2.
Net Present Value (NPV)
The cashflows estimated for the project
are in the future; they are not yet
realised
The future is not here yet, but decisions
would have to be taken in the present
time
3.
Net Present Value (NPV)
The question then is, what is the value of
these future estimated cashflows in the
present or current period, or better still
today?
future estimated cashflows would have
to be ‘brought’ to the current or present
period
4.
Net Present Value (NPV)
Bt - Ct
NPV = ∑
t
(1+r)
t=1
T
5.
Net Present Value (NPV)
Bt
Ct
NPV = ∑
-∑
t
t
(1+r) t=1 (1+r)
t=1
T
T
6.
Net Present Value (NPV)
Where :
Bt
is periodic benefit
Ct
is periodic cos t
∑
is the summation sign
7.
Net Present Value (NPV)
Decision Rule:
NPV > 0; project is viable, accept.
NPV < 0; project is not viable, reject.
NPV = 0; project is neither viable nor not
viable
8.
Net Present Value (NPV)
The value of NPV suggests how much a
project is adding in value terms to an
existing entity or how much value the
project is creating.
A positive NPV means that the project is
expected to add value to the firm and will
therefore increase the wealth of the
owners.
9.
Net Present Value (NPV)
Since the goal of projects is to add value
or increase owner’s wealth, NPV is a
direct measure of how well this project
will meet the goal.
NPV has units of currency such as Rs or
US dollars (US$).
10.
Net Present Value (NPV)
Year
0
1
2
3
4
5
6
7
A
-100
30
30
40
20
10
0
0
B
-100
30
30
30
30
30
10
10
11.
Net Present Value (NPV)
Cashflow Analysis for Project A and B
Cashflow
Discount Factor
Year
A
B
(1+0.30)^-t
0
-100
-100
1
30
2
Discounted Cashflow
A
B
1.0000
-100.00
-100.00
30
0.7692
23.08
23.08
30
30
0.5917
17.75
17.75
3
40
30
0.4552
18.21
13.65
4
20
30
0.3501
7.00
10.50
5
10
30
0.2693
2.69
8.08
6
0
10
0.2072
0.00
2.07
7
0
10
0.1594
0.00
1.59
-31.2691
-23.2675
Net Present Value
12.
Net Present Value (NPV)
Advantages
Takes opportunity cost of money into
account.
A single measure, which takes the
amount and timing of cashflows into
account.
With NPV one can consider different
scenarios.
13.
Net Present Value (NPV)
Results are expressed in value terms
units of currency. So one is able to
know the impact the value that the
project would create.
It is based on cashflows, which are
less subjective than profits.
14.
Net Present Value (NPV)
Disadvantages
Complex to calculate and communicate.
Meaning of the result is often misunderstood.
Only comparable between projects if the initial
investment is the same.
15.
Net Present Value (NPV)
It can be difficult to identify an
appropriate discount rate.
Cashflows are usually assumed to occur
at the end of a year, but in practice this
is over simplistic.
16.
Net Benefit Investment Ratio
Investments are required for project
benefits to be realised.
These investments in the project
cashflow can be identified as negatives.
17.
Net Benefit Investment Ratio
The procedure:
discount all the positive cashflows
separately
discount all the negative cashflows
separately.
Sum each of them
The sum of positive discounted cashflows
is divided by sum of negative discounted
cashflows.
18.
Net Benefit Investment Ratio
T
∑B
t =1
NBIR =
t
(1 + i)
t
T
∑K
t =1
t
(1 + i)
where K is sum of negative net benefit or investment
t
19.
Net Benefit Investment Ratio
The decision rule:
NBIR > 1 accept;
NBIR < 1 reject.
20.
Net Benefit Investment Ratio
Cashflow Analysis for Project A and B
Cashflow
Discount Factor
Year
A
B
(1+0.30)^-t
0
1
-100
30
-100
30
2
30
3
Discounted Cashflow
A
B
1.0000
-100.00
-100.00
0.7692
23.08
23.08
30
0.5917
17.75
17.75
40
30
0.4552
18.21
13.65
4
20
30
0.3501
7.00
10.50
5
10
30
0.2693
2.69
8.08
6
0
10
0.2072
0.00
2.07
7
0
10
0.1594
0.00
1.59
Sum of +ves
68.7309
76.7325
Sum of -ves
100.00
100.00
0.687309
0.767325
NBIR
21.
Net Benefit Investment Ratio
NBIR is also referred to as Profitability
Index by the accounting profession.
It is often used for ranking projects
especially if rationing is in place.
22.
Benefit – Cost Ratio (BCR)
A variant of the formula for NPV uses the
subtraction of discounted cash outflow
from discounted cash inflow.
In the case of BCR, the discounted cash
inflow is expressed in terms of the
discounted cash outflow.
23.
Benefit – Cost Ratio (BCR)
T
Bt
∑ +r )t
(1
t
BCR = T
Ct
∑ +r )t
(1
t
24.
Benefit – Cost Ratio (BCR)
This can be viewed as:
how many times the discounted cash
inflow covers the discounted cash outflow
over the project horizon.
25.
Benefit – Cost Ratio (BCR)
Decision criteria
For a single project, a B/C ratio which is
greater than 1 indicates acceptability
For multiple (competing) projects, the
project(s) with the highest B/C ratios
(greater than 1) should receive highest
priority
26.
Benefit – Cost Ratio (BCR)
NPV measures totals, indicates the
amount by which benefits exceed (or do
not exceed) costs.
B/C measures the ratio (or rate) by
which benefits do or do not exceed
costs.
They are clearly similar, but not identical.
With multiple projects, some may do
better under NPV analysis, others under
B/C.
27.
Internal Rate of Return (IRR)
IRR is the rate of return or discount rate
that makes the NPV = 0.
Decision Rule:
Accept the project if the IRR is greater than
the required return
28.
Internal Rate of Return (IRR)
This is the most important alternative to NPV.
It is often used in practice and is intuitively
appealing.
It is based entirely on the estimated cashflows and
is independent of interest rates found elsewhere.
Without a financial calculator, this becomes a trial
and error process.
29.
Internal Rate of Return (IRR)
A critical thing to note is that there
should be at least one change of sign in
order to realise IRR.
there should be a negative net cashflow
among positive net cashflows or a
positive cashflow among negative
cashflows.
The change in sign is crucial.
30.
Internal Rate of Return (IRR)
Using a spreadsheet;
Start with the cashflows.
You first enter your range of cashflows,
beginning with the initial cash outlay
(negative).
31.
Internal Rate of Return (IRR)
Call the IRR function
Choose insert on the menu bar
Select function
Choose IRR from among the list
Select the range of cashflows
Enter a guess rate, but it is not necessary; Excel
will start at 10% as a default
The default format is a whole percent – you will
normally want to increase the decimal places to at
least two to get the most accurate output.
32.
Internal Rate of Return (IRR)
NPV and IRR will generally give us the
same decision.
There are however some exceptions.
Non-conventional cashflows
cashflow
signs change more than once
Mutually exclusive projects
Initial
investments are substantially different
Timing of cashflows is substantially different
33.
Internal Rate of Return (IRR)
When the cashflows change sign more than
once, there is more than one IRR.
When we solve for IRR it would be noticed that
we are solving for the root of an equation and
when we cross the x-axis more than once, there
will be more than one return that solves the
equation.
Therefore, IRR may be unreliable if we have
any negative cashflows after our original
investment.
34.
Internal Rate of Return (IRR)
Suppose an investment will cost ¢90,000
initially and will generate the following
cashflows:
Year 1: 132,000
Year 2: 100,000
Year 3: -150,000
The required return is 15%.
Should we accept or reject the project?
35.
Internal Rate of Return (IRR)
Year 0
-90,000
Year 1
132,000
Year 2
100,000
Year 3
-150,000
IRR
NPV fx 15%
Less inv.
NPV at 15%
10.11%
reject
91,770
-90,000
1,770
IRR says to reject, but NPV says to accept. Go with NPV.
accept
36.
Internal Rate of Return (IRR)
Mutually exclusive projects
If you choose one, you can’t choose the
other
Example: You can choose to attend
graduate school next year at either Legon
or Central, but not both
37.
Internal Rate of Return (IRR)
Intuitively you would use the following
decision rules:
NPV – choose the project with the higher
NPV
IRR – choose the project with the higher
IRR
38.
Internal Rate of Return (IRR)
Period
Project A
Project B
0
-500
-400
1
325
325
2
325
200
IRR
19.43%
22.17%
NPV
64.05
60.74
39.
Internal Rate of Return (IRR)
The required return for both projects is
10%.
Which project should you accept and
why?
(Accept Project A because of NPV)
40.
Internal Rate of Return (IRR)
Conflicts between NPV and IRR
NPV directly measures the increase in value to the
firm.
Whenever there is a conflict between NPV and
another decision rule, you should always use NPV.
IRR is unreliable in the following situations
Non-conventional cashflows
Mutually exclusive projects
41.
Internal Rate of Return (IRR)
Advantages of IRR
It takes into account the time value of money,
which is a good basis for decision-making.
Results are expressed as a simple percentage,
and are more easily understood than some other
methods.
It indicates how sensitive decisions are to a
change in interest rates.
42.
Internal Rate of Return (IRR)
Advantages of IRR
It is a simple way to communicate
the value of a project to someone
who doesn’t know all the estimation
details.
If the IRR is high enough, you may
not need to estimate a required
return, which is often a difficult task.
43.
Internal Rate of Return (IRR)
Disadvantages
For mutually exclusive projects: timing and scale
differences. This may lead to incorrect decisions
in comparisons of mutually exclusive
investments.
Assumes funds are re-invested at a rate
equivalent to the IRR itself, which may be
unrealistically high.
44.
Internal Rate of Return (IRR)
IRR will produce more than one
mathematically correct rate for each year
in which inflows are followed by outflows
and vice versa. This is common with
projects with unconventional cashflows.
This can create some confusion to the
user.
45.
Choice of Discount Rate
Cost of capital - weighted average and marginal
(financing rate)
‘Opportunity cost’ of capital - what could they
earn if that money was elsewhere
Current capital position and expected capital
position over next few years
The rates of return for alternative investments.
Market sentiments.
46.
Sources of discount rate
Banks
Long term government papers
Ministry of Finance
Sponsors
47.
Suggestions
For industrial projects use market rate or
cost of borrowing funds.
For public sector projects use social time
preference rate.
For public projects to be funded from
international loans use the cost of
borrowing.
48.
Suggestions
Generally, in financial analysis, the market rate is
used, whilst the social time preference rate is
used for public sector projects.
When funding comes from various sources or
from the same source but at different rates, then,
compute and use the weighted average.
49.
Choosing Year 0 or Year 1
World Bank
World Bank believes that since investment
is made and some returns may accrue
from the first year, then discounting should
start from 0 to first year.
In this case, the initial year is Year 1.
50.
Choosing Year 0 or Year 1
Others
Other international originations use Year 0.
Their argument is that investment must
take place before benefits accrue.
Thus, discounting should start from the
second year.
Choose any convention but be
consistent.
51.
Deciding on a Project
We should consider several investment
criteria when making decisions.
NPV and IRR are the most commonly
used primary investment criteria.
Payback is a commonly used secondary
investment criteria, but only because of
its ease of use.
52.
Deciding on a Project
For a single project, a positive NPV
indicates acceptability.
For multiple (competing) projects, the
project(s) with the highest NPVs should
receive highest priority.
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