These techniques are considered good because they take into account time value of money.
(1) Net Present Value (NPV)
This method take into account time value of money. In this method present value of cash flows is calculated for which cash flows are discounted. The rate of interest is called cost of capital and is equal to minimum rate of return which must accrue from the project. Later, present value of cash out flows is calculated in same manner and subtracted from present value of cash inflows. This difference is called Net Present value or NPV. In case investment is made only in beginning of the project, it present value is equal to the amount invested in the project. Taking this assumption, NPV can be calculated as under:
Each cash inflow/outflow is discounted back to its present value (PV). Then they are summed. Therefore NPV is the sum of all terms , where
- 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.)
- 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).
If the project has a salvage value also, it should be added in cash inflows of last year. Similarly, if some working capital is also needed, it will be added to initial cost of project and to cash flows of last year.
1) Accept if NPV >0 (i.e. NPV is Positive)
2) Reject if NPV<0 (i.e. NPV is Negative)
3) May accept if NPV= 0
1) It takes into account time value of money.
2) It considers cash inflows form project throughout its life.
3) In this method variable discount rates can be used for the projects with longer life period.
4) This method is more closely related to firm’s objective of maximising wealth of shareholders.
5) True measure of profitability.
(1) Difficult to use, calculate & understand.
(2) In calculating NPV, discount rate is most significant because with different discount rates NPV will be different. Thus comparable profitability of projects will change with the change in discount rate. To determine required rate of return which is called cost of capital, is a difficult task. Different authors have their different opinions regarding its calculation.
(3) When the initial cost of 2 projects is different, this method is not very useful because we will accept or project whose NPV is higher and such a project may have more initial cost as compared to other. This method evaluates absolute profitability rather than relative profitability.
(4) When life of 2 projects is dissimilar, this method does not give satisfactory results. Normally, project with less life time is preferred. But as per this method, NPV of the project with longer life may be more, and thus finds will be blocked for a longer period, in this project. In such cases, NPV method may not present actual worth of alternate projects.
3) PROFITABILITY INDEX
It is Benefit –Cost ratio (B/C Ratio) or Profitability Index (P1).
It is the ratio of value of future cash benefits at required rate or return to the initial cash outflow of the investment. PI method should be adopted when the initial costs of projects are different. NPV method is considered good when the initial cost of different projects is the same. Thus NPV is an absolute measure of evaluating projects and PI is an absolute measures. Pl can be calculated as under:-
Present Value of Cash Inflows
Present Value of Cash outflows
- Accept if Pl>1.0
- Reject if Pl<1.0>
- Project may be accepted if Pl= 1.0
- Considers all cash flows.
- This method considers all benefits during the life time of the project.
- This method takes into account the time value of money.
- Pl method is considered better to NPV in case when the initial costs of projects are different for eg. The NPV of two project is equal ie, Rs 5000. The initial cost of project is Rs 40,000 and that of project B Rs 20,000. Project should be selected on the basis of profitability index, whereas under NPV method both the projects will be considered equally profitable.
- Generally consistent with the wealth maximisation principle.
1). It is difficult to understand and implement this method.
2). The calculations in this method are complex as compared to traditional methods.
3). Requires estimates of the cash flows which is a tedious task.
4). At times fails to indicate correct choice between mutually exclusive projects.
4). Discounted Pay Back Period:
This is an improvement over the pay back period method in the sense that it considers time value of money. Thus discounted pay book period indicates that period with which the discounted cash inflows equal to the discounted cash outflows involved in a project.