FINANCIAL MANAGEMENT ( PART-2 ) NET PRESENT VALUE 1. INTRODUCTION Dear students, welcome to the lecture series on financial management. Today in this lecture, we shall learn the techniques of evaluation of capital budgeting proposals. These techniques will be based on discounted cash flows or it is also known as time adjusted rate of return. We shall cover the topics net present value, profitability index, internal rate of return and their comparisons. The objective of this lecture is to understand various techniques employed to evaluate an investment proposal. We shall discuss each of this techniques based on time adjusted rate of return with its utility, advantages and disadvantages. 2. MEANING OF NET PRESENT VALUE Now students, we will learn what is net present value? Net present value method is the classic economic method of evaluating any investment proposal. It is a discounting cash flow technique which postulates or which recognizes the time value of money, it postulates different cash flows arising in different periods, differ in value and are comparable only when they are equivalent that is present value are found out, now what are the steps involved in analyzing net present technique.
First one is cash flow, cash flows are determine on the basis of certain realistic assumptions, Now these forecasted cash flows can be of three types, First initial incremental cash flows, Second interim incremental cash flows, Third, terminal cash flows.
What is initial incremental cash flow? It is the expenditure which we need to incur if we are going into a project, that means initial cost of investment, for example, we need to buy a machinery, so the cost of acquisition of machinery, any carriage inward related to it or any other installation expenses shall form the cost of that machine and it will be our initial cash outflow. If any additional working capital is required, that too will form part of initial cash out flow. In case of replacement of an asset, we need to sell it and need to buy a new one; in that case, any salvage value which we are receiving from selling that old asset shall be subtracted from the cost of investment or cost of new machine. So this comprises our initial incremental cash flow.
Second is interim incremental cash flow. What are these cash flows? They are accruing when a number of period have gone by, means after initial investment, in subsequent years, we are receiving these inflows. They are revenues which we can earn from installing a machine, they come year by year, so they are called in between or interim cash flows. Now comes terminal cash flows. Terminal cash flow means when a project comes to an end, what we are receiving or what we are giving back, so the examples of such terminal cash flows is in case of new machinery, if its life is 10 years, at the end of 10 th year, if I am going to sell these machinery, whatever selling amount as a salvage value of that old machine I am receiving is my terminal cash inflow. Similarly if I am recovering of working capital back which has not been used in the project or what has been left out, this will also form terminal cash inflows part so now first thing is clear, what are cash flows that are needed for a NPV technique. One thing should be kept in mind that these cash flows will be cash flows after tax but before depreciation and other amortization because we need to add back depreciations and amortization as they are not cash expenses. So now we will learn another factor which is involved in NPV technique and that is called discounting rate. Discounting rate is nothing but the opportunity cost of capital. What is opportunity cost of capital? It is the minimum expectation of share holder, which means whatever minimum rate of return, a investor expect from a firm to earn is called cost of capital and that will be used for discounting the cash flows arising from a project. Third is present value of cash inflows. Since our cash outflow is in zero period, we have to find out equivalents of inflows arising in subsequent year, for that we will use a technique called discounting of cash flows for which there is a formula.
What is the formula for discounting the cash flows? C/(1+R) and the exponent to the (1+ R) will be N, that is number of years, this way we shall compute the present value of cash flows and finally we will find out net present value, its formula is Present value of cash inflows - cost of investment or we can say Present value of cash inflow- present value of cash outflows. Both the terms should be in the present value, with this we have learned the factors which are involved into the NPV technique.
3. MERITS OF NPV TECHNIQUES Students, now we will evaluate this technique which we have learned for evaluating a capital budgeting proposal, that means all the merits and demerits of net present value method needs to be understood. So what are the merits of net present value method?
Firstly it takes into account time value of money, we all know that a rupee receive today is worth more than it is received tomorrow. So the most important part is that it takes into account present value that is equivalent of present rupee is ascertained in this method. Second is overall profitability of the project can be ascertained. How it takes into considerations overall profitability, it considers all the cash flows arising in a project to evaluate the profitability of the project, so the project holds the net present value is higher, we will accept that project, in that way it will enhance the share holders worth value of firm because more profitable projects will be accepted the better will be are avenues for generating profits. The third important merit of the system is it enhances share holders wealth; this is the virtue of this technique that it works on maximization of share holder s wealth.
How share holders wealth is maximized? If he takes as I have already explained that it works on profitability, so the value of firm increases by accepting profitable projects which in turn increases the market price of share and if market price of share is increased, it will automatically increase the wealth of share holders.
4. DEMERITS OF NPV TECHNIQUES Now what are the demerits of this system? Are there some limitations using NPV technique? Theoretically there cannot be but in practice, there are certain problems related to computation of NPV techniques like cash flows, they are based on estimations, if rationally they are not computed, they may give wrong results, so we have to be quite rational. First one is cash flows, cash flow estimation is based on probabilistic technique, it is easy to calculate NPV if cash flows forecasted are known to us, but what is the problem that these forecasted cash flows should be properly and rationally computed. If they are taken arbitrarily, it may give wrong results,
Second one is discount rate, it is difficult to precisely measure the discount rate, so there may be variation in the calculation or it may be subject to some error. Third one is mutually exclusive projects, further cautions needs to be applied in using NPV technique where projects are mutually exclusive because there may be certain projects which have different outflows and different time periods that is project life may be different, their initial investment will be different so the NPV criteria may give some ambiguous results, in that case, we have to take help of other techniques also, so these are the demerits of NPV method.
5. ILLUSTRATION TO UNDERSTAND COMPUTATION OF NET PRESENT VALUE Now we will learn how to calculate net present value with an example. For the sake of convenience, I am taking the same figures as we have learned in our previous lecture for calculating present value. So first is cost of investment, it will be 100. Then cash inflows which I am receiving from this project having a project life of five year will be, first year 40, second year 30, third year 30, fourth year 20 and fifth year 15.
Now we have to ascertain discounting factors which we all know that can be ascertained by using the formula 1/(1+R)ⁿ, so here the discounting rate will be 10 %, so discount factors will be 1/1.1 first will give me 0.909 and 0.826.,0.753, 0.683 and lastly for 5 th year, 0.621. Alternatively you can see the PV tables which are given in all the text books. There you have to find out the rate and parallel to it, there will be years. So for first year, discounting factor would have been mentioned over there subsequently for all the years, they have already calculated these factors, so you just need to take up the factors and place it in front of cash flows. So I have done this work, you can see this example on the screen, its 40 X 0.909, in this way, the entire cash flows will be multiplied with their respective discounting factors, we are getting present value for first year 36, second year 24, third year its 23, fourth year 17 and fifth year 9.
Adding them all, I am getting present value of cash inflows which is amounting to Rs 109 and we know our cost of investment was 100 Rs. so net present value is 109 100. I have used the formula, present value of cash inflows - present value of cash out flows. So my NPV is coming as 9 which is a positive NPV. Now what to do? Let s learn the decision criteria s, for accepting a proposal based on NPV, what we need to look at is NPV is positive or not, In case NPV is positive, that means cash inflows are exceeding cash out flows, we will accept the proposal.
In case it is negative, that means present value of all the cash inflows arising over the project life are less than initial cost of capital, we will reject the proposal because it s not going to be profitable for the firm. In this proposal, we are going to accept it as it s giving me a positive NPV. 6. DECISION BASED ON NPV TECHNIQUE Now let s take up question were we need to apply this technique for taking the decision. We can see the question on the screen, you have the opportunity to purchase an office building. You have a tenant lined up that will generate Rs. 60,000 per year in cash flow for three years. At the end of three years, you anticipate selling the building for Rs. 4,50,000. Assume cost of capital as 7 %, how much would you be willing to pay for the building. This question is saying that you have a building option to purchase, you are going to purchase a building is his giving a rent because you have a tenant tied up their so he will give you a rent of 16,000 for first year, 16,000 for second year and 16,000 for third year. So this 16,000 for first to three year are called interim incremental cash flows and at the end of third year, the selling price of the building, that means the service value which you will receive by selling this building
will be 4,50,000, so this is terminal cash flow. So in the third year, what you will be getting is 16,000 plus 4,50,000, that is 4,66,000. Now there is one more part in this question, it s says that if the building is being offered for sale, at a price of 3,50,000, would you buy the building or not? Let s see the solution, you can see this slide,
here for the first year a discount 16,000 using the formula, so my formula is what was the formula? It was C/(1 + R)ⁿ, so for the first year, n will be 1, 16000/(1.07), it will give me 14,953. So 16000 present values will be 14953. For second year, 16000 will be divided by 1.07 and again 1.07 because exponent is two years or you can use the discounting factors directly, so it will give me present value of 16,000 for second year as 13975. For third year, we have to discount 4,66,000 or you can say that 4,66,000/(1.07)³, 3 times you have to divide 4,66,000 by 1.07, so the value will be 3,80,395. Adding this all, we are getting Rs. 4,09,323, this is the amount we are ready to pay for this building. Now they are selling it to us for 3,50,000 Rs., so my initial incremental outflow or cost of this building will be 3,50,000, I need to subtract 4,09,323 from 3,50,000. It will give me a positive NPV which will amount to 59,323. It is a profitable investment, so we will go for it. Hopefully the way of calculating is clear with this example. Students now we shall summarize this lecture what we have learned today. Firstly we have learned the meaning of net present value that is it means PV of cash inflows minus PV of cash outflows. Then its merits, that it takes into consideration time value of money and profitability, it measures share holders wealth also and its demerits that cash flows are based on estimations, discounting rate is difficult to ascertain and in case of mutually exclusive project is difficult to find out the results. Then we have learned it s method of computation and an example. With this, we are concluding this lecture, thank you.