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PAPER No. : TITLE MODULE No. : TITLE

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Paper No and Title Paper No 8: Financial Management

Module No and Title Module 8: Investment evaluation criteria II-NPV and PI

Module Tag COM_P8_M8

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TABLE OF CONTENTS

1. Learning Outcomes 2. Introduction:Modern or Discounting Capital Budgeting Techniques 3.Net Present Value (NPV) Method 3.1. Meaning 3.2. Computation

3.3.Decision Making Criteria 3.4. Merits 3.5. Demerits

4. Profitability Index (PI) Method 4.1. Meaning 4.2. Computation

4.3.Decision Making Criteria 4.4. Merits 4.5. Demerits

5. Summary

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1. Learning Outcomes

2. Introduction: Modern or Discounting Capital Budgeting Techniques

The followings are the main techniques which are covered under discounting or modern approach to capital budgeting: 1: Net Present Value (NPV) method 2: Profitability Index (PI) 3: Internal Rate of Return (IRR) 4: Modified Internal Rate of Return (MIRR) 5:Discounted Payback period In this module, NPV and PI are discussed in detail. Discounted Payback period, Internal Rate of Return (IRR) and Modified Internal Rate of Return (MIRR) are discussed in next module.

After studying this module, you will be able to

• Know the meaning of Modern or Discounting Capital Budgeting Techniques.

• Understand the meaning, computation, merits and demerits of Net Present Value (NPV) Method of capital budgeting.

• Appreciate the meaning, computation, merits and demerits of Profitability Index (PI) technique of capital budgeting.

On the basis of discussion of tradition methods of capital budgeting technique, we found that these methods are easy and simple to compute and understand. However, the methods suffer from some limitations, ARR is based on accounting profits rather instead of cash flows and both ARR and Payback period ignore time value of money. In order to overcome these limitations, modern techniques came into existence. These are based on time value of money. The most important aspect of these techniques is that they use discounted cash flows rather than absolute cash flows to make investment decisions. Therefore, these techniques are also called discounted cash flow methods. Under this approach, first of all cash flows rather than accounting profits are estimated over the life of the asset. Once these estimations are obtained, these cash flows are discounted using the cost of capital as the discount rate. The logic and reasoning for the use of cost of capital as the discount rate is discussed in a separate module. For this module, we assume it as given and proceed to show the concept and utility of these modern techniques.

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3. Net Present Value (NPV)

3.1. Meaning

3.2. Computation

�� = ��

�1 + ��

�

��

− ��

Where, time ‘t’ is ranging from 1 to ‘n’ , �� is the net cash flow at the end of time ‘t’, k is the cost of capital which is used as a discount rate, and �� is the cash outflow arising in the beginning of the year. The amount of NPV is the net addition to the wealth of the shareholders in present value terms. In the above computation we assume that the cash outflow will occur only in the beginning of the project, however, it is also possible that the cash outflow may arise in future as well. The firm machine need higher cost of maintaining the machines in later years or it may have to incur some additional capital expenditure in later years. Under this scenario, in order to make cash outflows and cash inflows comparable, we need to compute the present value of those cash outflows as well which would arise in future. We need to modify our equation to incorporate the present value of cash outflows by using the following formula:

�� = ��

�1 + ��

�

��

− ��

�1 + ��

�

��

One of the most common ways of examining a project is to compute its net present value. This is the most basic and useful technique of capital budgeting decision. Under this method, first of all, cash flows are estimated over the life of the project. The next task is to calculate the present value of cash inflows from the project. The present value of cash inflows is compared with the present value of cash outflows.NPV is excess of present value of all cash inflows over present value of all cash outflows.

NPV of the project is calculated by subtracting the present value of the cash outflows from the present value of cash inflows. The computation of the NPV for the conventional project which involves initial cash outflow and is followed by the cash inflows can be computed as shown below:

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Using above equation, we can compute the present value of cash inflows as well cash outflows. Alternatively, we can write the above equation as:

�� = ��

�1 + ��

�

��

Note that the subscript now ranges from 0 to ‘n’ instead of 1 to ‘n’ as is done previously. Now, �� denotes the cash flow which may be cash inflow or cash outflow for any particular year. This is the generalised formula for computing the net present value.

3.3.Decision Making Criteria

(b) Negative NPV, when the computed value of NPV of a project is negative, we should reject those projects as the cost of these projects is higher than the benefits.

Let’s first consider very simple example to illustrate the process of computing NPV of a project. Example: There is machine available to a firm to start its operations. The followings are the cash flows related to the machine: Year Cash Flow 0 -50,000 1 10,000 2 15,000 3 20,000

The NPV technique is used frequently to build investment decision. The logic of taking the decision remains the same. We should accept the project whenever the benefits of the project exceed the cost of the project. Under capital budgeting decisions, the benefits are the present value of cash inflows and the cost is the amount of present value of the cash outflows. The NPV presents the net benefits, the decision rule depends on the value of NPV. There can be following three situations:

(a) The case of positive NPV, it will be positive only when the present value of cash inflows is greater than the present value of cost. Thus the projects with the positive NPV are accepted by the firms.

(c) Zero NPV, this situation will arise when the present value of cash inflows is equal to the present value of cash outflow. It means that the benefits are equal to the cost. We are indifferent under this situation, the project is generating that is available from the alternative avenues if we do not accept this project. Thus, we are indifferent; this project does not bring any additional value to the wealth of the shareholders which is the primary objective of financial management

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4 10,000 5 14,000 Compute the NPV of the machine when the required rate of return from the investment is 10%. Solution: Cost of the machine is Rs. 50,000 which is to be incurred at present and already is in present value terms. The next task is to compute the present value of cash inflows. The rate of discount is 10% and we will use present value factor table to calculate the present values as shown below: Computation of present value of cash flows Year Cash Flow PVF (10%) Present Value (PV)

1 10,000 0.909 9,090.91

2 15,000 0.826 12,396.69

3 20,000 0.751 15,026.30

4 10,000 0.683 6,830.13

5 14,000 0.621 8,692.90

Total 52,036.93

The NPV of the machine is equal to 52,036.93 – 50,000 = 2,036.93.

3.4. Merits

3: Different discount rates can be easily incorporated into the NPV computations. Thus we can see the sensitivity of the discount rates on the profitability of the project. 4: This method considers the all the cash flows spreading over the whole life of the project.

The NPV of the machine is positive, thus it will add value to the firm and should be part of firms assets. The decision is that the machine should be purchased.

There are several benefits of using NPV method for taking capital budgeting decisions. 1: One of the most necessary advantage of NPV technique is that it takes into consideration the time value of money. This is the major improvement over the traditional approach to capital budgeting. 2: It considers cash flows in order to analysis rather than the accounting profits. We saw earlier that the accounting profits do not reflect the true picture of the financial position of the firm. Accounting profits can be interpreted by using distinctaccounting methods. Cash flows do not suffer from these limitations.

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3.5. Demerits

However, it is endured with thedemerits which are explained below: 1: It is hard to compute as compared to the traditional tools of capital budgeting such as payback method and ARR method. 2: It is based on one very important factor, i.e. discount rate which is the weighted average cost of capital. Theoretically, this is very sound the logical concept, however, it is very difficult to compute in practice. This is the major flaw of NPV method. A slight change in discount rate can alter the value of NPV dramatically. 3: This is based on absolute amount of cash flows. Given a choice between two projects, we will choose a project with high NPV, though there is a possibility that the project with high NPV involves huge investment. Under the situation of limited capital, it is not possible for the firm to take up those projects. The NPV analysis fails to take it into account. 4: When two projects have different life span, it is difficult to use NPV criteria to make investment decision. For example, suppose there are two machines with 4 years and 6 years life having the same NPV of let’s say, Rs. 24,000. NPV criteria would suggest that both the machines are equally good; however, we can see that first machine needs to be replaced at the end of 4th year whereas the second machine can work for 6 year. However, we can use a modified form of discounting technique to incorporate this aspect which we will see later on. Despite these limitations, it is one of the most commonly used method of capital budgeting and a significant improvement over the traditional methods of capital budgeting.

4. Profitability Index (PI) or Benefit Cost Ratio

4.1. Meaning There is yet another modern approach to create investment decision. This is also based on all cash inflows and also takes into account the time value of money concept. This approach is in contrast with the net present value method in the sense that it rates the projects in relative terms. In case of NPV, we get the absolute amount of benefits which will arise due to a specific project whereas in case of profitability index, we compute a relative factor to take an investment decision. Profitability index, is also called as profit investment ratio and value investment ratio, can be defined by the ratio of returns

5: NPV technique is related to the basic objective of financial management, i.e. maximisation of the wealth of the shareholders. The wealth of the shareholders will be maximized when firm takes up the project which is generate extra cash flows in present value terms. In order to answer the question whether a particular project generates value to the shareholders, we use NPV analysis. This is very helpful and most sophisticated tool of making investment decision by the firm.

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generated to amount investment ina proposed project. It is a necessary tool for the ranking of projects as it permits you to quantify the amount of value generated per unit of investment. 4.2. Computation

Profitability index is calculated by dividing the present value of cash inflows by the present value of cash outflows. The formula is given below:

��=�� ℎ ��

�� ℎ ��

4.3.Decision Making Criteria

The explained phenomenon is the decision making criteria by using the profitability index:

• When PI>1, accept the project • When PI<1, reject the project • When PI=1, indifferent

The reason behind this decision rule is simple to understand. The profitability index will be more than one only when the present value of cash inflows is greater than present value of cash outlay. It means that the project will generate excess wealth for the shareholder which is the main purpose of financial management. Therefore, we should accept these types of projects. We can further note that under this situation, NPV will be positive, thus both the methods would lead to the identical result. However, when PI is less than one, under this situation the present value of cash inflows is less than the present value of cash outflow and we should not accept this kind of investment proposals. Under this scenario, the NPV will be negative and we get the identical decision rule by both the techniques. When cash inflows are equal to the cash outflows, then the PI value will be equal to one and NPV would be zero and we are in indifferent situation. In case of more than one machine is available or more than one investment option is available, we can use profitability index to rank the projects. On the basis of ranking, we can select the project with highest ranking. Example: There is machine available to a firm to start its operations. The followings are the cash flows related to the machine: Year Cash Flow 0 -1,00,000 1 20,000 2 35,000 3 30,000 4 20,000 5 25,000

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Compute the PI of the machine when the required rate of return from the investment is 10%. Solution: Year Cash Flow PVF (10%) Present Value (PV)

1 20,000 0.909 18,182

2 35,000 0.826 28,926

3 30,000 0.751 22,539

4 20,000 0.683 13,660

5 25,000 0.621 15,523

Total 98,830

��=98,830

1,00,000

= .988 The value of profitability index for this machine is 0.988 which is less than one, thus we should not purchase this machine. We can also note that the NPV for this machine is negative and the amount of NPV is 98,830-1,00,000 = (1170). Thus both the methods lead to the same result; the only difference is that NPV method talks about the absolute amount whereas the PI method gives us the relative value to make investment decision.

4.4. Merits As we have noticed that this approach is an extension of NPV method, thus it has all those merits of NPV such as:

1: PI method differentiates between cash flows occurring at different points of time and thus considers time value of money. 2: PI like NPV is based on cash flows rather than accounting profit. 3: PI also incorporates the riskiness of the project in capital budgeting analysis through use of an appropriate discount rate.

4: PI tells the present value of cash inflows generated per rupee of cash outflow. It thus can identify whether a project would increase firm’s value or shareholder’s wealth

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5: PI technique is very useful in ranking the projects and choosing projects which give maximum cash inflows for a given amount of capital investment or cash outflow in case of capital rationing. 4.5. Demerits

Limitations of PI are: 1: It is difficult to compute as compared to the traditional methods of capital budgeting such as ARR and Payback period method. 2: It requires computation of required rate of return to be used to discount future cash flows. 3: Computations of present values and forecasting of future cash flows is needed.

5. Summary

Ø Discounted Cash Flow or Modern techniques of capital budgeting are based on time value of money and they use discounted cash flows. Main ones are: Net Present Value (NPV), Profitability Index (PI), Internal Rate of Return (IRR), Modified Internal Rate of Return (MIRR) and Discounted Payback period.

Ø NPV is excess of present value of all cash inflows over present value of all cash outflows. It is computed by subtracting the present value of the cash outflows from the present value of cash inflows.

Ø Projects with positive NPV are selected while those with negative NPV are rejected. Mutually exclusive projects are ranked according to their NPV and those with highest positive NPV are selected.

Ø NPV considers time value of money, uses cash flows instead of accounting profit, incorporates risk through discount rate, is related to shareholder’s wealth maximization and considers all cash flows occurring during the life of a project.

Ø However, NPV is difficult to calculate, discount rate used is difficult to compute, exact cash flows are difficult to estimate and is not best to use when comparing projects with different lifetimes.

Ø Profitability index, also known as profit investment ratio, benefit cost ratio and value investment ratio, is the ratio of returns generated to amount investment in a proposed project. It is computed by dividing the present value of cash inflows by the present value of cash outflows.

Ø When PI>1, we accept the project and reject those with PI<1. Mutually exclusive projects are ranked according to their PI and those with highest PI are selected.

Ø Like NPV, PI also considers time value of money, is based on cash flows, incorporates the riskiness of the project through an appropriate discount rate, can

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identify whether a project would increase shareholder’s wealth and is useful in ranking and choosing mutually exclusive projects in case of capital rationing.

Ø But PI also suffers from limitations of being complex, requiring computations of required rate of return and estimation of cash flows.

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