NPV = Present Value of the Sum of all relevant/incremental future cash flow

Present Value

All

Relevant/Incremental*

Future

Cash

Decision Rule

Market survey
Planning meeting
Architect's drawing
Painting a building
License
Spent money
Fixed cost
Things already committed
Mutually Exclusive
Independent
Manager
Purpose: to decide whether we should build this building or not
Cash flow table
the Sum of all relevant/incremental future cash flows

Discounting means risk & opportunity cost (inflation & expected profit) are included

Cash received and paid BOTH must be taken

Include that cash which flows ONLY if the project is implemented

Yo = immediate future meaning that it must be included without discounting

Receivables, provisions, accruals, payables are NOT included till they become cash

Zero & above NPV is acceptable, the higher the better

If we do the project
uild this building or not
 1,000,000

A
ZERO NPV Does NOT mean an accounting breakeven
NPV 120,000
WACC, ROE, Ke, ROI
Higher risk projects MUST use higher discount rate

in flow = receiving = +ve, out flow = paying = -ve

Additional working capital, penalties, tax, new permits

Yo = start of Y1, Y1= end of year 1, Y2 = end of year 2

ALL expenses may NOT be cash

Profit/Income may NOT be cash

Gain/loss may NOT be cash

BUT PLEASE check the significance & sensitivity

If we do NOT do this project

 100,000
50,000

Go ahead
Yo -10
Y1 -6
Y2 -3
Y3 25
1,000,000

119,000

99% A B
Yo (10,000.00) (10,000.00)

Y1
PAST FUTURE 50,000

Do not do it
 NPV Significance Test Indicator
> 30% positive
20-30% positive
10%-20% positive
5%-10% positive
up to 5% positive
Zero NPV
up to 5% negative
5%-10% negative
10%-20% negative
20-30% negative
> 30 % negative

IMPORTANT
Decision Guidelines Pyramid
Highlight that cashflow is a "forecast"
Mention that Discount Rate is an "estimate"
Remind about the inherent assumptions in the model
Discuss the senstivity of the computed NPV result as per Table
Point out that non-financial factors are not taken into consideration
Issue a Disclaimer to save your skin & suggest that a risk analysis should be done
icator

Definitely YES
Strongly Recommended
Recommended
Proceed with caution

Maybe Area

Wait, do not reject

Not a good idea
Reject it
Absolutely NOT

ast"
timate"
n the model
sult as per Table
n into consideration
k analysis should be done
NET PRESENT VALUE (NPV)
Discount Rate = 20%

project A project B PV A PV B
Y0 (10,000) (10,000) (10,000) (10,000)
Y1 4,000 7,000 3,333 5,833
Y2 5,000 5,000 3,472 3,472
Y3 5,000 1,500 2,894 868
Total 4,000 3,500 (301) 174

Select Project B

A sales man whose company manufactures & sells car engine tuning computer-based machine is trying to convince S
workshop to buy his machine. Cost of the machine is 0.9 million. Currently, Shahjahan is using manual tools for engi
kit 2 years ago for 250,000 and just last week he got new tools of 50,000 which he has not yet paid for.

Shahjahan currently earns 30,000 cash each month from this business

The sales man showed him a recently done survey which clearly depicts that wherever computerized tuning machine
25% which will require an additional working capital of 40,000

All of his existing tools can be immediately sold at a price of 130,000. After 4 years these tools will have no salvage v
life of 4 years & 25% salvage value.

Shahjahan doesn't know what his cost of capital is but he has invested his savings in a bank account where he is gettin

Should Shahjahan buy computerized tuning machine?

Solution
Find discount rate
Prepare cash flow for all options
Compute PV for each option
Find NPV for each option
check the sensitivity
Answer the requirement Manual Computer
 Yo - (810,000)
Y1 360,000 450,000
Y2 360,000 450,000
Y3 360,000 450,000
Y4 360,000 715,000
NPV

If he continue using Manual tools he will be better off as this option has a higher NPV
Therefore, he should NOT purchase the computer system
 machine is trying to convince Shahjahan, who owns an auto-
n is using manual tools for engine tuning. He had bought this tool
s not yet paid for.

Buy Not Buy

r computerized tuning machine was installed business increases by
(900,000)
(40,000)
hese tools will have no salvage value. Computerized system has a
130,000
37,500

bank account where he is getting 9% return.

450,000

360000
Working Capital should be taken as an outflow in Y0

At the project end working capital is taken as inflow

PV
Manual Computer
 - (810,000)
330,275 412,844
303,005 378,756
277,986 347,483
255,033 506,524
1,166,299 835,607

ff as this option has a higher NPV

Profitability Index (PI)

Data Given
Timelines Net Cash Flow Discount Rate is: 15%
Yo (start of Y1) (18,000,000)
Y1 (1,600,000)
Y2 3,400,000
Y3 6,626,000
Y4 14,500,000
Y5 11,200,000

Using PI find out if this project is financially viable

Solution

Timelines Net Cash Flow PV

Y0 (18,000,000) (18,000,000) 18,000,000
Y1 (1,600,000) (1,391,304) 19,395,088
Y2 3,400,000 2,570,888 PI 1.08
Y3 6,626,000 4,356,703
Y4 14,500,000 8,290,422
Y5 11,200,000 5,568,379
1,395,088
Profitability Index = PV of All Net Cash Flows (without initial investment) / Initial Investment

PV Y1 to Y5 19,395,088
Initial Investment 18,000,000
PI 1.08
Company may ACCEPT this project as its PI is more than 1 …. But
 66.66667
55.55556

RULE
PI less than 1 should be rejected