Lecture(4.1) Financial Appraisal

7/24/2019 Lecture(4.1) Financial Appraisal

1/14

Financial Appraisal


2/14

Discounted cash flow methods

Net Present Value (NPV)is the sum of the present values of all cash

flows associated with the project. Future cash flows are discounted at

a certain hurdle rate to arrive at their present value. Higher NPV

indicates a better proposal in case the nitial nvestments are similar.

Benefit-Cost Analysis calculates the ratio of either Present Value ofbenefits to the nitial nvestment !"enefit #ost $atio "#$% or the Net

Present Value to nitial nvestment !Net "enefit #ost $atio N"#$%.

&he criterion is preferable to NPV criteria for comparing proposals

having widel' differing initial investments.

Internal Rate of Return (IRR)is the discount rate at which NPVof the project is (ero. Higher $$ indicates better proposal

irrespective of the amount of initial investment.


3/14

Discounted cash flow methods

Future cash flows are discounted to thepresent value and therefore can becompared to initial investment directl'.

All project cash flows for its entire lifeare considered in D#F evaluation

"oth profitabilit' of project during its

operations and recover' of initialinvestment are calculated in D#F anal'sis.


4/14

Net Present Value

&he net present valueof an income stream is the sum of

the present values of the individual amounts in the

income stream. )ach future income amount in the stream

is discounted* meaning that it is divided b' a numberrepresenting the opportunit' cost of holding capital from

now !'ear +% until the 'ear when income is received or

the outgo is spent. &he opportunit' cost can either be how

much one would have earned investing the rupee

someplace else* or how much interest one would have had

to pa' if one borrowed a rupee.


5/14

Net Present Value

Future Value = Present Value (1 +Interest Rate) n

The present value of a future incomeamount is the amount that, if we ha ittoa!, we coul invest an have it "row toe#ual the future income amount$

Present Value = (Future Value) % (1 +Interest Rate) n


6/14

Net Present Value

The &iscount Rate = The Interest Rate 'se in Reverse

,hen an interest rate is used in reverse li-e this* to

calculate how much 'ou need now to have a certain

amount later* economists conventionall' use the term

discount raterather than interest rate. &he two terms meanthe same thing. A reason for using the term discount rate

when 'ou calculate a present value is that 'ou are ta-ing a

larger number* the future value* and calculating from it a

smaller number* the present value. Present Value = (Future Value) (&iscount Rate) n

&iscount rate = 1 % (1 + interest rate) ,hen the discount rate goes up* present values go down. ,hen the

discount rate goes down* present values go up.


7/14

Net Present Value

Three properties of the net present value of an income streamare

/. Higher income amounts ma-e the net present value higher. 0ower

income amounts ma-e the net present value lower.

1. f profits come sooner* the net present value is higher. f profits

come later* the net present value is lower.2. #hanging the discount rate changes the net present value. For an

investment with the common pattern of having costs earl' and profits

later* a higher discount rate ma-es the net present value smaller.


8/14

Net Present Value

3ince NPV method gives Net value of returns in Present $upee

terms* NPV4s of different projects can be directl' added. &his helps

in deciding the projects that can be accepted amongst several

contenders under limited funds situation.

3ince NPV gives net value of returns in absolute $upee terms* itcannot be used to compare projects that re5uire different initial

investments.

$an-ing of projects b' NPV method is influenced b' nature of cash

flow patterns 6 discount rates. Projects with similar initial

investments give different ran-ings at different discount rates.

&he method also does not indicate the ris- margin available over

the hurdle rate or the cost of capital.


9/14

nternal $ate 7f $eturn

&he internal rate of return is the interest

rate that ma-es the present value of the

investment8s income stream 99 its costs andpa'offs 99 add up to +.

&he internal rate of return is a measure of

the worth of an investment. f the ris-s are

e5ual investments with higher internal rates

of return pa' better.


10/14


&he internal rate of return is nota goodwa' to evaluate an investment that hascosts later rather than just earlier. Ane:ample of that would be an investmentthat generates an environmental problemthat will re5uire a cleanup at the end of the

income stream. For some suchinvestments* the worseinvestments havehigher internal rates of return.


11/14


$$ indicates margin of safet' over costof capital.

$an-ing of projects can be done forprojects with different initial investments.

$an-ing of projects does not change withchange in cost of capital.

f cash flows change sign more than once*there can be multiple values for $$


12/14

N P V I R R

NPV method finds the present value of

future cash flows at the given rate of

discounting

$$ finds the rate of discounting at which

the NPV becomes ;ero.

#omputation of NPV is comparativel'

simple.

#omputation of $$ is a complicated

process as it involves trial 6 error

method with multiple computations to

arrive at the right value.

A project with positive value of NPV at

the rate of discounting e5uivalent to the

,A## is considered acceptable while theone with negative NPV is rejected.

A project with an $$ greater than

,A## is considered acceptable while the

one with a lower $$ is rejected

Value of NPV depends on the rate of

discounting used and therefore*

comparative ran-ing of projects ma'

change as discounting rate changes.

$$ is independent of the discounting

rate and therefore can give a direct

comparison between projects.

NPVs of different projects can be addedto find total addition in value of the firm.

$$s for different projects cannot followthe value additivit' principle.

NPV criterion can be used in case of

var'ing cost of capital i.e. rate of

discounting from 'ear to 'ear

$$ criterion cannot be used in case rate

of discounting changes from 'ear to 'ear.


13/14

Non Discounting #riteria

Pay Bac! Period is the length of time to recoverinitial cash outla' on the project. 3horter the pa'bac-

period* the more desirable the project. &his criterion

tends to shield the project from the ris- of futureuncertainties in the cash flows to certain e:tent.

Accountin" Rate of Return is a measure of projectprofitabilit' that relates income to investment* bothmeasured in accounting terms. t is generall'e:pressed as a ratio of Average ncome after &a: tonitial nvestment.


14/14

Drawbac-s of Non discounted cash flow

method

t ignores time value of mone'. t treats all present andfuture cash flows having same value.

t overloo-s cash flows be'ond pa'bac- period and

discriminates against projects that generate substantialcash flows in later 'ears.

"' focusing attention on capital recover'* it divertsattention from profitabilit'.

&hough it measures project4s li5uidit'* it does not

indicate firm4s li5uidit'. "' ignoring cash flows be'ond pa' bac- period* the

ris-s be'ond pa' bac- period are also ignored

Documents

Lecture(4.1) Financial Appraisal