Techniques for Evaluating Projects

Net Present Value

 • An investor could receive Rs 10000 today or a
year from now. Most investors would not be
willing to postpone receiving Rs 10000 today.
However, what if an investor could choose to
receive Rs 10000 today or Rs 10500 in one
year?
• The 5% rate of return (RoR) for waiting one
Think of a year might be worthwhile for an investor unless
situation? another investment could yield a rate greater
than 5% over the same period.
 Majorly, there are three
techniques of project evaluation
Project
Evaluation
• Net Present Value (NPV)
Techniques • Payback Period (PB)
• Internal Rate of Return (IRR)
 Net present value is the present value of the cash flows at
the required rate of return of your project compared to
your initial investment

In practical terms, it’s a method of calculating your return

on investment, or ROI, for a project or expenditure

Net Present NPV considers the time value of money, translating future

cash flows into today’s dollars.

Value (NPV)
It provides a concrete number that managers can use to
easily compare an initial outlay of cash against the present
value of the return.

NPV is a financial metric that seeks to capture the total

value of a potential investment opportunity.
 The NPV relies on a discount rate that may be derived
from the cost of the capital required to invest
 1. Projection of all of the future cash inflows and outflows
associated with an investment

2. Discount all those future cash flows to the present day,

and then

NPV 3. Add them together.

Calculation
-Basic Steps 4. The resulting number after adding all the positive and
negative cash flows together is the investment’s NPV.

A positive NPV means that, after accounting for the time

value of money, you will make money if you proceed with
the investment.
NPV
Formula Where NPV =Net Present Value
Rt =Net cash flow at time t
i = Discount rate
t =Time (or period) of cash flow
Question1
ABC Ltd company wants to expand its business and so it is willing to
invest Rs 10,00,000. The investment is said to bring an inflow of Rs.
1,00,000 in first year, 2,50,000 in the second year, 3,50,000 in third
year, 2,65,000 in fourth year and 4,15,000 in fifth year. Assuming the
discount rate to be 9%, calculate NPV
Solution

Year Cash Flow Present value Computation

NPV = Rt/(1+r) – I
t

0 -10,00,000 -10,00,000 –
Where,
1 1,00,000 91,743 1,00,000 /(1.09)1
NPV =Net Present Value
2 2,50,000 2,10,419 2,50,000 /(1.09)2
r =Discount rate 3 3,50,000 2,70,264 3,50,000 /(1.09)3
Rt = Net Cash Inflows in time t 4 2,65,000 1,87,732 2,65,000 /(1.09)4
I = initial Capital Investment 5 4,15,000 2,69,721 415000 /(1.09)5
(Net cash outflows)
NPV =Net cash inflows-Net cash outflows
• The total sum of present value of cash inflows for all the 5
years is Rs. 10,29,879.
• The initial investment is Rs. 10,00,000.
• Hence, the NPV is Rs. 29879. 
Time Value of Money in NPV calculation

• Net present value method is a tool for analyzing profitability of a particular

project. It takes into consideration the time value of money. The cash
flows in the future will be of lesser value than the cash flows of today.
And hence the further the cash flows, lesser will the value. This is a very
important aspect and is rightly considered under the NPV method.
• This allows the organisation to compare two similar projects judiciously,
say a Project A with a life of 3 years has higher cash flows in the initial
period and a Project B with a life of 3 years has higher cash flows in latter
period, then using NPV the organisation will be able to choose sensibly the
Project A as inflows today are more valued than inflows later on.
Question 2
Suppose a company can invest in equipment that will cost Rs 5,000,000 and is
expected to generate Rs 10,00,000 per year in revenue for 20 years. The salvage
value* of the project at the end of its life is negligible. Assuming the interest rate as
18%, compounded annually, check the feasibility of the project using NPV.
Note: What is salvage value?
• Salvage value is the book value of an asset after all depreciation has been fully
expensed.
• The salvage value of an asset is based on what a company expects to receive in
exchange for selling or parting out the asset at the end of its useful life.
 Solution
Initial outlay of the project (P) = Rs 50,00,000
Net annual revenue (A)= Rs. 10,00,000
P = A*[(1+i) – 1]/[i*(1+i) ]
n n
Life of the project (n) =20 years

Where, Interest rate (i) =18% compounded annually

P =Present worth NPV = -50,00,000+ 10,00,00(P/A,i,n)

-50,00,000+ 10,00,00(P/A,18%,20)
A = Annual equivalent payment -50,00,000 + 1000000[(1+0.18)20-1]/0.18(1+0.18)20

i = Interest rate =-50,00,000 + 1000000*5.35

n = Number of interest period =Rs 352700

Since, the NPV of the cash flow pattern of the project is positive,
the project is financially feasible
Question 3
The cost of setting up a telecom (mobile) tower is Rs 1,50,00,000. The
annual equivalent yield from the tower (through service) is Rs.
20,00,000. The salvage value after its useful life of 10 years is Rs.
3,00,000. Check whether the project is financially feasible based on
present worth method by assuming an interest rate of 10%
compounded annually.
Solution
Step 1: Calculate present worth of annual return (yield)
= A*[(1+i)n – 1]/[i*(1+I)n]
= 2000000[(1+0.10)10-1]/0.10(1+0.10)10
= Rs 1,22,89,200

Step 2: Calculate the present worth of salvage value at the end of year 10

Salvage Value/(1+i)n
3000000/(1+0.10)10
= Rs 1,15,650

Step 3: Initial outlay of the project

= Rs 1,50,00,000

Step 4: Calculate the net present value

=-15000000 + 12289200 + 115650

= -Rs 2595150
Question 4
Suppose a company can invest in equipment that will cost $1,000,000
and is expected to generate $25,000 a month in revenue for five years.
The company has the capital available for the equipment and could
alternatively invest it in the stock market for an expected return of 8%
per year. The managers feel that buying the equipment or investing in
the stock market are similar risks.
Solution
Identify the discount rate
The alternative investment is expected to pay 8% per year. However, because the equipment
generates a monthly stream of cash flows, the annual discount rate needs to be turned into a
periodic or monthly rate. Use the following formula,
Periodic rate = [(1+0.08)1/12-1]
= 0.64%

Assume the monthly cash flows are earned at the end of the month, with the first payment arriving
exactly one month after the equipment has been purchased. This is a future payment, so it needs to
be adjusted for the time value of money. 
The full calculation of the present value is equal to the present value of all 60 future cash flows,
minus the $1,000,000 investment. 
Question 5 (Level of difficulty High)
A project involves an initial outlay of Rs 30,00,000 and with the
following transactions (as shown in the table) for the next five years.
The salvage value at the end of the life of the project after five years is
Rs 3,00,000. Check whether the project is financially feasible by
assuming an interest rate of 15% compounded annually.

End of Maintenance & Operating Expense Revenue

year (Rs) (Rs)
1 200000 800000
2 250000 1000000
3 300000 1200000
4 350000 1400000
5 400000 1600000
Question 6 (practice question)
The details of the feasibility report of a project are as shown below.
Check the feasibility of the project, based on present worth method,
using i = 12%
The initial outlay = Rs. 5000000
Life of the project = 15 years
Annual equivalent revenue = Rs. 1500000
Modernizing cost at the end of the 8th year = Rs. 2000000
Salvage value at the end of the life = Rs. 5,00,000