The rate at which cash flows are discounted is called the cost of capital. Net Present Value (NPV) The net present value of a project is the sum of the present value of all cash flows associated with the project, i.e. In the case of IRR, the rate is determined by the factors of the project (cash flows and their timing).
The return on future investments will depend on the timing of the investment. The decision rule is that if the present value of the sum of the composite reinvested cash inflows (PVTS) is greater than the present value of cash outflows (PVO), the project should be accepted. With equality, the firm is indifferent to the selection or rejection of the project.
Basic principals for measuring benefits and costs
It makes better sense than the NPV method as the NPV method does not consider cash inflows in terms of interest earnings. The main limitation of this method is that future interest rates are difficult to determine. a) Consider random effects. In addition to the direct cash flows of the project, all the incidental effects it has on the rest of the firm must be considered.
The project may increase the profitability of some lines of existing activities because they complement each other or may reduce the profitability of some lines of existing activities due to competition. If a project uses some resources available within the firm, it should be converted into opportunity costs of these resources even if there are no clear monetary outflows resulting from the use of these resources. So, when a new project is started, it is expected to bear a portion of the total overhead costs, which can hardly bear any relation to the incremental overall cost of the project.
For the purpose of investment appraisal, it is the incremental overhead that matters and not the allocated overhead. iv) Long term fund principal. In capital investment appraisal, the main focus is usually on the profitability of long-term funds. Therefore, cash flows related to long-term funds must be separated. v) Interest exclusion principal Interest on long-term debt must be excluded when calculating profit and tax.
This is because the cost of capital used to assess cash flows reflects the time value of money. Therefore, interest costs, which represent the time costs of debt, should be excluded from the cash flow estimate.
Components of cash flow
Otherwise, double counting will occur. ii) Operating cash flow This cash flow arises from operations of the project and is generally positive. If the investment is measured by long-term funds committed to the project, consisting of equity capital (both equity and preferred) and long-term loans, then the after-tax operating cash flow. Profit after tax + Interest on long-term loans (1- tax rate) + Depreciation + Other non-cash costs.
In this expression, interest on long-term loans is added after adjustment for the tax factor, as we are considering return targets after tax. Profit before tax on long-term loans (1- tax rate) + Depreciation + Other non-cash costs such as. Terminal cash flows These cash flows are a result of winding down the operations of the projects and are generally positive.
Assuming that the measure of investment is long-term funds committed to the project, the terminal cash flow is given by. Net salvage value of fixed assets: Usually the sale price of fixed assets is higher than the depreciated book value at the time of sale. If a loss is incurred on the sale, then the net salvage value of fixed assets is equal to.
Net recovery of working capital margin Working capital is normally expected to be liquidated at face value. Accordingly, no profit or gain is expected from its liquidation and net recovery of working capital margin is equated to working capital margin provided at inception.
Depreciation of fixed assets
Methods of depreciation
Degressive method; and (iv) the sum-of-the-years number method. i) Straight line method (SL method). This method is based on the assumption that the asset will provide the same level of service throughout its useful life and therefore an equal amount should be charged as the cost over the estimated life of the asset. With this method, depreciation is based on the estimated production capacity of the asset in question.
This method results in decreasing periodic depreciation expense over the estimated life of the asset. This method depreciates each year by applying a percentage to the net cost of the asset at the beginning of that year. This rate is applied to the original cost of the asset during the first year and then to the net book value over the estimated life of the asset.
Both the declining balance method and the sum-of-the-years figure method provide for a higher depreciation charge in the first year of the asset's use and a gradually decreasing periodic charge thereafter. But overall depreciation charged and the overall profit will be the same at the end of the project. The remaining useful life of the equipment is 5 years after which it will have no salvage value.
Salvage value of old equipment after 5 years 0 Book value of old equipment after 5 years 53,144. The trade credit level will remain at Rs. 36 ALL and will be paid in full at the end of the project.
IRR and return on invested capital
The outstanding balance at any time t during the life of the project is given by the expression A clean investment is one for which the uncovered investment balance is either zero or negative throughout the life of the project, i.e. it is the life of the project. A pure investment is one from which the firm does not borrow at any point during the life of the investment, but fully recovers its investment at the end of the project.
Thus, the internal rate of return in the case of a pure investment is the return earned on the money invested by the company in the project. ii) Mixed investments. For project C, the unrecovered balance is negative at the beginning, positive at the end of the first year, and zero at the end of the project. If the return attributed to the funds borrowed from the project is the same as the interest on the funds borrowed from the project, the return can be considered internal to the project.
This is generally not the case, and generally the rate of interest on the funds loaned to the project is different from the rate of return attributed to the funds borrowed from the project. Thus, in the case of a mixed investment, the rate of return cannot be considered internal to the project. Define r* as the return on capital invested and k as the cost of funds borrowed from the project.
When the unreturned balance from the project is negative (i.e. the firm has funds committed to the project) it is compounded to r*;. When the balance not covered by the project is positive (i.e. the firm has overdrawn funds from the project) it is compounded in k. Thus, the irreversible balance is a function of r* and k. Since the life of the project is n years, so
Conflict between NPV and IRR methods
The exclusivity of projects can be for two reasons. i) Technical exclusivity Technical exclusivity refers to a situation where the alternatives to be considered have different returns and the most profitable alternative must be chosen. The reason for the conflict The reason for the conflict lies in the fact that the NPV method assumed that intermediate cash (in)flows are reinvested at a rate equal to the cost of capital, which is a fairly reasonable assumption that provides a minimum opportunity rate on intermediate capital. currents. However, the IRR method assumes that interim flows are reinvested at a rate equal to the project's IRR.
According to this approach, in the case of mutually exclusive projects with different costs, if the IRR of both projects exceeds a predetermined required rate, calculate the IRR at the difference in the costs of the two projects. Since the incremental IRR (15.24%) is more than the cost of capital (10%), project A should be chosen, for which the decision was also made using the NPV method. Sol: To calculate the annual capital charge, we first calculate the present value of the cash flows associated with the two projects.
If the projects under consideration are indivisible, what should be the decision of the firm. Project Initial outlay (Rs.) Present value of the cash flow occurring from the project (Rs.). NPV of this combination is equal to the NPV of the projects + NPV of the unused sum which can be calculated as follows.
If an equipment costs Rs. 5,00,000 and last for eight years, what should be the minimum annual cash inflow before it is worth buying the equipment. A new machine can be bought for Rs. 3,00,000 which would have an expected working life of 10 years and salvage value Rs. The chip can be manufactured by the firm, for which the firm has to purchase a machine at a cost of Rs. 4,00,000 and the expected life of the machine is 5 years after which it will have no salvage value.
The life of the machines will be six years, after which they will cost Rs. B).
