Capital Budgeting Decisions By Heena Malhotra

Payback Period Traditional or Non Discounting ccounting Rat of Return (ARR) Capital Budgeting Techniques Net Present Value (NPV) Profitability Index (PI) Time adjusted or Discounted Cash Flows Internal Rate of Return (IRR) Modified Internal Rate of Return (MIRR) Discounted Payback By Heena Malhotra

NPV PVC1 - PVCo By Heena Malhotra

Decision Rule: If NPV 20LAccept the Proposal If NPV s0 Reject the Proposal The NPV method can be used to select between mutually exclusive projects, the one with the higher NPV should be selected By Heena Malhotra

ABC Ltd is a small company that is currently analyzing capital expenditure proposals for the purchase of equipment; the company uses the net present value technique to evaluate projects. The capital budget is limited to 500,000 which ABC Ltd believes is the maximum capital it can raise. The initial investment and projected net cash flows for each project are shown below. The cost of capital of ABC Ltd is 12%. You are required to compute the NPV of the different projects. Project A Project B Project C Project D 200,000 190,000 250,000 210,000 Initial Investment Project Cash Inflows Year 1 50,000 40,000 75,00075,000 75,000 60,000 40,000 20,000 50,00050,000 50,000 50,000 50,000 75,000 60,000 80,000 75,000 100,000 2 70,000 75,000 4 5 By Heena Malhotra

SOLUTION Calculation of net present value: Period PV factor Project A Project B Project C Project D 0.893 0.797 0.712 0.636 0.567 1.000 (2,00,000) (1,90,000) (2,50,000) (2,10,000) 35,720 39,850 49,840 47,700 42,525 25,635 44,650 39,850 35,600 31,800 28,350 (19,750) 66,975 59,775 42,720 42,720 50,880 56,700 27,050 3.750 66,975 59,775 25,440 11,340 4 Net Present Value By Heena Malhotra

Advantages of NPV O NPV method takes into account the time value of money. O The whole stream of cash flows is considered o It focus on the long term objectives. O The NPV uses the discounted cash flows The NPVs of different projects therefore can be compared. It implies that each project can be evaluated independent of others on its own merit. By Heena Malhotra

Limitations of NPV It involves difficult calculations. The application of this method necessitates forecasting cash flows and the discount rate. Thus accuracy of NPV depends on accurate estimation of these two factors which may be quite difficult in practice. The decision under NPV method is based on absolute measure. It ignores the difference in initial outflows, size of different proposals etc. while evaluating mutually exclusive projects By Heena Malhotra

SOLUTION Calculation of net present value: Period PV factor Project A Project B Project C Project D 0.893 0.797 0.712 0.636 0.567 1.000 (2,00,000) (1,90,000) (2,50,000) (2,10,000) 35,720 39,850 49,840 47,700 42,525 25,635 44,650 39,850 35,600 31,800 28,350 (19,750) 66,975 59,775 42,720 42,720 50,880 56,700 27,050 3.750 66,975 59,775 25,440 11,340 4 Net Present Value By Heena Malhotra

Present value interest factor of 1 per period at i% for n periods, PVIF(i,n). 0.980 0.97 0.962 0.952 0.943 0.935 0.926 0.917 0.909 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 0.942 0.915 0.889 0.924 0.888 0.855 0.9060.8630.822 0.784 07470.7130.681 0.650 0.621 0.888 0.837 0.790 0.7 0.990 2 0.980 3 0.971 4 0.961 5 0.951 6 0.942 7 0.933 0.871 0.813 0.760 0.711 0.665 .623 0.583 0.547 0.513 8 0.923 9 0.864 0.823 0.840 0.816 0.794 0.772 0.751 0.792 0.763 0.735 0.708 0.683 46 0.705 0.666 0.630 0.596 0.564 0.853 0.789 0.731770.627 0.582 0540 0.502 0.467 0.837 0.766 0.703 0.914 0.592 0.5440.500 0.460 0.424 0.558 0.508 0.463 0422 820 0.744 0.676 0.614 0.804 0.722 0.650 0.5 0.788 0.701 0.625 0.5570.497 0.4440.397 0.356 0.319 0.773 0.681 0.601 0.758 0.661 0.577 0.50 0.743 0642 0.555 0481 0417 0.362 0.315 0.275 0.239 0.728 0.623 0.534 0.714 0.605 0.513 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180 0.896 120.887 13 0.879 14 0.870 85 0.527 0.475 0.429 0.388 0.350 0.530 0.469 0.415 0.368 0.326 0.290 0.442 0.388 0.340 0.299 0.263 16 0.853 17 0.844 18 0.836 0.458 0.436 0.394 0.339 0.292 0.252 0.218 0.371 0.317 0.270 0.231 0.198

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