* Capital Budgeting

Discounted Cash Flow

2. Discounted Cash Flow Techniques
Discounted cash flow method is also known as time adjusted method. The methods are improvements over pay back period
and the accounting rate of return since these consider return after pay back periodas well as time value of money. In recent
years, the method has been recognized as the most meaningful technique for financial decisions.
The method is based on the assumption that rupee one received today is worth more than rupee one to be received in
future. The following methods are used to judge the profitability of different proposals on the basis of this method:
(a) Present Value Method: Present value method recognizes that cash flow streams at different time periods differ in
value and can be compared only when they are expressed in terms of a common denominator. The following steps
are involved in this method :
1. Determination of cash outflows i.e. initial investment and subsequent outlay.
2. Determination of future cash inflows for different periods.
3. Determination of discounting rate i.e. cut off rate. It is generally taken to be equal to cost of capital.
4. Computation of Present Value Factor (P.V.F.) with the help of discounting rate.
5. Compute present value of all cash inflows for different periods and add them together. Salvage value and working
capital released at the end of the project’s economic life are also considered as cash inflows and are duly
discounted to present value. It is calculated as follows : -
Present Value = Cash Inflows x P.V.F.
6. Cash outflows at zero period of time are not discounted, initial amount is taken as present value of cash outflows,
however, cash outflows at subsequent periods are discounted by the same present value factor.

r
n
 Computation of Present Value Factor (P.V.F.)
The present value of cash inflows can be calculated with the help of
following formula:
P.V.F. = 1
(1+1)n
P.V.F. = Present value factor of rupee one

r = Required earning rate or discounting rate

n = Number of years

Acceptance Criterion : The present value of the future cash inflows or

streams are compared with the present value of the outlays. If the present
of the cash inflows is equal to or greater than the investment
proposal/outlay, the project may be accepted. If, however, it is less, the
proposal may be rejected. It can be shown as under:
When PV > I, Accept the proposal
When PV < I, Reject the proposal
Here, I = Initial Investment or Capital Outlay
PV = Present Value of Future Cash Inflows.

(b) Net Present Value Method: Net present value (NPV) method is also known as excess present value or net
gain method. The net present value of the project is the difference between the sum of the present value of its cash
inflows and present value of cash outflows (i.e. initial investment or capital outlays).
It can be expressed as follows :
Net Present Value (NPV) = Total Present Value. of Initial
Cash Inflows - Investment
The following steps are involved under this method :
(1)The present value of cash inflows and the present value of investment outlay (i.e. cash out flows) should be
calculated using discounting rate.
(2)The Net Present Value (NPV) is found cut by subtracting the present value of cash outflows from the present
value of cash inflows.
Acceptance Criterion : If the net present value is positive, the project should be accepted; if negative it
should be rejected. Symbolically
If NPV > Zero Accept the proposal
If NPV < Zero Reject the proposal.
If the two projects are mutually exclusive, the one with higher net present value should be choosen. Under this
method, projects can be ranked in order of net present value i.e., first rank will be given to the project with &»e
highest positive NPV.
Illustration 10 : Project M initially costs Rs. 50,000. It generates the
following cash flows:
Y e ar C a sh In flow s P resen t V alu e of R e 1 at 10%

R s.

1 18 ,000 0.90 9

2 16 ,000 0.82 6

3 14 ,000 0.75 1

4 12 ,000 0.68 3

5 10 ,000 0.62 1

Taking the cut off rate at 10%, suggest whether the project should be accepted
or not. Use net present value method.
Solution:
Calculation of Present Value of Cash Inflows

Year Cash Inflows P.V. factor Present Value of

@ 10% Cash Inflow

Rs. Rs.

1 18, 000 0.909 16, 362

2 16, 000 0.826 13, 216

3 14, 000 0.751 10, 514

4 12, 000 0.683 8,196

5 10, 000 0.621 6,210

To tal Present Value 54, 498

Net Present Value = Total Present Value of Cash Inflows - Initial

Investment
= Rs. 54,498 - Rs.50,000 = Rs. 4,498

Suggestion:. Project should be accepted.

Illustration 11 : Pawan Brothers is considering the purchase of a machine. Two machines X and Y
each costing Rs. 1,00,000 are available Earnings after taxation (EAT) are expected to be as under:
Y ea r M ac hi ne X M ac h in e Y D i sc ou nt F ac to r a t
1 0%
Rs . R s.

1 30 ,0 00 10 , 000 0 . 909
2 40 ,0 00 20 , 000 0 . 826
3 50 ,0 00 30 , 000 0 . 751
4 35 ,0 00 35 , 000 0 . 683
5 15 ,0 00 40 , 000 0 . 621
1, 70, 000 1 ,3 5 ,00 0

Calculate Net Present Value (NPV) of two alternatives assuming depreciation is charged on straight line basis.
 Solution :
(i) Calculation of Cash inflows of Machine X and Machine Y

Machine X Machi ne Y

Year EAT Depreciation Cash EAT Depreciation Cash

Inflow Inflow

Rs. Rs. Rs. Rs. Rs. Rs

1 30,000 20,000 50, 000 10,000 20,000 30, 000

2 40,000 20,000 60, 000 20,000 20,000 40, 000

3 50,000 20,000 70, 000 30,000 20,000 50, 000

4 35,000 20,000 55, 000 35,000 20,000 55, 000

5 15,000 20,000 35, 000 40,000 20,000 60, 000

 (ii) Calculation of Present Value of Cash Inflows :

Machine X Machi ne Y

Yea r Discount
Factor @ Cash Present Present
Inflow Value Cash Inflow Value
10%

Rs. Rs. Rs. Rs.

1 0 .909 50,000 45,450 30,000 , 27,270

2 0 .826 60,000 49,560 40,000 33,040

3 0 .751 70,000 52,570 50,000 37,550

4 0 .683 55,000 37,565 55,000 37,565

5 0 .621 35,000 21,735 60,000. 37,260

0 .909 2,70, 000 2 ,06, 880 2, 35,000 1, 72,685

 Net Present Value =Total Present Value - Initial Investment

Machine X = Rs. 2,06,880 - Rs. 1,00,000 = Rs. 1,06,880

Machine Y = Rs. 1,72,685 - Rs. 1,00,000 = Rs. 72,685

Working Notes:
(i) It is assumed that economic life of the both machines is
5 years
(ii) It is assumed that after the expiry of economic life
salvage of both machines will be nil.
(iii) Depreciation has been calculated as under :
Depreciation =
= = Rs.20,000
Illustration 12 : DCM Ltd. is considering an investment proposal. The project willcost Rs. 50,000. The project
has a life expectancy of five years and no salvage value. The company’s tax rate is 55%. The company uses
straight line depreciation. The estimated cash flows before tax (CFBT) from the proposed investment proposal
are as follows
Year : CFBT (Rs.)
1 10,000
2 11,000
3 14,000
4 15,000
5 25,000
Calculate Net Present Value (NPV) at 10% discount rate and suggest
whether the proposal should be accepted or not.
First of all we should determine annual depreciation to compute net profits
(CFBT - Depreciation) on which the company is to pay taxes. This will be
shown as follows :
(i) Calculation of Cash Inflows (CFAT)

C a sh
N et
Profits T axe s N e t Profit in fl ow
Y ear C FBT Depreciation @ s ( C FA
( 2 )- 55 % a ft er Ta x T )
( 3)=
( 6)+ ( 3)
(1) ( 2) (3) ( 4) ( 5) ( 6) (7 )
R s. R s. Rs. R s. Rs . R s.
1 10 ,000 10, 000 N il Nil N il 10, 000
2 11 ,000 10, 000 1,00 0 55 0 450 10, 450
3 14 ,000 10, 000 4,00 0 2, 200 1,80 0 11, 800
4 15 ,000 10, 000 5,00 0 2, 750 2,25 0 12, 250
5 25 ,000 10, 000 15,00 0 8, 250 6,75 0 16, 750
11,2 50 61, 250
( ii ) Ca lc ula t ion o f N et P res en t V a lue ( N P V )

C a sh In flow To ta l Pr e se nt V alu
Pr e sen t V alu e
Y ea r s e
Fac tor @ 10 %
(C FA T) C FA T x P.V . Fa cto r
R s. R s. R s.
1 1 0,000 0.9 09 9, 090
2 1 0,450 0.8 26 8, 632
3 1 1,800 0.7 51 8, 862
4 1 2,250 0.6 83 8, 367
5 1 6,750 0.6 21 10 ,401
T ota l P re se nt V a lu e of CF A T 45 ,352
Le ss : Initial Investment 50 ,000
N e t Pre se nt V a lue ( N P V ) - 4,64 8

Since Net Present Value (NPV) is negative so the proposal should not
be accepted.