEST POSITIVE NET PRESENT VALUE AND SO ON
  • FORMULA
  • PV= 1/(1+r)n
  • PV = PRESENT VALUE
  • r= RATE OF RETURN/DISCOUNT FACTOR
  • n =NUMBER OF YEARS
  • PV= A1/(1+r) + A2/(1+r)2 +A3/(1+r)3------- An/(1+r)n
  • A1, A2, A3----- An FUTURE NET CASH FLOWS

  

 

  • PROBLEM

  • SOLUTION PROJECT X
  • SOLUTION PROJECT Y

  • MERITS
  1. RECOGNIZES THE TIME VALUE OF MONEY
  2. CAN BE USED WHERE UNIFORM CASH OUTFLOWS AND UNEVEN CASH FLOWS OR CASH FLOWS AT DIFFERENT TIME PERIOD
  3. EARNING ARE CONSIDERED  FOR ENTIRE LIFE AND MEASURE OF TRUE PROFITABILITY
  4. THE DISCOUNTING PROCESS FACILITATES MEASURING CASH FLOWS IN TERMS OF PRESENT VALUES THAT IS IN TERMS OF RUPEES, NPV(A+B)=NPV ( A) +NPV (B) CALLED VALUE ADDITIVITY WHICH MEANS THAT IF WE KNOW THE NPV OF INDIVIDUAL PROJECT THE VALUE OF THE FIRM WILL INCREASE BY SUM OF THEIR NPVS

 

  1. THIS VALUE ADDITION IS AN IMPORTANT PROPERTY OF AN INVESTMENT CRITERION WHICH MEANS THAT EACH PROJECT CAN BE EVALUATED INDEPENDENT OF OTHERS ON ITS OWN MERITS
  2. NPV METHOD IS ALWAYS CONSISTENT WITH THE OBJECTIVES OF SHAREHOLDER’S VALUE MAXIMIZATION

 

 

  • LIMITATION
  1. DIFFICULT TO OBTAIN THE ESTIMATE OF CASH FLOWS
  2. PRECISELY MEASURE THE DISCOUNT RATE
  3. AT TIMES FAILS TO INDICATE CORRECT CHOICE BETWEEN MUTUALLY EXCLUSIVE PROJECTS
  4. MAY NOT GIVE GOOD RESULTS WHILE COMPARING PROJECTS WITH UNEQUAL LIVES.
  • INTERNAL RATE OF RETURN
  • ALSO A MODERN TECHNIQUE OF CAPITAL BUDGETING THAT TAKES INTO ACCOUNT THE TIME VALUE OF MONEY. ALSO KNOWN AS
  • TIME ADJUSTED RATE OF RETURN,
  • DISCOUNTED CASH FLOW,
  • DISCOUNTED RATE OF RETURN,
  • YIELD ON AN INVESTMENT
  • RATE OF RETURN OVER COST
  • ADJUSTED RATE OF INTERNAL RETURN
  • INTERNAL RATE OF RETURN
  • ,
  • THE INTERNAL RATE OF RETURN CAN BE DEFINED AS THAT RATE OF DISCOUNT WHICH EQUATES THE PRESENT VALUE OF CASH INFLOWS TO THE PRESENT VALUE OF CASH OUTFLOW.
  • THE IRR OF PROPOSAL IS DEFINED AS DISCOUNT RATE WHICH PRODUCES A ZERO NPV
  • HERE THE DISCOUNT RATE IS CALCULATED BY HIT AND TRIAL METHOD.
  • THE SPECIFIC PROCEDURE TO FIND OUT THE VALUE OF r IMPLIES FINDING OUT THE NET PRESENT VALUE OF THE PROPOSAL AT TWO DIFFERENT ASSUMED VALUES OF r WITH IN WHICH THE IRR IS EXPECTED TO LIE. TWO RATES ARE INTERPOLATED TO MAKE THE NET PRESENT VALUE EQUAL TO ZERO.
  • WHEN ANNUAL NET CASH FLOWS ARE EQUAL OVER THE LIFE OF THE ASSET

 

  • PRESENT VALUE FACTOR= INITIAL OUTLAY/ANNUAL CASH FLOW
  • CHECKING OF PRESENT VALUE ANNUITY TABLE ( PRESENT VALUE OF AN ANNUITY OF RE 1)
  • FIND OUT THE RATE AT WHICH NUMBER OF YEARS EQUAL TO LIFE OF THE ASSET WHICH WILL  CALCULATE THE PRESENT VALUE FACTOR TO THE PRESENT VALUE
  • INITIAL OUT LAY = 50,000
  • AGE = 5 YEARS
  • ANNUAL CASH INFLOW= 12,500
  • PRESENT VALUE FACTOR= 50,000/12500=4
  • BY CHECKING PRESENT VALUE OF ANNUITY TABLE THAT AT 8% FOR FIVE PERIOD,THE PRESENT VALUE IS 3.9927 WHICH IS NEARLY 4 SO INTERNAL RATE OF RETURN IS 8%
  • FORMULA
  • CO =C1/(1+r)
  • CO = INITIAL OUTLAYS
  • C1  =ANNUAL CASH INFLOW
  • r= rate of discount which has to be calculated
  • UNEVEN CASH FLOWS
  • HERE THE DISCOUNT RATE IS CALCULATED BY HIT AND TRIAL METHOD.
  • THE SPECIFIC PROCEDURE TO FIND OUT THE VALUE OF r IMPLIES FINDING OUT THE NET PRESENT VALUE OF THE PROPOSAL AT TWO DIFFERENT ASSUMED VALUES OF r WITH IN WHICH THE IRR IS EXPECTED TO LIE. TWO RATES ARE INTERPOLATED TO MAKE THE NET PRESENT VALUE EQUAL TO ZERO.
  • STARTED WITH THE ASSUMED DISCOUNT RATE AND FIND OUT THE TOTAL PRESENT VALUE OF  CASH OUTFLOWS WHICH IS EQUAL TO PRESENT VALUES OF INFLOWS.
  • SEVERL DISCOUNT RATES ARE MAY HAVE TO BE TRIED UNTILL THE APPROPRIATE RATE OF DISCOUNT  RATE IS FOUND.

 

  • FORMULA
  • C= A1/(1+r) + A2/(1+r)2 +A3/(1+r)3------- An/(1+r)n
  • A1, A2, A3----- An FUTURE NET CASH FLOWS AT DIFFERENT PERIOD
  • C = INITIAL OUTLAY AT TIME ZERO
  •   r= RATE  OF DISCOUNT OF INTERNAL RATE OF RETURN
  • ACCEPT THE PROPOSAL IF THE INTERNAL RATE OF RETURN IS HIGHER THAN OR EQUAL TO MINIMUM RATE OF RETURN I.E THE COST OF CAPITAL OR CUT OFF RATE AND REJECT THE PROPOSAL IF THE INTERNAL RATE OF RETURN IS LOWER THAN COST OF CAPITAL
  • IN CASE OF ALTERNATIVE PROPOSAL SELECT THE HIGHER RATE OF RETURN
  • IN BOTH THE TECHNIQUES NET ANNUAL CASH INFLOWS MEANS ANNUAL CASH INFLOW AFTER TAX BUT BEFORE DEPRECIATION FOR EXAMPLE NET PROFIT AFTER TAX AND AFTER DEP IS 100 . THEN WE WILL ADD BACK THE DEPRECIATION  TO MAKE IT ANNUAL CASH INLOW AFTER TAX BUT BEFORE DEPRECIATION

 

 

  • PROBLEM
  • A COMPANY IS CONSIDERING A PROPOSAL TO PURCHASE A NEW EQUIPMENT. THE COST OF THE EQUIPMENT IS RS 5,00,000 . THE EXPECTED LIFE OF THE PROJECT IS 5 YEARS WITHOUT ANY SCRAP VALUE. COMPANY IS  CHARGING STRAIGHT LINE DEPRECIATION METHOD. TAX RATE IS APPLICABLE IS 35% .
  • BEFORE TAX CASH FLOWS
  • 1=1,80,000
  • 2=2,20,000
  • 3=1,90,000
  • 4=1,70,000
  • 5=1,40,000
  • CALCULATION OF CASH FLOWS
  • COMPUTATION OF INTERNAL RATE OF RETURN
  • COMPUTATION OF INTERNAL RATE OF RETURN
  • SOLUTION

·         

TE 

PRESENT VALUE AT 17% RATE OF DISCOUNT IS 4,93,526 AND AT 16% IT IS 504,848. SO THE INITIAL COST OF INVESTMENT WHICH IS 5,00,000 LIES BETWEEN THESE TWO VALUES

·         AT 16 % NPV=5,04,848-5,00,000=4,848

·         AT 17% NPV= 4,93,526-5,00,000= -6,474

·         SO IRR= 16% + (4848/(4848+6474)) ( 17%-16%)

·         = 16% + ( 4848/11322) ( 1%)

·         = 16% + .43%= 16.43%

 

 

  • ACCEPTANCE RULE
  • THE ACCEPT OR REJECT RULE USING THE IRR METHOD IS TO ACCEPT THE PROJECT IF ITS INTERNAL RATE OF RETURN IS HIGHER THAN THE OPPORTUNITY COST OF CAPITAL ( r>k)
  • K  IS ALSO KNOWN AS REQUIRE RATE OF RETURN OR THE CUT OFF RATE OR HURDLE RATE
  • THE PROJECT IS REJECTED  IF r is less than k
  • THE DECISION MAKER MAY REMAIN INDIFFERENT IF THE INTERNAL RATE OF RETUNR IS EQUAL TO THE OPPORTUNITY COST OF CAPITAL
  • MERITS
  • POPULAR INVESTMENT CRITERIA AND IT MEASURES RETURN IN PERCENTAGE  AND CAN BE EASILY COMPARED WITH THE OPPORTUNITY COST OF CAPITAL
  • RECOGNIZE THE TIME VALUE OF MONEY
  • CONSIDERS ALL CASH INFLOWS OCCURRING OVER THE ENTIRE LIFE
  • GENERALLY GIVES THE SAME ACCEPTANCE RULE
  • ALSO CONSISTENT WITH SHAREHOLDER WITH THE SHAREHOLDER’S WEALTH MAXIMIZATION
  • LIMITATION
  •  A PROJECT MAY HAVE MULTIPLE RATES OR IT MAY HAVE NOT UNIQUE RATE OF RETURN IN CASE OF NON CONVENTIONAL PROJECTS
  • MUTUALLY EXCLUSIVE PROJECTS :- FAIL TO INDICATE A CORRECT CHOICE BETWEEN MUTUALLY EXCLUSIVE PROJECTS UNDER CERTAIN SITUATIONS
  • VALUE ADDITIVITY PRINCIPLE DOES NOT HOLD WHEN IRR IS USED.
  • CONFLICT BETWEEN NPV AND IRR
  • IN CAS OF MUTUALLY EXCLUSIVE  INVESTMENT PROPOSAL WHICH COMPETE WITH ONE ANOTHER IN SUCH A WAY THAT ACCEPTANCE OF ONE AUTOMATICALLY EXCLUDES THE ACCEPTANCE OF THE OTHERS THE NPV AND IRR MAY GIVE CONTRADICTORY RESULT
  •  DUE TO :
  • SIGNIFICANT DIFFERENCE IN THE SIZE ( AMOUNT ) OF CASH OUTLAY OF VARIOUS PROJECTS
  • PROBLEM OF DIFFERENCE IN THE CASH FLOW PATTERN OR TIMING OF THE VARIOUS PROPOSAL
  • DIFFERENCE IN UNEQUAL LIVES OF THE PROJECT

·         WHILE CHOOSING AMONG MUTUALLY EXCLUSIVE.SELECTION OF THE PROJECT GIVING THE LARGEST POSITIVE NET PRESENT VALUE USING APPROPRIATE RATE OF DISCOUNT THAT THE OBJECTIVE IS TO MAXIMIZE THE WEALTH OF SHAREHOLDERS

  • PROFITABILITY INDEX
  • ALSO CALLED BENEFIT COST RATIO OR DESIRABILITY FACTOR
  • RELATIONSHIP BETWEEN PRESENT VALUE OF CASH INFLOWS AND PRESENT VALUE OF CASH OUTLAYS
  • PROFITABILITY INDEX = PRESENT VALUE OF CASH INFLOWS/ PRESENT VALUE OF CASH OUTFLOWS
  • OR PV OF CASH INFLOWS/INITIAL CASH OUTLAY
  • OR NET PROFITABILITY INDEX = GROSS PROFITABILITY MINUS 1
  • OR NET PROFITABILITY INDEX= NET PRESENT VALUE/INITIAL CASH OUTLAY
  • ACCEPTANCE RULE IT THAT THE PROFITABILITY INDEX IS MORE THAN ONE IS ACCEPTED AND IF LESS THAN ONE REJECTED
  • PROFITABILITY INDEX
  • EVALUATION
  1.  SLIGHT MODIFICATION OF NPV . AS THE NPV METHOD HAS THE LIMITATION THAT IT IS NOT EASY TO RANK PROJECTS ON THE BASIS OF THIS METHOD WHEN  THE COSTS OF THE PROJECT DIFFER
  2. LIMITATION OF THIS METHOD IS SAME OF NET PRESENT VALUES

 

  • NET PRESENT VALUES VS PROFITABILITY INDEX
  • ARE CLOSELY RELATED TO EACH OTHER AND BOTH PROVIDE THE SAME ACCEPTANCE /REJECTION RULES
  • BUT IN CASE OF MUTUALLY EXCLUSIVE PROPOSALS HAVING DIFFERENT SCALES OF INVESTMENT THEN THEY MAY GIVE CONTRADICTORY RESULT
  • THEN IN THIS SITUATION NET PRESENT VALUE SHOULD BE SELECTED AS IT IS BETTER THAN IRR
  • CAPITAL RATIONING
  • REFERS TO A SITUATION WHERE A FIRM IS NOT IN A POSITION TO INVEST IN ALL PROFITABLE PROJECTS DUE TO THE CONSTRAINS ON AVAILABILITY OF FUNDS
  • SO THE FIRM CAN NOT TAKE ALL THE PROJECTS THOUGH ALL ARE PROFITABLE AND HAS TO SELECT THE COMBINATION OF PROPOSAL THAT WILL YIELD THE GREATEST PROFITABILITY
  • PROJECTS ARE RANKED ACCORDING TO PROFIT ABILITY INDEX
  • LIKE FIRM HAS FUNDS 10,000,00

 

  • TERMINAL VALUE METHOD
  1. IS AN IMPROVEMENT OVER THE  NET PRESENT VALUE METHODS OF MAKING CAPITAL INVESTMENT DECISIONS
  2. ASSUMED THAT EACH OF THE FUTURE CASH FLOWS IS IMMEDIATELY REINVESTED IN ANOTHER PROJECT AT A CERTAIN HURDLE RATE OF RETURN UNTIL THE TERMINATION OF THE PROJECT
  3. NET CASH FLOWS AND OUTLAYS ARE COMPOUNDED  FORWARD RATHER THAN DISCOUNTING THEM BACKWARD
  4. IN CASE OF SINGLE PROJECT,THE PROJECT IS ACCEPTED IF THE PRESENT VALUE OF THE TOTAL  OF THE COMPOUNDED REINVESTED CASH INFLOWS IS GREATER THAN THE PRESENT VALUES OF THE OUTLAYS OTHERWISE IT IS REJECTED
  5. IN CASE OF MUTUALLY EXCLUSIVE PROJECTS WITH HIGHER PRESENT VALUE OF THE TOTAL OF THE COMPOUNDED CASH FLOWS IS ACCEPTED.

 

  1. FURTHER EXTENDED TO CALCULATE THE TERMINAL RATE OF RETURN ALSO CALLED MODIFIED INTERNAL RATE OF RETURN OT OVERCOME THE SHORT COMING OF INTERNAL RATE OF RETURN
  2. THE TERMINAL RATE OF RETURN IS THE COMPOUND RATE OF RETURN WHEN APPLIED TO INITIAL OUTLAY ACCUMULATES TO THE TERMINAL VALUE
  • PROBLEM
  • INITIAL OUTLAY=20,00
  • LIFE OF THE PROJECT= 4 YEARS
  • CASH INFLOWS 10,000 PER ANNUM FOR FOUR YEARS
  • COST OF CAPITAL = 12%
  • END OF THE YEAR        EXPECTED RATE OF INTEREST AT WHICH THE CASH INFLOWS INVESTED
  • 1                                              7%
  • 2                                              7%
  • 3                                              9%
  • 4                                              9%
  • SOLUTION

  • SOLUTION
  • PV = COMPOUNDED VALUE OF CASH INFLOWS/( 1+K) 4
  • = 44,600/( 1+.12) 4
  •   44600 X .636=28,366 WHICH IS MORE THAN CASH OUTLAY THE PROJECT IS ACCEPTED.

 

 

 

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