This document discusses several concepts in corporate finance including time value of money, payback period, profitability index, net present value, and internal rate of return. It provides examples of calculating payback period and profitability index for two projects. It also explains that net present value and internal rate of return are equivalent methods for evaluating mutually exclusive projects, as both recognize the time value of money and measure costs and benefits in terms of cash flows over the project's lifetime.

1. Corporate
Finance

2. Comment:
Cash flows of different
period in absolute terms
are incomparable.

3. TVM is based on the concept that a rupee
that you have today is worth more than
the promise or expectation that you will
receive a rupee in the future. Money that
you hold today is worth more because
you can invest it and earn interest. After
all, you should receive some
compensation for foregoing spending.

4. For instance, you can invest your rupee
for one year at a 6% annual interest rate
and accumulate RS. 1.06 at the end of
the year. You can say that the future
value of the rupee is Rs.1.06 given a 6%
interest rate and a one-year period. It
follows that the present value of the
Rs.1.06 you expect to receive in one
year is only Re.1.

5. Comment :
Payback period is more a
method of liquidity than
profitability.

6. Payback period is more a method of
liquidity as it is concerned with the
inflow of cash from a project
irrespective of profit or loss from the
project.

7. Example
We will calculate the payback period and and
profitabilty index for both the projects..
Cost of capital is 10%

8. Year Project X Project Y Ccf (x) Ccf(Y)
1 10000 50000 10000 50000
2 20000 40000 30000 90000
3 30000 20000 60000 110000
4 45000 10000 105000
5 60000 10000
Payback period(X) = 3+ (40000/45000)
= 3.88 yrs
Payback period(Y) = 2 + (10000/20000)
= 2.5 yrs

9. Profitability index = present value of cash inflows/
present value of cash outflows
Project X= 116135/100000 = 1.1613
Project Y= 106550/100000= 1.0655

10. Comment:
NPV and IRR method of
capital budgeting are
equivalent methods for
evaluating mutually exclusive
projects.

11.  Under NPV method cashflows are discounted at
a discount rate.
 Under IRR method, a discount rate which makes
NPV of an investment proposal zero is
calculated and compared with cost of capital to
find the acceptability of the project.
 Both recognise time value of money concept.
 Both are consistent with the objective of wealth
maximisation.

12. Both of them measure cost and benefits of
the project in terms of cash flows and
consider all cash flows occurring during the
life of the project.
These methods give similar result only
when projects have conventional cash
flows, when projects are of independent
nature.

13. Example

14. IRR(A) = (10000/30000)100 = 33.33%
IRR(B) = (5000/20000)100 = 25%
Calculation of NPV:
Inflow Discounting
factor
Present
value
Outflow NPV
Project A 40000 0.909 36360 30000 6360
Project B 25000 0.909 22725 20000 2725
In this case we will select project A