Page 134 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 6: Capital Budgeting

Notes
Example: JP Company wants to buy a machine with a cost of 33,522 and annual cash
savings of 10,000 for each of 5 years. JP Company's cost of capital is 12%. With uniform cash
flows, the present value (PV) is computed using the present value of and annuity of 5 payments
of 10,000 each at 12%, the NPV is calculated as follows:
PV of Cash inflows = 10,000 × 3,605 (PV 1 - 5 years @ 12%) 36,050
Less: Present Value of Cash outflows 33,522
Net present value of the project 2,528
Since NPV is positive, the project is acceptable since the net value of earnings exceeds by 2,528
the amount paid for the use of the funds to finance the investment.
The net present value relies on the time value of money and the timings of cash flows in
evaluating projects. All cash flows are discounted at the cost of capital and NPV assumes that all
cash inflows from projects are reinvested at the cost of capital.
As a decision criterion, this method can be used to make a choice between mutually exclusive
projects. The project with the highest NPV would be assigned the first rank, followed by others
in the descending order.

Merits

1. It recognises the time value of money.
2. The whole stream of cash flows throughout the project life is considered.
3. A changing discount rate can be built into the NPV calculations by altering the denominator.
4. NPV can be seen as the addition to the wealth of shareholders. The criterion of NPV is,
thus, in conformity with basic financial objectives.
5. This method is useful for selection of mutually exclusive projects.

6. An NPV uses the discounted cash flows i.e., expresses cash flows in terms of current
rupees. The NPV's of different projects therefore, can be added/compared. This is called
the value additive principle, implying that NPV's of separate projects can be added. It
implies that each project can be evaluated independent of others on its own merit.

Limitations

1. It is difficult to calculate as well as understand and use in comparison with the payback
method or even the ARR method.
2. The calculation of discount rate presents serious problems. In fact, there is difference of
opinion even regarding the exact method of calculating it.
3. PV method is an absolute measure. Prima facie between the two projects, this method will
favour the project, which has Higher Present Value (or NPV). But it is likely that this
project may also involve a larger initial outlay. Thus, in case of projects involving different
outlays, the present value method may not give dependable results.
4. This method may not give satisfactory results in case of projects having different effective
lives.

Desirability Factor/Profitability Index (PI)

NPV of a project is a function of the discount rate, the timings of the cash flow and the size of the
cash flows. Other things being equal, large investment proposals yield larger net present values.

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