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1 N P V P r o file
D is c o u n t
2 C a s h F lo w r a te NPV
3 -2 0 0 0 0 0% 1 2 ,5 8 0
IR
4 5430 5% 7 ,5 6 1
R
5 5430 10% 3 ,6 4 9
7 5430 16% 0
8 5430 20% ( 1 ,9 4 2 )
9 5430 25% ( 3 ,9 7 4 )
F ig u r e 8 .1 N P V P r o f ile
Evaluation of IRR Method
Merits of this method are as under:
• Recognizes the time value of money.
• Considers all CFs occurring over the entire life
of the project to calculate its of return.
• Gives the same acceptance rule as the NPV
method.
• Consistent with the objective of maximizing
shareholders’ wealth. Whenever a project’s IRR
is greater than the OCC, the wealth will be
enhanced.
• Like the NPV method, the IRR method is
also theoretically a sound investment
evaluation criterion.
• However, IRR rule can give misleading and
inconsistent results under certain
circumstances.
• Also, properly stated, the two criteria are
formally equivalent, the IRR rule contains
several pitfalls.
• The problems that IRR rule may suffer from
is mentioned in the subsequent slides.
Profitability Index
• Profitability index is the ratio of the present
value of cash inflows, at the required rate of
return, to the initial cash outflow of the
investment.
• The initial cash outlay of a project is Rs
100,000 and it can generate cash inflow of Rs
40,000, Rs 30,000, Rs 50,000 and Rs 20,000
in year 1 through 4. Assume a 10 per cent rate
of discount. The PV of cash inflows at 10 per
cent discount rate is:
PV Rs 40,000(PVF 1, 0.10) + Rs 30,000(PVF 2, 0.10) + Rs 50,000(PVF 3, 0.10) + Rs 20,000(PVF 4, 0.10)
= Rs 40,000 0.909 + Rs 30,000 0.826 + Rs 50,000 0.751 + Rs 20,000 0.68
NPV Rs 112,350 Rs 100,000 = Rs 12,350
Rs 1,12,350
PI 1.1235 .
Rs 1,00,000
The project with positive NPV will have PI greater than one.
PI less than means that the project’s NPV is negative.
Evaluation of PI Method
• It recognises the time value of money.
• It is consistent with the shareholder value
maximisation principle. A project with PI greater
than one will have positive NPV and if accepted, it
will increase shareholders’ wealth.
• In the PI method, since the present value of cash
inflows is divided by the initial cash outflow, it is a
relative measure of a project’s profitability.
• Like NPV method, PI criterion also requires
calculation of cash flows and estimate of the
discount rate. In practice, estimation of cash flows
and discount rate pose problems.
Payback Method
• Payback is the number of years required to
recover the original cash outlay invested in a
project.
• If the project generates constant annual cash
inflows, the payback period can be computed
by dividing cash outlay by the annual cash
inflow. That is:
Initial Investment C0
Payback = =
Annual Cash Inflow C
Assume that a project requires an outlay of Rs
50,000 and yields annual cash inflow of Rs
12,500 for 7 years. The payback period for the
project is:
Rs 50,000
PB = = 4 years
Rs 12,000