Page 168 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes Logic tells, cash flows of the larger machine are merely a multiple of cash flows of the smaller
machines. To adjust, the size of the cash flows, we can calculate a profitability index, which is the
ratio of the present value of cash inflows to the present value of the cash outflows. Thus,
profitability index

P.V. of cash inflow
(PI) =
P.V. of cash outflow
The higher the PI, the more desirable the project in terms of return per rupees of investment. A
PI of I.O. is the cut-off point for accepting projects and is equivalent to being NPV positive. A PI
of less than 1.0 indicates negative net present value for the project.

Internal Rate of Return (IRR)

Internal rate of return is the interest rate that discounts an investment’s future cash flows to the
present so that the present value of cash inflows exactly equals the present value of the cash
outflows i.e., at that interest rate the net present value equals zero.
The discount rate i.e., cost of capital is considered in determination of the net present value
while in the internal rate of return calculation, the net present value is set equal to zero and the
discount rate which satisfies this condition is determined and is called Internal Rate of Return.
Any investment that yields a rate of return greater than the cost of capital should be accepted
because the project will increase the value of the firm.

Did u know? Unlike, the NPV method, calculating the value of IRR is more difficult. The
procedure depends on whether the cash flows are annuity (equal year wise) or non-
uniform.
The following steps are taken in determining IRR for an annuity (equal cash flows):

1. Determine the payback period of the proposed investment.
2. From the table of Present value of Annuity, look for year that is equal to or closer to the
life of the project.

3. From the year column, find two Present Value or discount factors closest to payback
period, one larger and other smaller than it.
4. From the top row of the table note, the two interest rates corresponding to these Present
values as in (3) above.
5. Determine IRR by interpolation
When cash flows are not uniform, an interest rate cannot be found using annuity tables.

Instead trial and error methods or a computer can be used to find the IRR. If the IRR is computed
manually, the first step is to select an interest rate that seems reasonable (this can be done by
calculating average annual cash flows by the annuity method as mentioned earlier) and then
compute the present value of the individual cash flows using that rate.
If the net present value is positive, then the interest rate used is low, i.e., IRR is higher than the
interest rate selected. A higher interest rate is then chosen and the present value of the cash flows
is computed again. If the new interest rates yield a negative net present value, then a lower
interest rate is to be selected. The process is repeated until the present value of cash inflow is
equal to the present value of the cash outflows. Finding the rate of return using trial and error
methods can be tedious, but a computer can accomplish the task quite easily.

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