WHAT IS MONEY

- Money, in and of itself, is nothing.

- It can be a shell, a metal coin, or a piece of paper with a
historic image on it, but the value that people place on it
has nothing to do with the physical value of the money.
- Money derives its value by being a medium of exchange,
a unit of measurement and a storehouse for wealth.
- Money allows people to trade goods and services
indirectly, understand the price of goods (prices written
in dollar and cents correspond with an amount in your
wallet) and gives us a way to save for larger purchases in
the future.
- Money is valuable merely because everyone knows
everyone else will accept it as a form of payment - so let's
take a look at where it has been, how it evolved and how
it is used today.
 The History of Money
Barter
- The first people didn't buy goods from other people
with money.
- They used barter. Barter is the exchange of personal
possessions of value for other goods that you want.
- This kind of exchange started at the beginning of
humankind and is still used today.
- From 9,000-6,000 B.C., livestock was often used as a
unit of exchange. Later, as agriculture developed,
people used crops for barter.

- For example, I could ask another farmer to trade a

pound of apples for a pound of bananas.
 Shells
At about 1200 B.C. in China, cowry shells became the first
medium of exchange, or money. The cowry has served as money
throughout history even to the middle of this century.
Leather Currency
- In 118 B.C., banknotes in the form of
leather money were used in China.
- One-foot square pieces of white
deerskin edged in vivid colors were
exchanged for goods.
- This is believed to be the beginning
of a kind of paper money.
 Noses
- During the ninth century A.D.,
the Danes in Ireland had an
expression "To pay through the
nose."
- It comes from the practice of
cutting the noses of those who
were careless in paying the
Danish poll tax.
 Paper Currency
- From the ninth century to the fifteenth
century A.D., in China, the first actual
paper currency was used as money.
- Through this period the amount of
currency skyrocketed causing severe
inflation.
- Unfortunately, in 1455 the use of the
currency vanished from China.
- European civilization still would not have
paper currency for many years.
 PURCHASING POWER OF MONEY ?
TIME VALUE OF MONEY
 The value of money received today is different
from the value of money received after some time
in the future.

 An important financial principle is that the value

of money is time dependent. This principle is
based on the following four reasons:
 TIME VALUE OF MONEY
 Inflation: Under inflationary conditions the value of money, expressed in
terms of its purchasing power over goods and services, declines.

 Risk - Re 1 is now certain, whereas Re. 1 receivable tomorrow is less

certain. This 'bird-in-the-hand' principle is extremely important in
investment appraisal.

 Personal Consumption Preference - Many individuals have a strong

preference for immediate rather than delayed consumption. The promise of a
bowl of rice next week counts for little to the starving man.

 Investment Opportunities - Money like any other desirable commodity,

has a price, given the choice of Rs. 100 now or the same amount in one
year's time, it is always preferable to take the of Rs. 100 now because it
could be invested over the next year at (say) 18% interest rate to produce
Rs. 118 at the end of one year.
 SIMPLE INTEREST

Simple interest is the interest calculated on the

original principal only for the time during which the
money lent is being used. Simple interest is paid or
earned on the principal amount lent or borrowed.
Simple interest is ascertained with the help of the
following formula:
Interest = Pnr
Amount = P(l + nr)
Where,
P = Principal
r = Rate of Interest per annum (r being in decimal)
n = Number of years
WHAT IS THE SIMPLE INTEREST AND AMOUNT OF RS. 8,000 FOR 4
YEARS AT 12% P.A.
 Solution:

¿ 𝟖𝟎𝟎𝟎 ×𝟒 ×𝟎 . 𝟏𝟐
¿ 𝟑𝟖𝟒𝟎
𝑨𝒎𝒐𝒖𝒏𝒕 ( 𝑷𝒓𝒊𝒏𝒄𝒊𝒑𝒍𝒆+ 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 )=𝒑 (𝟏+𝒏𝒓 )
¿ 𝟖𝟎𝟎𝟎 [ 𝟏+ ( 𝟒 × 𝟎 . 𝟏𝟐 ) ]

¿ 𝟖𝟎𝟎𝟎 ( 𝟏+𝟎 . 𝟒𝟖 ) =𝟖𝟎𝟎𝟎×𝟏 . 𝟒𝟖=𝟏𝟏𝟖𝟒𝟎

Interest = Amount – Principal = 11,840 - 8,000 = Rs. 3,840
ILLUSTRATION : AT WHAT RATE PER CENT WILL RS. 26,435
AMOUNT TO RS. 31,722 IN 4 YEARS
 Solution - A = P(l + nr)
𝒓
𝟑𝟏𝟕𝟐𝟐=𝟐𝟔𝟒𝟑𝟓 (𝟏+𝟒 × )
𝟏𝟎𝟎
1,057.40 r = 31,722 - 26,435

r = 5,287/1,057.40= 5
.'. Rate of interest = 5%
ILLUSTRATION : A SUM DEPOSITED AT A BANK FETCHES
RS. 13,440 AFTER 5 YEARS AT 12% SIMPLE RATE OF
INTEREST. FIND THE PRINCIPAL AMOUNT.
Solution : A = P(l +nr)
13,440 = P (1+5 x 0.12)

13,440 = P + P x 0.6
1.6P = 13440
P = 13440/1.6 = 8400

Principle Amount = Rs.8400

 COMPOUND INTEREST

If interest for one period is added to the principal to

get the principal for the next period, it is called
‘compound interest’.
The time period for compounding the interest may be
annual, semiannual or any other regular period of
time.
The period after which interest becomes due is called
'interest period' or ‘conversion period’. If conversion
period is not mentioned, interest is to be compounded
annually.
THE FORMULA USED FOR COMPOUNDING OF INTEREST INCOME OVER 'N'
NUMBER OF YEARS.

Where,
A = Amount at the end of 'n' period
P = Principal amount at the beginning of the 'n'
period
i = Rate of interest per payment period (in decimal)
n = Number of payment periods
 When interest is payable half-yearly

When interest is payable quarterly

When interest is payable monthly

When interest is payable daily

ILLUSTRATION
WHAT SUM WILL AMOUNT TO RS. 5,000 IN 6 YEARS' TIME AT
PER ANNUM.

Solution:
6
¿ 5000 (1 +0.085 )
6
¿ 5000 (1.085 )

¿ 5000 × 1.63147

¿ 8157
ILLUSTRATION
FIND OUT THE COMPOUNDED INTEREST ON RS. 6,000 FOR 3 YEARS AT 9% COMPOUNDED
ANNUALLY.

Solution:
3
¿ 6000 ( 1 + 0.09 )
3
¿ 6000 ( 1.09 )

¿ 6000 × 1.29503

¿ 𝑅𝑠 . 7770
ILLUSTRATION: FIND OUT THE COMPOUNDED INTEREST ON RS.
2,500 FOR 15 MONTHS AT 8% COMPOUNDED QUARTERLY.

Solution :
4 × 1.25
0.08
¿ 2500 (1 + )
4
5
¿ 2500 (1 +0.02 )
¿ 2500 (1.02)5

5
𝐿𝑒𝑡 𝑥=1.02 ∴ log 𝑥=5 𝑙𝑜𝑔 1.02 log 𝑥=5 × 0.0086=0.0430

∴ 𝑥=𝑎𝑛𝑡𝑖𝑙𝑜𝑔 ( 0.0430 )=1.104 ∴ 𝐴=2500 ×1.104= 𝑅𝑠.2760

Compound Interest = 2760 – 2500 = Rs. 260

ILLUSTRATION : FIND THE PRESENT VALUE OF RS. 2,000 DUE IN 6 YEARS IF MONEY IS WORTH COMPOUNDED SEMIANNUALLY.

Solution:
2 ×6
0.05
2000=𝑃 (1+ ) 12
2 ► 2000=𝑃 (1.025)
► log 2,000 = log P+ 12 log 1.025 ► 3.30103=𝑙𝑜𝑔𝑃 +12 ×0.01072
► 𝑙𝑜𝑔𝑃=3.30103 −0.12864 ► 𝑙𝑜𝑔𝑃=3.1724

► 𝑃=𝑎𝑛𝑡𝑖𝑙𝑜𝑔3.17234 ► 𝑃=1487.30

𝐶𝑜𝑚𝑝𝑜𝑢𝑛𝑑 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 =2000 −1487.30=𝑅𝑠 . 512.70

 PRESENT VALUE

 It is a method of assessing the worth of an

investment by inverting the compounding process
to give present value of future cash flows. This
process is called 'discounting.
 The present value of 'P' of the amount 'A' due at
the end of 'n' conversion periods at the rate T per
conversion period.
THE VALUE OF 'P' IS OBTAINED BY SOLVING THE FOLLOWING
EQUATION:

𝑨
𝑷= 𝒏
( 𝟏+𝒊 )
ILLUSTRATION: ASCERTAIN THE PRESENT VALUE OF AN AMOUNT
OF RS. 8,000 DEPOSITED NOW IN A COMMERCIAL BANK FOR A
PERIOD OF 6 YEARS AT 12% RATE OF INTEREST.

Solution:
𝑨
► 𝟖𝟎𝟎𝟎= ►
( 𝟏+𝟎 . 𝟏𝟐 )𝟔

► A = 8000 × 1.97382 = Rs. 15791

ILLUSTRATION
FIND OUT THE PRESENT VALUE OF RS. 10,000 TO BE REQUIRED AFTER 4 YEARS IF THE INTEREST
RATE IS 6%.

 Solution

10000 10000 10000

¿ ¿ ¿ ¿ 𝑅𝑠 .7921
( 1 +0.06 ) 4 (1.06 )
4 1.26482

An amount of Rs. 7921 to be deposited into bank to get Rs. 10,000 at the end of 4
years at interest rate of 6%
CALCULATION OF DISCOUNT FACTORS
The exercise involved in calculating the present
value is known as discounting and the factors by
which we have multiplied the cash flows are known
as the 'discount factors'.
The discount factor is given by the following
expression:

Where 'i' is the rate of interest per annum and 'n' is

the number of years over which we are discounting.
Discounted cash flow is an evaluation of the future
cash flows generated by a capital project, by
discounting them to their present day value. The
discounting technique converts cash inflows and
outflows for different years into their respective
values at the same point of time, allows for the time
value of money.
ILLUSTRATION

A firm can invest Rs. 10,000 in a project with a life

of three years. The projected cash inflows are as
follows:
Year 1 2 3
Cash Inflows(Rs) 4000 5000 4000

The cost of capital is 10% p.a.

Should the investment be made ?

 SOLUTION
FIRSTLY THE DISCOUNT FACTORS CAN BE CALCULATED BASED ON RE. 1 RECEIVED IN WITH 'I' RATE OF
INTEREST IN 3 YEARS.

𝟏
𝒏
( 𝟏 +𝒊 )
Year 1 =

Year 2 =

Year 3 =
Year Cash Flow Discount Present
Factor Value
0 (10000) 1.000 (10000)
1 4000 0.909 3636
2 5000 0.826 4130
3 4000 0.751 3004
NPV = (3636 + 4130 + 3004) - 10000 = 770

Since the net present value is positive, investment

in the project can be made.
The present value of future cash flow can also be
ascertained as follows:
𝐼1 𝐼2 𝐼𝑛
𝑉= + + …+
( 1 +𝑖 ) ( 1+ 𝑖 ) 2
( 1 +𝑖 ) 𝑛

𝟒𝟎𝟎𝟎 𝟓𝟎𝟎𝟎 𝟒𝟎𝟎𝟎

¿ + +
( 𝟏+𝟎 . 𝟏𝟎 ) (𝟏 +𝟎 . 𝟏𝟎 ) 𝟐
( 𝟏+𝟎 . 𝟏𝟎 )𝟑

𝟒𝟎𝟎𝟎 𝟓𝟎𝟎𝟎 𝟒𝟎𝟎𝟎

¿ + +
𝟏 . 𝟏𝟎 𝟏 . 𝟐𝟏 𝟏 . 𝟑𝟑𝟏

𝟑𝟔𝟑𝟔 +𝟒𝟏𝟑𝟐 +𝟑𝟎𝟎𝟓=𝟏𝟎𝟕𝟕𝟑

𝑵𝑷𝑽 =𝟏𝟎𝟕𝟕𝟑 −𝟏𝟎𝟎𝟎𝟎=𝑹𝒔 .𝟕𝟕𝟑

 You’re required to make an investment of
Rs.15,000 today to a venture, which promises to
give you cash stream for next 8 years. The
expected cash stream is as follows.
Year 1 2 3 4 5 6 7 8
Cash Flow 1,000 2,000 2,000 3,000 3,000 4,000 4,000 5,000

 If the discount rate is 12% then what would be your

decision regarding the investment opportunity?
 Present Value of an Uneven Cash Flow Stream

Year Cash Flow Present Value of Individual Cash Flow

1 1,000 0.893 893

2 2,000 0.797 1,594
3 2,000 0.712 1,424
4 3,000 0.636 1,908
5 3,000 0.567 1,701
6 4,000 0.507 2,028
7 4,000 0.452 1,808
8 5,000 0.404 2,020

Present Value of the Cash Flow Stream 13,376

Net Present Value of Cash flows

Negative NPV indicates no investment decision
ILLUSTRATION: COMPARE PROJECTS A AND B USING
THE GIVEN DATA. USE NPV METHOD OF EVALUATION.
Project—A
Investment on the project : Rs. 10,00.000/-
Life of the project : 5 years.
Period of implementation : 1 year.
Cost of capital : 15%.
Year 1 2 3 4 5

Cash inflow 2,00,000/- 3,00,000/- 4,00,000/- 3,00,000/- 1,00,000/-

Project—B
Investment on the project : Rs. 10,00.000/-
Life of the project : 5 years.
Period of implementation 1 year.
Cost of capital : 13%.

Year 1 2 3 4 5
Cash inflow 3,00,000/- 4,00,000/- 4,00,000/- 3,00,000/- 2,00,000/-
 SOLUTION:
 Project—A: Present value of future cash inflows is
given by
THE NET PRESENT VALUE IS NEGATIVE AND
HENCE THE PROJECT SHOULD NOT BE TAKEN UP
 Project B: Present value of future cash inflows is given by:

Since the net present value is positive, project 'B' is comparatively better
than Project 'A' and hence out of the two projects. Project 'B' can be
 TEASER
 You’re required to take an investment decision on
behalf of your immediate boss.
 Cash outflow (Money to be invested) = 100,000
 Time period for the cycle is 3 yrs.
 Investment options are 2, namely Project A and
Project B
 NPV of the cash inflows after three years for both
the projects is

 What’s your decision?

 SOLUTION
 Anyone who’s chosen any project ( A or B) is going
to get fired.
 ANNUITY

 An annuity is a cash flow, either income or outgoings,

involving the same sum in each period. An annuity is the
payment or receipt of equal cash flows per period for a
specified amount of time. For example, when a company set
aside a fixed sum each year to meet a future obligation, it is
using annuity.
 The time period between two successive payments is called
'payment period or 'rent period.
 The word 'annuity' is broader in sense, which includes
payments which can be annual, semiannual, quarterly or
any other fixed length of time.
 Annuity does not necessarily mean payment taken to be one
year.
 FUTURE VALUE OF ORDINARY ANNUITY
An ordinary annuity is one in which the payments or receipts occur
at the end of each period. In a five year ordinary annuity, the last
payment is made at the end of the fifth year.

Where,
A = Annual or future value which is the sum of the compound
amounts of all payments
P = Amount of each installment
i = Interest rate per period
ILLUSTRATION
MR. X IS DEPOSITING RS. 2,000 IN A RECURRING BANK DEPOSIT
WHICH PAYS 9% P.A. COMPOUNDED INTEREST. HOW MUCH AMOUNT
MR. X WILL GET AT THE END OF 5TH YEAR.

Solution

𝟐𝟎𝟎𝟎
¿
𝟎 .𝟎𝟗
[ ( 𝟏+𝟎 . 𝟎𝟗 )𝟓 − 𝟏 ]

¿ 𝟏𝟏𝟗𝟔𝟗
𝐴 𝑖 % , 𝑛= 𝑃 × 𝐹 𝑉𝐼𝐹𝐴𝑖 % ,𝑛
𝐴 9 % , 5=𝑃 × 𝐹 𝑉𝐼𝐹𝐴 9 % ,5

𝐴9 % , 5=2000× 5.985=11970
 Suppose you have decided to deposit ` 30,000 per
year in your Public Provident Fund Account for 30
years. What will be the accumulated amount in your
Public Provident Fund Account at the end of 30
years if the interest rate is 8 percent?
 Solution:-
 You want to buy a house after 5 years when it is
expected to cost `2 million. How much should you
save annually if your savings earn a compound
return of 12 percent?
 Solution:-
 Annual Deposit in a Sinking Fund
 Futura Limited has an obligation to redeem Rs500
million bonds 6 years hence. How much should the
company deposit annually in a sinking fund account
wherein it earns 14 percent interest, to cumulate
Rs500 million in 6 years time?
 Solution:-
ILLUSTRATION
FIND THE FUTURE VALUE OF ORDINARY ANNUITY RS. 4,000 EACH SIX MONTHS FOR 15
YEARS AT 5% P.A. COMPOUNDED SEMIANNUALLY.

Solution

𝟒 𝟎𝟎𝟎
¿
𝟎 . 𝟎𝟐𝟓
[ ( 𝟏+𝟎 . 𝟎𝟐𝟓 )𝟑𝟎 − 𝟏 ]

¿ 𝟏𝟕𝟓𝟎𝟒𝟎
PRESENT VALUE OF DEFERRED ANNUITY

An annuity where the first payment is delayed

beyond one year, the annuity is called a 'deferred
annuity'. The present value 'V of a deferred annuity
'P' to begin at the end of 'm' years and to continue
for 'n' years is given by:
ILLUSTRATION
Z LTD. INTEND TO INVEST RS. 15,000 PER ANNUM AT THE END OF YEARS 5, 6, 7 AND 8 AT AN ANNUAL
INTEREST RATE OF 12%. FIND OUT THE PRESENT VALUE OF THE DEFERRED ANNUITY PAYMENTS.

Year Investment Amount Discounted@12% Present Value (Rs.)

5 15000 0.567 8505

6 15000 0.507 7605
7 15000 0.452 6780
8 15000 0.404 6060

Present Value of Deferred Annuity 28950

PRESENT VALUE OF PERPETUITY

A perpetuity is a financial instrument that promises

to pay an equal cash flow per period forever, that is,
an infinite series of payments and principal amount
never be repaid. The present value of perpetuity is
calculated with the following formula:
ILLUSTRATION: X LTD. HAD TAKEN A FREEHOLD LAND FOR AN
ANNUAL RENT OF RS. 1,200. FIND OUT THE PRESENT VALUE OF
FREEHOLD LAND WHICH IS ENJOYABLE IN PERPETUITY IF THE
INTEREST RATE IS 8% P.A.

Solution:

P = 1200 I + 0.08

𝟏𝟐𝟎𝟎
¿
𝟎 . 𝟎𝟖
¿ 𝑹𝒔 .𝟏𝟓𝟎𝟎𝟎
 AMORTIZATION
- Amortization is the gradual and systematic writing off of an
asset or an account over a period.
- The amount on which amortization is provided is referred to as
'amortizable amount.
- Depreciation accounting is form of amortization applied to
depreciable assets.
- Depletion is a form of amortization in case of wasting assets.
- The gradual repayment or redemption of loan or debentures is
also referred to as amortization.
- Sinking fund method and Insurance policy method are used for
systematic writing-off of an asset or redemption of bonds and
other long-term debt instruments.
- Present value of an annuity interest factors can be used to solve
a loan amortization problem, where the objective is to determine
ILLUSTRATION : MR. BALU HAS BORROWED A LOAN OF RS. 5,00,000 TO CONSTRUCT HIS HOUSE WHICH REPAYABLE IN 12
EQUAL ANNUAL INSTALLMENTS THE FIRST BEING PAID AT THE END OF FIRST YEAR. THE RATE OF INTEREST CHARGEABLE
ON THIS LOAN IS (A 4% P.A. COMPOUNDED. HOW MUCH OF EQUAL ANNUAL INSTALLMENTS PAYABLE TO AMORTIZE THE
SAID LOAN.

Solution:
V=500000 i=0.04 n=12
500000

𝐿𝑒𝑡 𝑥=( 1.04 ) 𝑙𝑜𝑔𝑥=− 12𝑙𝑜𝑔 1.04

12

¿ −12 × 0.0170=−0.204 ¿ −1+ 1− 0.204 ¿ 1 .796

𝑥=𝑎𝑛𝑡𝑖𝑙𝑜𝑔1 .796=0.6252

𝑃
500000=
0.04
( 1− 0.6252 ) 𝑃= 𝑅𝑠.53362
 INTERNAL RATE OF RETURN (IRR) METHOD
 The internal rate of return of a project is the discount rate that
makes the net present value equal to zero.
 In other words, internal rate of return is that rate of discount which
would equate the present value of cash out flows (investments on
the project) to the present value of cash inflows (the benefits over
the life of the project).
 In the calculation of net present value of a project, the discount rate
(cost of capital) is assumed and the net present value is calculated
by discounting future cash inflows at the assumed discount rate.
 In the calculation of internal rate of return from a project, the net
present value is set equal to zero and the corresponding discount
rate is determined; the discount rate at which the net present value
is zero is the internal rate of return.
 The following illustration will explain the method of arriving at the
IRR
ILLUSTRATION: FOR A PROJECT WITH THE GIVEN
DATA, CALCULATE THE INTERNAL RATE OF RETURN

Year Cash outflow Cash inflow

0 Rs. 10,00,000/-
1 — Rs. 4,00,000/-
2 — Rs. 2,50,000/-
3 — Rs. 2,50,000/-
4 — Rs. 2,00,000/-
5 — Rs. 2,00,000/-
6 — RS. 1,50,000/-
 SOLUTION:
 Let 'r' be the internal rate of return. The IRR is arrived at by
equating the present value of cash out flow and the present value
of cash inflows.

 The IRR is arrived at by trial and error method

 Let us first assume that r = 12% p.a.

 The present value of cash inflows is nearly equal to
the present value of cash outflow at a discount rate of
12% p.a.
 If we want a more accurate result, we can arrive at the
present value of cash inflows assuming a slightly
higher discount rate than 12%.
 Let us assume a discount rate of say, 13% p.a.
 Present value of cash inflows at a discount rate of
13% p.a.
 Though r = 13% p.a is a closer approximation than r
= 12% it can further be improved.
 Assume r = 14% p.a.
 Present value of cash inflows at a discount rate of
14% p.a.
 The difference between the present value of cash
outflow and the present value of cash inflows
(discounted at a rate of 14% p.a.) is only Rs.
2,587/-. Hence the IRR can be taken as 14% p.a.
 However, for academic interest let us workout the
present values of cash inflows at a discount rate of
15% and see the results.
 Present value of cash inflows at a discount rate of
15% p.a.
 At a discount rate of 15% p.a. the present value of
cash inflows falls short of the present value of the
cash out flow by Rs. 20,121.00 (10,00,000 -
9,79,879).
 Thus, the correct value of V lies between 14% and
15%. The correct value of Y at which the present
value of cash outflows is equal to the present value of
cash inflows can be arrived at by interpolating
between 14% and 15%.
COMPARISON BETWEEN NPV METHOD AND IRR METHOD
 Both NPV method and IRR method appear to be the
same structurally.
 Prima facie, it appears that if two projects are
compared using NPV method and IRR method, both
the methods would rank the projects in the same
order.
 Though in most cases the decision based on either
of the methods would be similar, there are certain
instances wherein the ranking by the two methods
may differ from each other.
 Though it sounds not logical, the following
illustration will clear the apprehensions.
ILLUSTRATION: COMPARE THE PROJECTS 'A' AND 'B’
USING NET PRESENT VALUE METHOD, ASSUMING A
DISCOUNT RATE OF 11% P.A
Year Project 'A' Project 'B'
[Cash flow] [Cash flow]
0 -10,00,000/- -10,00,000
1 8.00,000/- 4,00,000/-
2 6,00,000/- 4,00,000/-
3 — 3,00.000/-
4 — 3,00,000/-
5 — 2,00,000/-
 (Note: Negative figures indicate cash outflow)
 SOLUTION:
 N.P. V. Method:
 For arriving at the present value of future cash
inflows, instead of working out the reduction
factor ,
 the same can be directly obtained from present value
factor tables. [Refer P.V.I.F. table]
 Discount factor at Project 'A' Project 'B'
Year 11% Cash flow Present value Cash flow Present
value
0 1.000 -10,00,000 -10,00,000 -10,00,000 -10,00,000
1 0.90090 8,00,000 7,72.720 4,00,000 3,60,360
2 0.81162 6,00,000 4,86,972 4.00,000 3,24.648
3 0.73119 3,00,000 2,19,357
4 0.65873 3,00,000 1,97,619
5 0.59345 2,00,000 1,18,690
2,07,692 2,20,674

As seen from the above table, project 'B' gives a higher net
present value and hence out of the two projects. Project 'B' can
be chosen.
Let us workout the internal rate of return of the two projects
by IRR method and see if the results obtained by NPV method
matches with the results of IRR method. Project 'A'
LET US ASSUME AN IRR OF 25%.
PRESENT VALUE OF CASH INFLOWS:
Year Discount factor at Cash inflow Rs. Present value
25% of cash inflow
Rs.
12 0.80000 8,00,000 6,40,000
0.64000 6,00,000 3,84,000
10,24,000

Let us assume an IRR of 26%.

Present value of cash inflows:
Year Discount factor at Cash inflow Rs. Present value
26% of cash inflow
Rs.
1 0.79365 8,00,000 6,34,920
2 0.62988 6,00,000 3,77,920
10,12.840
STILL THE PRESENT VALUE OF CASH INFLOWS IS HIGHER THAN THE
PRESENT VALUE OF CASH OUTFLOW (I.E., RS. 10,00,000).
LET US ASSUME AN IRR OF 28%.
PRESENT VALUE OF CASH INFLOWS:
Year Discount factor at 28% Cash inflow Rs. Present value
of cash inflow
Rs.
1 0.78125 8,00,000 6,25,000
2 0.61035 6,00,000 3,66,210
9,91,210

The present value of cash inflows when discounted at the rate of 28% works out to Rs.
9,19,210/- which is below the present value of cash out flow by Rs. 8,790/- (10,00,000 -
9,91,210). The correct value of IRR can be obtained by interpolating between 26% and
28%.
PROJECT ‘B':
LET US ASSUME AN IRR OF 27%.
PRESENT VALUE OF CASH INFLOWS:
Year Discount factor Cash inflow Present value
at 27% Rs. of
cash inflow
Rs.

1 0.78740 4,00,000 3,14,960

2 0.62000 4.00,000 2,48,000
3 0.48819 3.00,000 1,46,457
4 0.38440 3,00.000 1,51,320
5 0.30268 2,00,000 60,536
8,85,273
Since the present value of cash inflow falls short by Rs. 1,14,727/-(10,00,000 -
8,85,273), the IRR will be below 27%.
Let us assume an IRR of 21%.
Present value of cash inflows:
Year Discount Cash inflow Present
factor Rs. value
at 21% of cash
inflow
Rs.
1 0.82645 4.00.000 3,30,580
2 0.68301 4,00,000 2,73,204
3 0.56447 3,00,000 1,69,341
4 0.46651 3,00,000 1,39,953
5 0.38554 2,00,000 77,108
9,90,186
Since the present value of cash inflows when discounted at a rate of 21%
is also below Rs. 10,00,000/- the IRR for project B is even below 21%.
Let us assume an IRR of 19%.
Present value of cash inflows:

Year Discount factor Cash inflow Present value

at 19% of cash inflow
Rs. Rs.
1 0.84034 4,00,000 3,36,136
2 0.70616 4,00,000 2,82.464
3 0.59342 3,00,000 1,78,026
4 0.49867 3,00,000 1,49,601
5 0.41905 2,00,000 83,810
10,30,037
 Since the present value of cash inflows when
discounted at 19% exceeds the present value of cash
outflow, the correct value of 1RR can be obtained
by interpolating between 19% and 21%.
 Observations:
 As seen from the above example the following are the observations.
Project 'A ' Project B' Result
 Net present value Rs. 2,07,692/- Rs. 2.20,674/- Project 4B"
ranks higher than Project—
A

 Internal rate 27.1872% 20.5075%

Project 'A' of return ranks higher than
Project—B

 The difference in the results obtained by NPV method and IRR method can
arise due to two reasons, viz.,
 When the size of the projects are different, requiring different capital
outlays. and
 When the times of the cash inflows are different.
IRR (INTERNAL RATE OF RETURN)