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# New Approach to NPV

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Time Varying NPV

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### New Approach to NPV

1. 1. Capital Budgeting Decision Rules <ul><li>Net Present Value (NPV) </li></ul>
2. 2. Different Capital Budgeting Decision Rules <ul><li>Payback Period </li></ul><ul><li>Average on investment Return Method </li></ul><ul><li>Discounted Payback Period </li></ul><ul><li>Net Present Value (NPV) </li></ul><ul><li>Internal Rate of Return (IRR) </li></ul><ul><li>Modified Internal Rate of Return (MIRR) </li></ul><ul><li>Profitability Index </li></ul><ul><li>Cost Benefit Ratio </li></ul>
3. 3. Net Present Value (NPV) <ul><li>Definition </li></ul><ul><li>The Net Present Value (NPV) of a project is the sum of the present values of all the cash flows – positive as well as negative – that are expected to occur over the life of the project. </li></ul><ul><li>Where, </li></ul><ul><li>C t = Cash Flow for t th Period </li></ul><ul><li>t = Period instance of Project Life </li></ul><ul><li>r = Cost of Capital </li></ul><ul><li>n = Life of the Project </li></ul>
4. 4. Properties of NPV Rule <ul><li>NPV are Additive </li></ul><ul><ul><li>NPV (A + B) = NPV (A) + NPV (B) </li></ul></ul><ul><ul><li>Value of a Firm = NPV (Present Projects) + NPV (Future Projects) </li></ul></ul><ul><li>Intermediate Cash Flows are Invested at Cost of Capital </li></ul><ul><ul><li>The NPV rule assumes that the intermediate cash flows of a project – that is, cash flows that occur between the initiation and the termination of the project – are invested at a rate of return equal to the cost of capital </li></ul></ul><ul><li>NPV Calculation Permits Time Varying Discount Rates </li></ul>
5. 5. Discount rate Change with Time <ul><li>The discount rate may change over time for the following reasons: </li></ul><ul><ul><li>The level of the interest rates change over time and hence sheds light on expected rates in future. </li></ul></ul><ul><ul><li>The risk characteristics of the project may change over time resulting change in cost of capital. </li></ul></ul><ul><ul><li>The financing mix of the project may vary over time causing change in cost of capital. </li></ul></ul>
6. 6. NPV using Time Varying Discount Rates Where, C t = Cash flow at the end of each period r j = One period discount rate applicable to period j (r 0 = 0) n = Life of the project α t = Certainty of Cash flow in percentage Risk Less Approach Certainty Equivalent Approach
7. 7. NPV using Time Varying Discount Rates <ul><li>These methods seeks to address a concern of predicting real returns and applying this predictability in the investment decision-making process. </li></ul><ul><li>There are major problems in Valuation </li></ul><ul><ul><li>the market risk premium must be estimated, </li></ul></ul><ul><ul><li>an appropriate risk-free rate must be chosen, and </li></ul></ul><ul><ul><li>the beta of the project or company must be determined. </li></ul></ul><ul><ul><li>All three of these inputs into are not constant. </li></ul></ul>
8. 8. NPV using Time Varying Discount Rates <ul><li>These methods forecast the future cost of capital using trend analysis and probability on basis of expectancy of sure cash flow. </li></ul><ul><li>These models can be further intervened for valuation of overseas by accounting the exchange rate exposure and global inflation. </li></ul>
9. 9. Limitations of NPV <ul><li>NPV is expressed in absolute terms rather relative terms and hence it does not give any picture of extent or scale of investment and what to choose, e.g. </li></ul><ul><ul><li>Project A; NPV 5,000,000; Investment 50,000,000 </li></ul></ul><ul><ul><li>Project B; NPV 2,500,000; Investment 10,000,000 </li></ul></ul><ul><li>NPV rule does not consider the life of project as a measure of decision. Hence for mutually exclusive projects with different lives the rule becomes biased. </li></ul>