Page 133 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes Merits: This method is quite simple and popular because it is easy to understand and includes
income from the project throughout its life.

Limitations

1. This method ignores the timing of cash flows, the duration of cash flows and the time
value of money.

2. It is based upon a crude average of profits of the future years. It ignores the effect of
fluctuations in profits from year to year.

Conclusion

The traditional techniques of appraising capital investment decision have two major drawbacks:
1. They do not consider total benefits throughout the life of the project and
2. Timing of cash inflows is not considered.
Hence, two essential ingredients of a theoretically sound appraisal method are that:

1. It should be based on total cash stream through the project life and
2. It should consider the time value of money of cash flows in each period of a projects life.

Did u know? The discounted cash flows techniques also known as time adjusted techniques
satisfy these requirements and provide a more objective basis for selecting and evaluating
investment projects.

6.3.2 Discounted Cash Flow Methods

Discounted cash flow refers to the fact that all projected cash inflows and outflows for a capital
budgeting project are discounted to their present value using an approximate interest rate.
Three discounted cash flow methods are generally used in capital budgeting. One is called Net
Present Value Method (NPV); the other is called Profitability Index or Desirability factor and the
third Internal Rate of Return (lRR). All the three methods focus on the timing of cash flows over
the entire life of the project. The spotlight is on the cash flows as opposed to accounting measures
of revenue and expense.
All discounted cash flow methods are based on the time value of money, which means that an
amount of money received now is worth more than an equal amount of money received in
future. Money in hand can be invested to earn a return.
To simplify the process of evaluating proposals using discounted cash flows, the assumption is
often made that cash flow or cash savings from a project occur at the end of accounting period
since the results are not materially different from mere precise calculations.

Net Present Value (NPV)

Under this method, all cash inflows and outflow are discounted at a minimum acceptable rate of
return, usually the firm's cost of capital. If the present value of the cash inflows is greater than
the present value of the cash outflows, the project is acceptable i.e., NPV > 0, accept and
NPV < 0, reject. In other words, a positive NPV means the project earns a rate of return higher
than the firm's cost of capital.

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