Financial management By Sonam nigam Sakshi dhaundiyal
NPV (net present value)• A present value is the value now of a stream of future cash flows, negative or positive. The value of each cash flow needs to be adjusted for risk and the time value of money.• A net present value (NPV) includes all cash flows including initial cash flows such as the cost of purchasing an asset, whereas a present value does not. The simple present value is useful where the negative cash flow is an initial one-off, as when buying a security
net present value (NPV)• Definition• The difference between the present value of the future cash flows from an investment and the amount of investment. Present value of the expected cash flows is computed by discounting them at the required rate of return.
Cash Flow Estimation• Cash flow estimation is a common practice in many businesses where analyzing potential market trends is a required step in planning strategies. Businesses have a number of different areas they can choose to focus on.• There is an element of risk to all of these decisions based on what the business is giving up. Cash flow estimation is a common tool used in risk analysis to help the business judge possibilities from a monetary perspective.• A projects cash flow is its revenue added to the company with its costs subtracted. Before investing in a new project, a company should have a good estimate of its expected revenues. Measuring total costs can be a bit more difficult. Total costs first include all costs of running the project. They should also include the revenues lost from other projects.• For example, if building a new plant means slowing production at another, that cost should be considered. Sunk costs, investments that have already been spent, are not counted in measuring a projects cash flow. Subtracting the total costs of a project from its revenue gives the estimated cash flow.
Payback Period Method• The payback is another method to evaluate an investment project. The payback method focuses on the payback period.• The payback period is the length of time that it takes for a project to recoup its initial cost out of the cash receipts that it generates. This period is some times referred to as" the time that it takes for an investment to pay for itself.“• The basic premise of the payback method is that the more quickly the cost of an investment can be recovered, the more desirable is the investment.• The payback period is expressed in years. When the net annual cash inflow is the same every year, the following formula can be used to calculate the payback period.
• Payback period = Investment required / Net annual cash inflow
Capital budgeting• Capital budgeting (or investment appraisal) is the planning process used to determine whether an organizations long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures.• Many formal methods are used in capital budgeting, including the techniques such as• Accounting rate of return• Net present value• Profitability index
• Internal rate of return• Modified internal rate of return• Equivalent annuity These methods use the incremental cash flows from each potential investment, or project. Techniques based on accounting earnings and accounting rules are sometimes used - though economists consider this to be improper - such as the accounting rate of return, and "return on investment." Simplified and hybrid methods are used as well
Accounting rate of Return• The Accounting rate of Return is found out by dividing the average income after taxed by the average investment, i.e., average net value after depreciation. The accounting rate of return, thus, is an average rate.
• There are two variants of the accounting rate of return• (a) Original Investment Method,• (b) Average Investment Method. Original Investment Method Under this method average annual earnings or profits over the life of the project are divided by the total outlay of capital project, i.e., the original investment. Thus ARR under this method is the ratio between average annual profits and original investment established.
• Average Investment Method: Under average investment method, average annual earnings are divided by the average amount of investment. Average investment is calculated, by dividing the original investment by two or by a figure representing the mid-point between the original outlay and the salvage of the investment. Generally accounting rate of return method is represented by the average investment method.
• The following are the merits of the accounting rate of Return method• (1) It is very simple to understand and use. (2) Rate of return may readily be calculated with the help of accounting data. (3) It takes investments and the total earnings from the project during its life time.
ARR is most often used internally when selecting projects. It can also be used to measure the performance of projects within an organisation. It is rarely used by investors, and should not be used at all, because:• Cash flows are more important to investors, and ARR is based on numbers that include non-cash items.• ARR does not take into account the time value of money — the value of cashflows does not diminish with time .• It does not adjust for the greater risk to longer term forecasts.• There are better alternatives which are not significantly more difficult to calculate.