C h a p t e r —

TIME VALUE OF MONEY

6.1 TIME VALUE OF MONEY

The individual’s preference for possession of given amount of cash now, rather than the same amount at some
future time, is called “Time preference for money”. Three reasons may be advanced to account for the
individual’s time preference for money. They are :
1. Uncertainty: As an individual is not certain about future cash receipts, he prefers receiving cash now.

2. Preference for present consumption : Most people have subjective preference for present consumption
over future consumption of goods and service either because of urgency of their present wants of
because of the risk of not being in the position to enjoy future consumption that may be caused by
illness or death or because or inflation. A money is a means by which individual acquire most goods
and service they may prefer to have money now.
3. Investment opportunities : Most individual prefer present cash to future cash because of the available
investment opportunities to which they can put present cash to earn additional cash.

For Example, an individual who is offered Rs. 100 now or Rs. 100 one year from now, would prefer Rs. 100
now. If he put the sum of Rs 100 on the bank @ 5 % interest rate , his total cash one year from now will be
Rs. 105. Thus if he wishes to increase to cash resources, the opportunity to earn interest would lead him to
prefer Rs. 100 now, not Rs. 100 after one year. In case of business firm as well as individuals, the justification
for time preference for money lies simply in the availability of investment of opportunities. The time
preference of money is generally expressed as interest rate + risk premium if any exist.

The time preference of money can be broadly classified as follows:

(1) Compound value or future value
– Compound value of lump sum.
– Compound value of an annuity
(2) Present value
– Present value of lump sum
– Present value of an annuity
(3) Value of an annuity due
– Compound value of an annuity due
– Present value of an annuity due

6.1.1 COMPOUND VALUE (FUTURE VALUE) OF MONEY

The interest (i) that is paid on principal (p) as well as on any interest earned but not with drawn during earlier
period is called compound interest. The process of finding the future value of a payment or services of payment
(or receipt) when applying the concept of compound interest is called compounding. The compounding may be
categorized as compound value of lump sum and compound value of annuity.
 Time Value of Money

Compound value of lump sum

Let us assumes Rs. 100 is placed at saving account at 5% interest rate. The following grow on principal is
obtained.
Amount deposited = Rs. 100 @ 5% per annum
At the end of first year:
100 + 100 x 0.05 = 105
At the end of second year:
105 + 105 x 0.05 = 110.25
At the end of third year:
110.25 + 110.25 x 0.05 = 115.76

Let ‘i’ represented the interest rate and ‘P’ is the principle, then we get:
F1 = P + Pi = P (1 + i)
Where, F1 = compound value at end of first year
Similarly, F2 = F1 + F1 x i
= F1 (1 + i)
F2 = P (1 + i) (1 + i) = P (1 + i)2

Similarly, F3 = F2 + F2 x i
= F2 (1 + i)
F3 = P (1 + i)2 (1 + i) = P (1 + i)3

Similarly, Fn = P (1 + i)n ------------ (1)

The term (1 + i)n is compound value factor (CVF) of an lump sum of Re 1, and it always has value greater
than 1 for positive interest rate i.e. ‘i’ indicating that CVF increases as ‘i’ and ‘n’ increases.

Solved problem 1
Find the future value (lump sum) at the end of seven year where Rs. 1250 is deposited @ 7% interest.
Here,
P = 1250
n =7
I = 0.07
F7 = P (1 + i)n
= 1250 (1 + 0.07)7
= Rs. 2007

(b) Compound value of annuity

An annuity is the fixed payment (or receipts) each year for specific number of years.
Example, if you rent a flat and promise to make a series of payment over an agreed period, you have created
an annuity. The equal installment loans from the house financing companies or employees are common
example of annuities. Let us assume, Re 1 is deposited in a saving account at the end of each year for four
years @ 6% interest.
i.e. Re 1 deposited at end of first year
Re 1 deposited at end of second year
Re 1 deposited at end of third year
Re 1 deposited at end of fourth year
This implies that Re 1 deposited at the end of first year will grow for three years. Similarly Re 1 deposited at
the end of second year will grow for two years. Similarly Re 1 deposited at the end of third year will grow
for one year. And Re 1 deposited at the end of fourth year will not yield any interest.
Now,
Compound value of Re 1 deposited in fourth year is only Re 1, But deposited in first year is 1 (1 + 0.06)1 =
1.06, deposited in second year is 1 (1 + 0.06)2 = 1.124 ,deposited in third year is 1 (1 + 0.06)3 = 1.191 .Now, the
aggregate compound value of Re 1 deposited at the end of every year for four years would be :(a + b + c +
d) = (1 + 1.06 + 1.124 + 1.191) = 4.375

This can be shown that

F4 = A (1 + i)3 + A (1 + i)2 + A (1 + i) + A
Where F4 is the future value at end of fourth year.

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A = annuity
i = interest rate
F4 = A [(1 + i)3 + (1 + i)2 + (1 + i) + 1]
We can extends above equation for n period and rewrite the equation as

 (1 + i ) n - 1 
Fn = A   ………………………. (2)
 i 
 
Where A = constant period flow of cash and term within bracket are compound value factor for an annuity
(CVAF)

Solved problem 2
Determined compound value if Rs. 100 are deposited at the end of each year for four years @ 10% interest.
Here,
 (1 + 0.1) 4 - 1 
F4 = 100   = 100 x 4.641 = 461.1
 0.1 
 

6.1.2 PRESENT VALUE OF MONEY

It has been so far, how compounding techniques can be used for the adjusting the time value of money. It
increases investor’s analytical power to compare cash flows that are separated by more than one period, given
his interest rate period. The compounding techniques similarly could be used for the present value of future cash
inflow or cash outflow. The present value of a future cash inflow or outflow is the amount of current cash that is
equivalent to the future cash inflow or outflow. The process of determining the present value of future payment
(receipts) or series of future payments (receipts) is called discounting. The compound interest rate used for
discounting cash flows is called the discounting rate.

(a) Present value of a lump sum

In dealing with compound value of lump sum, we know that there is no difference between Re 1 now and
Re 1 (1 + i) (where ‘i’ is interest rate) one year from now, or Re 1 (1 + i)2 after two years, or Re 1 (1 + i)n after n
years. This was given by Fn = P (1 + i)n . However, we can determined the present value of lump sum “P” by
arranging the equation as
Fn
P = ……………………….. (3)
(1 + i) n
Where Fn and i are provided.
Let us consider an example, with 10% interest rate Re 1 at end of first year will be
F1 = P (1 + i)
= 1 (1 + 0.1)
= 1.1
However, for obtaining Re 1 at end of first year, the amount that is needed is given by: 1 = P x 1.1 or P =
1
= 0.909 i.e. if 0.909 is deposited it will become Re 1 at the end of first year or next year. This implies that
1.1
present value of Re 1 (if interest rate is 10%) to be received after one year is equivalent to Re 0.909. Stated
differently Re 0.909 deposited now will grow to Re 1 after one year.
The present value of Re 1 inflow at the end of two years can also be worked out easily. An amount ‘P’
deposited now would grow to F2 = P (1 + i)2 after two years. There for if F2 expected to be received after two
years is Re 1, the following amount should be deposited now.
F2 1
F2 = P (1 + i)2 or P= = = 0.826
(1 + i) 2 1.012
i.e. 0.826 is the present value of Re 1 at 10% interest rate to be received after two years. The investors will be
indifferent between Re 1 after two years and Re 0.826 now. At 10% interest rate Re 0.826 now will grow to Re
1 after two years. Similarly the present value of Re 1 to be received after three years will be
F3 = P (1 + i)3
P = F3 / (1 + i)3
= 1/(1+0.1)3 = 0.751
Thus, the formula

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 Time Value of Money

Fn
P = ……………….. (4)
(1 + i) n
can be used for determining the present value of Fn for year n with interest i.
1
The term is the present value factor (PVF) and it is always less than 1 for positive ‘i’ indicating that
(1 + i) n
future amount has a smaller present value.

(b) Present value of annuity

The present value of annuity is the reserve of future value of annuity. To find the present value of annuity,
we will have to find out the present value of the amount every year and will have to aggregate all the
present values to get the total present value of the annuity. For example, an investor who has determined his
interest rate 10% may have opportunity to receive an annuity of Re 1 for four years.
The present value of Re 1 received after one year is given by
Fn F1 1
P = = = = 0.909
(1 + i) n (1 + i)1 1.1
Similarly, after two years
F2 1
P = = = 0.826(1)
(1 + i) 2 (1.1) 2

After three years

F3 1
P = = = 0.751
(1 + i) 3 (1.1) 3
After four years
F4 1
P = = = 0.683
(1 + i) 4 (1.1) 4
Thus, the total present value of annuity of Re 1 is
P = 0.909 + 0.826 + 0.751 + 0.683
= 3.169
Thus, the present value of annuity of Re 1 for four year at 10% interest rate is Rs. 3.169. This can be
determined by formula
 1 
1 - 
(1 + i) n 
P = A ……………… (5)
 i 
 
 

Solved problem 4
What is the present value of 50000 to be received after 15 years if the interest rate is 9%?
Here,
Fn = 50000
i = 0.09
n = 15
By using formula
Fn 50000
P = = = Rs. 13726
(1 + i) n (1 + 0.09)15

Solved problem 5
Determine the present value of annuity, if the person receives annuity of Rs.5000 for 4 years, considering the rate
of interest as 10%.

Here,
n =4
I = 0.1
A = 50000

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 1   1 
1 -  1 - 
(1 + i) n (1 + 0.1) 4
Now, P = A  =
50000   = 158493.27
 i   0.1 
   
   

6.1.3 VALUE OF AN ANNUITY DUE

The concept of compound value and present value of annuity discussed earlier are based on the assumption that
the series of payment are made at the end of the year. In practice payment could be made at the beginning of the
year. Example, when you buy a refrigerator on installments sales, the dealer requires you to make the first
payment immediately i.e., on beginning of the first period and subsequent installment on beginning of each
period. A series of fixed payment starting at the beginning of each year for a specified number of years is called
an annuity due.

a Compound value of an annuity due

Recall the compound value of an annuity, when Re 1 deposits are made at the end of year, the compound
value at end of four year is 4.375. However, the Re 1 deposited in the beginning of each year of 1 through the
year four will earn interest respectively for 4 years, 3 years, 2 years and 1 year. Thus, the compound value of
this series is
F4 = A (1 + i)4 + A (1 + i)3 + A (1 + i)2 + A (1 + i)1
= 1 (1.06)4 + 1 (1.06)3 + 1 (1.06)2 + 1 (1.06)1
= 4.637
This can be given by formula
 (1 + i) n - 1 
Fn = A  (1 + i) ………………… (6)
 i 
 
b Present value of an annuity due
We have calculated that present value of annuity Re 1 for four years when payment are made at the end of
year to be 3.169 (10% interest rate). However, if the present value of this annuity if each payment is made at
the beginning of the year is given by :
For first year, present value (at the beginning of the year) is 1
For second year, present value (at the beginning of the year) is 1/1.1 = 0.909
Fn 1
Similarly, using P = , the present value for third year (beginning), fourth year are =
(1 + i) n (1.1) 2
1
0.826 and = 0.751, Thus, the present value of an annuity due is equal to 1 + 0.919 + 0.826 0.751 =
(1.1) 3
 1 
1 - 
 (1 + i) n 
3.487 the formula is given by P = A 
i  (1 + i) …………………. (7)
 
 

6.1.3 SUMMARY OF FORMULAS

Compound value
(a) Compound value of lump sum, Fn = P (1 + i)n
 (1 + i) n - 1 
(b) Compound value of annuity, Fn = A 
 i 
 
Present value
Fn
(a) Present value of lump sum, P =
(1 + i) n

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 1 
1 - 
(1 + i) n
(b) Present value of annuity, P = A  

i
 
 
Value of annuity due
 (1 + i) n - 1 
(a) Compound (future) value of annuity due, Fn = A  (1 + i)
 i 
 
 1 
1 - 
(1 + i)n
(b) Present value of annuity due, P = A  (1 + i)
 i 
 
 

Note these values can be obtained from table too. This table is given on any financial management book. The
abbreviation used are :
P = Present value
A = Annuity
Fn = Future value
i = interest rate, discounting rate, opportunity cost, required rate of return, minimum rate of return,
desired rate of return.

Solved Problem 6
Calculate the present value of Rs. 600 assume 5% time preference rate.
(a) received one year from now.
(b) received at the end of five years.
(c) received at the end of fifteen years.

Solution.
(a) received one year form now i.e. present value of 600 at the end of one year
Fn 600
P= = = 571.42
(1 + i) n (1 + 0.05)
(b) present value of 600 received at the end of five years.
Fn 600
P= = = 470.11
(1 + i) n (1 + 0.05) 5
(c) received at end of fifteen years i.e. present value of 600 at end of fifteen years.
Fn 600
P= = = 288.61
(1 + i) n (1 + 0.05)15
Solved Problem 7
Determine the present value of Rs. 700 each paid at the end of each of next six years. Assume 8% rate of interest

Solution.
 1   1 
1 - n  1 - 6 
 (1 + i)   (1 + 0.08) 
Here, present value of annuity is given by P = A  = 700  = 3236.01
i 0.08
   
   

Solved Problem 8
Assume 10% discount rate. Compute the present value of Rs.1100, Rs.900, Rs.1500 and Rs.700 received at the end
of one through four year.

Solution.
The data are given as uneven cash flow. The present value for uneven cash flow are computed as
1100 900 1500 700
P = + + +
(1 + 0.1)1 (1 + 0.1) 2 (1 + 0.1) 3 (1 + 0.1) 4

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= 1000 + 743.80 + 1126.97 + 478.10

= 3348.88

Solved Problem 9
Below is given the information related to the cash flows of three project X, Y, Z. the initial cost of each project is
Rs.155000 and the firm’s cost of capital is 10%. Calculate the total present value of each of three projects.
Project X: Cash flows Rs.40000 per year and life 5 years
Project Y: Year 1 2 3 4 5
Cash flow 30000 40000 50000 60000 40000
Project Z: Cash flow Rs.45000 per year from 1 to 4 year and 30000 at the end of 5th year

Solution:
(a) Project X cash flow 40000 per year for 5 years. Here, 40000 cash flow is continued for 5 years, so the present
value of annuity is determined for 5 years.
 1   1 
1 - n  1 - 5 
 (1+ i)   (1 + 0.1) 
P = A  = 40000   = 151631.47
i 0.1
   
   
(b) Project Y

Cash
Year Present value
flow
1 30000 30000 / (1 + 0.1)1 27272.727
2 40000 40000 / (1 + 0.1)2 33057.85
3 50000 50000 / (1 + 0.1)3 37565.74
4 60000 60000 / (1 + 0.1)4 40980.80
5 40000 40000 / (1 + 0.1)5 24836.85
Total 163713.96

Fn
Here, present value of lump sum, P =
(1 + i) n
(c) Project Z
Here, cash flow of 45000 is continued for 4 year thus, present value of annuity is determined for 4 years and
present value of lump sum of 5th year is determined as follows:

Cash
Year Present value
flow
1-4 45000  1 
1 -  =142643.9451
 (1 + 0.1) 4 
4 5000
 0.1 
 
 
5 30000 30000 = 18627.63969
(1 + 0.1) 5
Total 161271.57

6.2 CAPITAL BUDGETING AND NATURE OF INVESTMENT DECISION

The investment decision of the firm is generally called the capital expenditure decision or capital budgeting. A
capital budgeting decision may be defined as the firm’s decision to invest its current funds most efficiently in the
long-term assets in anticipation of an expected flow of benefits over a series of years. The long-term assets are
those that affect the firm’s operation beyond one-year period. The firm’s investment decisions would generally
include expansion, acquisition, modernization and replacement of long-term assets. Similarly, sale of division or
business (divestment) is also analyzed as investment decision. It is important to note that investment in long-
term assets invariably requires funds to be tied up in the current assets such as inventories and receivables. The
following are the features of investment decisions:

(a) The exchange of current funds for future benefits.

(b) The funds are invested in long-term assets.

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(c) The future benefits will occur to the firm over a series of years.

The expenditure and benefits of investments should be measured in cash. In the investment analysis, it is cash
flow that is important, not the accounting profit. It may also be pointed that the investment decision affects the
firm’s value. The firm value will increase if the investments are profitable and add to the shareholder’s wealth.
Thus, investment should be evaluated on the basis of criterion that is compatible with the objective of the
shareholder’s wealth maximization. An investment will add to the shareholder’s wealth if it gives return greater
than the current interest rate or opportunity rate.

The need of the sound capital expenditure policy arises due to the following:

1. The amount involved in capital expenditure is usually comparatively heavy than the revenue expenditure.
So, it should be seen that amount invested in capital expenditure gives the best possible results.

2. Investment in capital expenditure is for a longer period, so risk in such type of expenditure is heavy. Capital
investment affects future profit for a number of years. So, the future profitability of the concern is linked
with capital investment decisions.

3. Heavy losses are likely to occur due to obsolescence of fixed assets on account of rapid technological
changes. This fact should be taken into consideration.

4. The progressive management should always be on the look out for ways of improving the profitability of the
company by wise investment of available capital funds.

6.2.1 TYPES OF INVESTMENT DECISIONS

There are many ways to classify investments.

One classification is as follows:
a. Expansion of existing business
b. Replacement and modernization

Another useful way to classified investment is as follows:

a. Mutually exclusive investments
b. Independent investment
c. Contingent investment

Mutually exclusive investments:

It serves the same purpose and competes with each other. If one investment is under taken, others will have
to be excluded e.g. a company may acquire either automatic plant or semi automatic plant. He cannot invest
in two plants for the same production.

Independent investments:
They serve different purpose and do not compete with each other. E.g. A company may invest on new
mixing machine and packing machine. These two are independent decision.

Contingent investments:
These are dependent projects, the choice of one necessitates that one or more investment should also be
under taken e.g. A company decides to invest in sugar plant in remote, it has to invest in electricity, road etc.

6.2.2 STEPS IN CAPITAL BUDGETING

The capital budgeting generally consists of the following steps.

(i) Project generation

The generation of project means the search for investment alternative. As we know capital budgeting is the
investment in the fixed long-term assets, which generate the return or yield the return for the period of time.
The project might be either investment in new assets or replacement of existing assets or modernization of
the existing facilities etc. These investments might be mutually exclusive one or independent one or
contingent investments.

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(ii) Project evaluation

It is the second and most crucial step in the project evaluation. Among lot of alternatives or for single
opportunity, which project is to be taken or whether the project is profitable, one or not the answer is
obtained by evaluating the project under various criterion. The overall investment is evaluated in terms of
cash flow, which is also called as the incremental-after tax-cash flows. The cash flow approach to measure
benefits is superior to the accounting system of profit basis because it:

(a) Avoids ambiguities of the accounting profit concept.

(b) Measure the total benefits
(c) Take cognizance of the time value of money.

The accounting profit is useful for performance measure, but cash flow is useful as decision criterion. The
measure difference between the cash flow and the accounting profit approaches relate to the treatment of
depreciation, which is ignored as an item of cost in computation under the cash flow approach. The methods
of evaluation we deal on the successive headings.

(iii) Project selection

Once the cash flow of the alternatives are analyzed or evaluated using difference evaluation criterion, which
includes modern approach and traditional approach. Those project which has the highest present value or
higher cash flow or higher internal rate of return are selecting. To summarize, the best project is selected.
The selected project might be mutually exclusive, independent or contingent investment.

(iv) Project implementation:

The selected projects are then implemented. The implementation should be carried out in a very systematic
manner. A capital budget, which include the source time and amount of capital should be prepared and
investment should be done according to the planned budget.

(v) Project monitoring and control:

The completed and remaining work of the project should be monitored an evaluated with plan in frequent
interval so that any deviation could be corrected on time. This ensures that the project will be completed on
time with the budgeted investment figure.

6.2.3 PROJECT EVALUATION OR INVESTMENT EVALUATION CRITERION

Three steps are involved in the evaluation of the investment.

a. Estimation of cash flows.
b. Estimation of required rate of return
c. Application of the decision rule for making a choice.
The first two steps are out of our scope. However, we have discussed it in preceding topics. Our discussion will
be confined to the merit and demerit of various investment criterions.

The investment decision rule may be referred to as capital budgeting techniques or investments criterion. A
sound appraisal technique should be used to measure the economic worth of an investment project. The essential
property of a sound technique is that it should maximize the shareholder’s wealth. The following character
should be possessed by the sound investment evaluation criterion.

a. It should be a measure of the project’s profitability by considering all cash flows.

b. It should provide a means of distinguishing between acceptable and unacceptable projects.
c. It should provide a ranking of the projects in order of their economic desirability.
d. It should recognize the fact that bigger cash flows are preferable to smaller ones and early cash flows are
preferable to later ones.
e. It should help to choose among mutually exclusive projects that project which maximizes the
shareholder’s wealth.
f. It should be a criterion, which is applicable to any conceivable investment project independent of others.

A number of evaluation techniques or capital budgeting techniques are used in practice. They may be grouped in
the following two categories.

1 Discounted cash flow (DCF) criteria (modern method)

(a) Net present value (NPV)
(b) Internal rate return (IRR)

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(c) Profitability index

2 Non-discounted cash flow criteria (Traditional method)

(a) Pay back period (PB)
(b) Accounting rate of return (ARR)

We will show in the successive topics that the NPV criterion is the most valid technique of evaluating investment
project. It is generally consistent with the objective of maximizing shareholder’s wealth.

Payback period

The payback period (PB) is the most popular and widely recognized traditional methods of evaluating
investment proposals. It is defined as the number of years required to recover the original cash flow (cash outlay)
invested in a project.

If the project generates constant annual cash inflows, then payback period is given by
Net cash outlay (investment) Initial investment
PBP = = ………………(8)
Net cash inflow (annual) Annual cash inflow

Solved example 10

1) Compute PBP from the information furnished below.

Initial investment = Rs. 50,000
Life of the project = 5 years
Cash flow after tax = Rs. 13,000 per year

Solution:
Initial investment 50000
PBP = = = 3.846 years
Cash flow after Tax 13000

However, if the cash inflow is unequal, the pay back period can be found out by adding up the cash inflows
until the total is equal to the initial cash outlays.

Solved example 11

Compute PBP from the information furnished below.

Initial investment = Rs. 80,000

Life of project = 5 years
Cash inflow

Year 1 2 3 4 5
CFAT Rs.21,000 24,000 30,000 25,000 20,000

Solution :

Here, we find that the cash inflow is uneven so that formula (1) could not be used.

Calculation of PBP of the project

Year CFAT Cum. CFAT Remarks

1 21000 21000
2 24000 45000
3 30000 75000 Minimum period
Recoverable balance is (80000 –
75000) = 5000
4 25000 100000
5 20000 120000

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Amount to be recovered
Now PBP = Minimum period +
CFAT of maximum year
Acceptance rule:
The payback period should be less than or equal to standard PBP. For mutually exclusive project, those
project is selected which has less PBP. In the above 2 projects, project B is selected.

Merits of PBP
• It is simple to understand and easy to calculate.
• The cost of analysis of PBP is very less due to simplicity.
• It gives insight into liquidity of the project.

Demerits of PBP
• It fails to take account of cash inflows earned after the payback period.
• It is not appropriate method of measuring the profitability of an investment project as it doesn’t
consider the entire cash flows yielded by the project.
• It fails to consider the pattern of cash inflows i.e. magnitude and timing of the cash inflows.
• It does not consider the time value of money, thus it does not maximize the market value of the firm’s
share. Share value does not depend on the payback period of the investment projects.

Accounting rate of return

The accounting rate of return (ARR) is determined by dividing the average after tax profit (average net income
after tax) by average investment. The after tax profit is obtained from the financial statement, so this seeks the
help of the financial accounting statement.

Average net income after tax

ARR = × 100 . ………… (9)
Average investment
Here,
Total net income
Average net income after tax =
Life of the project
Cost of investment for construction depreciation
Average investment =
2
Beginning book value of investment + ending book value of investment
=
2
Book value = value after deducting depreciation.

Solved example 12

A Company is considering two proposals-M & N, each costing Rs.3, 00,000.00 to the company. The expected life
of both the proposals is 4 years. The company has to pay 40% tax on the earning. Depreciation is charged on
straight-line basis. The before tax cash flow of the two proposals are estimated to be the follows.

Year Proposal M Proposal N

1 125000 150000
2 125000 135000
3 125000 120000
4 125000 125000
Solution:
Cost of proposal
(a) Annual depreciation =
Expected life
For M depreciation = Rs.300000 / 4 = Rs.75000 / year
For N depreciation = Rs.300000 / 4 = Rs.75000 / year

(b) Calculation of average earning after tax

Year
Project M
1 2 3 4
CFBT (Cash flow before tax) 125000 125000 125000 125000
Less depreciation 75000 75000 75000 75000

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Earning before tax (EBT) 50000 50000 50000 50000

Less tax 40% 20000 20000 20000 20000
Earning after tax 30000 30000 30000 30000

30000 + 30000 + 30000 + 30000

Average net income after tax = = 30000
4

Year
Project N
1 2 3 4
CFBT 150000 135000 12000 125000
Less depreciation 75000 75000 75000 75000
EBT 75000 60000 45000 50000
Less tax 30000 24000 18000 20000
EAT 45000 36000 27000 30000

45000 + 36000 + 27000 + 30000

Average net income after tax = = 34500
4
30000
For project M, ARR = × 100 = 20%
150000
34500
For project N, ARR = × 100 = 23%
150000
Acceptance rule:
The project N is selected as it has higher ARR. As accept or reject criterion, this method will accept all those
projects whose ARR is higher than the minimum rate established by management and reject those projects
which have ARR less than minimum rate. This method would rank a project as number one of it has highest
ARR and lowest rank would be assigned to the project with lower ARR.

Merits of ARR method:

• Simple to understand and use.
• It can be easily calculated from accounting data.
• It incorporates the entire stream of income in calculating the project’s profitability.

Demerits of ARR method:

• It uses the accounting profits not cash inflows in appraising the projects.
• The averaging of income ignores the time value of money.

Net present value (NPV)

NPV is one of the modern methods of evaluating the investment proposals. It is one of the discounted cash flow
(DCF) techniques explicitly recognizing the time value of money. It correctly postulates that cash flows arising at
different time periods differ in value and are comparable only when their equivalents present values are found
out.

NPV methods are as follows:

a. Appropriate rate of interest should be selected to discount the forecasted cash flows. This appropriate
rate of interest is the firm’s opportunity cost of capital, which is equal to the minimum rate of return
expected by investors to be earned by the firm on investment of equivalent risk.
b. Second the present value of the investment cash flow should be computed using opportunity cost of
capital of the discounting rate.
c. The net present value should be found out by subtracting the initial cash out lay from the present value
of cash inflows. The firm should accept the project if NPV is positive.

Net present value = Total present value – Net cash outlay, where,
Or NPV = TPV – NCO ……………….. (10)

Solved Example 13

Below is given the information related to the cash flows of there projects x, y, z. The initial cost of each project is
Rs. 155000 and the firm cost of capital is 10%. Calculate the present value of each three project and decide the best
project according to NPV.

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Project Year 1 2 3 4 5
X Cash Flow 40000 40000 40000 40000 40000
Y Cash Flow 30000 40000 50000 .60000 40000
Z Cash Flow 45000 45000 45000 45000 .30000
Solution:

Step I : calculation of total present value.

Project X : Here even cash flow of 40000 per year for years so present value of annuity @ 10% cash flow
determined as.
 1   1 
1 − n  1 − 5 
(1 + i )   (1 + 0.1) 
P = A = 40000  = 151631.047
 i  0.1
   
   

Project Y : The cash flow is different in all 5 years. So the present value of each year should be determined by
Fn
using formula of present value of lump sum i.e. P =
(1 + i ) n
Year Cash P =
Fn Present value
flow (1 + i ) n

1 30000 30000/(1.1)1 27272.7

2 40000 40000/(1.1)2 33057.85
3 50000 50000/(1.1)3 37565.7
4 60000 60000/(1.1)4 40980.8
5 40000 40000/(1.1)5 24836.8
Total present value 163713.96

Project Z : Here, even cash flow of 45000 for 4 years and 30000 for 5th year has occurred so for cumulative 4-
year present value of annuity is determine and too 5th year present value of lump sum is determined.

Year Cash flow Present value formula Present value

 1  142643.9
1-4 45000 1 − 
 (1.1) 4 
45000  
0.1
 
 
5 30000 30000 18627.6
(1.1)5
Total present value 161271.5

Step II: determination of NPV

Project TPV - NCO NPV Remarks

X 151631.4 -155000 -3368.6 Reject
Y 163713.9 -155000 8713.9 Accept and select
Z 161271.5 -155000 6271.3 Accept

Here, project X is rejected due to negative NPV. However among project Y & Z, project Y is selected due to
higher NPV than the later one.

Acceptance Rule of NPV:

The project is accepted if NPV positive and rejected if NPV is negative. The market value of the firm’s share
would rise if project with positive and higher NPV are selected. This will be so, because the +ve NPV will be
displayed by those projects which would generate cash inflows at a rate higher than the minimum required

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 Time Value of Money

by the investors. The NPV method can be used to select between mutually exclusive projects, the one with
the higher NPV should be selected.

Merit of NPV method

a. It recognizes the time value of money, a rupee received today is worth than a rupee received tomorrow.
b. It uses all cash flows occurring over the entire life of projects in calculating its worth
c. The discounting process facilitates measuring cash flows and discounting rate are known
Demerit of NPV method

a. It is quite difficult to obtain the estimate of cash flows due to uncertainty.

b. It is quite difficult to measure the discount rate.

Note: NPV is regarded as the most beneficial evaluation criterion. If no demarcation is done about the criterion,
NPV should be used if possible.

Profitability Index

Yet another time adjusted method of evaluating the investment proposal is the benefit- cost (B/C) ratio or
profitability index (PI) .PI is the ratio of the present value of cash inflows at the required rate of return to the
initial cash outflows of the investment which is called the net cash outlay or NCO
TPV
PI = ………………….. (11)
NCO

Taking the solved example 13, PI is calculated as

Project TPV NCO PI Remarks
X 151631.4 155 151631.4/155000=0.98 Reject
Y 163713.9 15500 163713.9/155000=1.06 Accept and Select
Z 161271.5 155000 161271.5/155000=1.04 Accept

Acceptance rule

The accept or reject rule , using PI is to accept project if its pl is greater than one ,since the project will have
+ve net present value. The higher PI is selected.

Evaluation
The merit & demerit of PI are same as NPV.

Internal Rate of Return

Internal rate of return (IRR) is another discounted cash flow technique which takes account of the magnitude and
timing of cash flows. Internal ratio of return (IRR) can be defined as that rate which equates the present value of
cash inflow with the present value of cash outflow of an investment. It is the rate at which the NPV of the
investment is zero. It is called internal rate because it depends solely on the outlay and proceed associated in the
investment and not an any rate determined outside the investment.

The following formula will be used to determine IRR.

TPV LR - NCO
IRR = LR + (HR − LR) ………………… (12)
TPV LR - TPV HR
Where
LR = lower discounting rate
HR = higher discounting rate
TPVLR = total present value at lower rate
TPVHR = total present value at higher rate
NCO = net cash outlay.

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Acceptance rule
The accept or reject rule using IRR method is to accept the project if its IRR is higher than the opportunity
cost of capital. The cost of capital may also be expressed as required rate of return or cut off rate or hurdle
rate. They shall be rejected if its internal rate of return is lower than the opportunity cost of capital.

Merit

Like NPV method the IRR method recognize the time value of money and consider all cash flows occurring
over the entire life of projects to calculate its rate of return. It generally gives the same acceptance rule as
NPV method. IRR can be determined by finding the discount rate where NPV is zero. For this, trial and
error approach could be utilized. If the cash outlay (present value of cash outlay) is higher than the present
value of cash inflow i.e. NPV is negative, lower rate should be tried. If cash outlay is less than the PV of cash
inflow NPV is positive, then higher rate should be tried.

This will be further illustrated from the solved example 14.

Solved example 14

A project costs Rs. 120000 and is expected to generate cash inflows of Rs. 40000, 35000,35000, 30000, and 40000
respectively even its 5 year life. Calculate the internal ratio rate of return. The present value at 12% discount rate
and 10%discountrate for 5 years is given below

Present value factor (PVF)

Discount 1 2 3 4 5
rate
12% 0.893 0.797 0.712 0.636 0.567
16% 0.862 0.743 0.641 0.552 0.476

Solution :

Year Cash Inflow (Rs) PVF (12%) PV@12% PVF@16% PV@16%

1 40000 0.893 35720 0.862 34480

2 35000 0.797 27895 0.743 27005
3 30000 0.712 21360 0.641 19320
4 35000 0.636 22260 0.552 19320
5 40000 0.567 22680 0.476 19050

Total present value 129915 118075

Less cost of project 120000 120000
Net present value + 9,915 -1925

Now we have
Positive NPV of Rs 9915 at 12% (lower rate) and negative of Rs 1925 at Rs. 16% (higher rate) and the TPV
being Rs 129915 at 12% and Rs 118075 at 16%., IRR is thus given by :

TPV LR - NCO 129915- 120000

IRR = LR + (HR − LR) = 12 % + (16%−14%) = 15.35%
TPV LR - TPV HR 129915- 118075

Solved example 15
Project cost 16000 and is expected to generate cash inflow of 8000, 7000 and 6000 at the end of each year for
next 3 years. The present value factor for the discount rate 15%,16%.20% for 3 year is given below:
Present value factor
Discount 1st yr 2nd yr 3rd yr
rate
16% 0.862 0.703 0.641
20% 0.833 0.694 0.571
15% 0.870 0.756 0.658

Solution:
Calculation of NPV at different rates.

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 Time Value of Money

Year Cash flows PVF@16% PV PVF@20% PV PVF@15% PV

1 8000 0.862 6896 0.833 6664 0.870 6960
2 7000 0.743 5201 0.694 4858 0.756 5292
3 6000 0.641 3846 0.579 3474 0.658 3948

Total Present Value 15943 14996 16200

Less Cost of Project 16000 10000 16000
NPV - 57 - 1004 + 2000

Hence, we come to know that IRR lies between 15 to 16% or can be in 15 to 20%.Calculating IRR by formula :
TPV LR - NCO
IRR = LR + (HR − LR)
TPV LR - TPV HR
16200- 16000
For 15 % to 16 %, we have IRR = 15 % + (16%−15%) = 15.77%
16200- 15943

16200- 16000
For 15 % to 20 %, we have , IRR = 15 % + (20%−15%) = 15.99%
16200- 14996

From the above we came to know that the lower the difference between higher rate and lower rate the more
accurate result will be obtained.

Solved example 16

From the following statement calculate NPV and IRR.

Year Cash Flow DF (10%) DF (10%)

1-4 700000 2.798 3.170
5 600000 0.476 0.621
6 930000 0.410 0.564

Solution
Calculation of NPV

Year Cash Flow DF (16%) PV DF (10%) PV

1-4 700000 2.798 1958600 3.170 2219000
5 600000 0.476 285600 0.621 372600
6 930000 0.410 381300 0.564 524520

TPV 2625500 3116120

NCO 3000000 3000000
NPV - 374500 116120

Now,
TPV LR - NCO
IRR = LR + (HR − LR)
TPV LR - TPV HR
For 16 % to 10 %, we have

3116120- 3000000
= 10 % + (16%−10%) = 11.42%
3116120- 2625500

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