# The financial executive compares the present values

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The financial executive compares the present values with the cost of the proposal. If the present value is greater than the net investment, the proposal should be accepted. Conversely, if the present value is smaller than the net investment, the return is less than the cost of financing. Making the investment in this case will cause a financial loss to the firm. There are four methods to judge the profitability of different proposals on the basis of this technique (i) Net Present Value Method This method is also known as Excess Present Value or Net Gain Method. To implement this approach, we simply find the present value of the expected net cash inflows of an investment discounted at the cost of capital and subtract from it the initial cost outlay of the project. If the net present value is positive, the project should be accepted: if negative, it should be rejected. NPV = Total Present value of cash inflows Net Investment If the two projects are mutually exclusive the one with higher net present value should be chosen. The following example will illustrate the process: Assume, the cost of capital after taxes of a firm is 6%. Assume further, that the net cash-inflow (after taxes) on a Rs. 5,000 investment is forecasted as being 2,800 per annum for 2 years. The present value of this stream of net cash-inflow discounted at 6% comes to 5,272 (1,813 x 2800). Therefore, the present value of the cash inflow = 5,272 Less present value of net investment = 5,000 Net Present value = 272 (ii) Internal Rate of Return Method This method is popularly known as time adjusted rate of return method/discounted rate of return method also. The internal rate of return is defined as the interest rate that equates the present value of expected future receipts to the cost of the investment outlay. This internal rate of return is found by trial and error. First we compute the present value of the cash-flows from an investment, using an arbitrarily elected interest rate. Then we compare the present value so obtained with the investment cost. If the present value is higher than the cost figure, we try a higher rate of interest and go through the procedure again. Conversely, if the present value is lower than the cost, lower the interest rate and repeat the process. The interest rate that brings about this equality is defined as

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230 the internal rate of return. This rate of return is compared to the cost of capital and the project having higher difference, if they are mutually exclusive, is adopted and other one is rejected. As the determination of internal rate of return involves a number of attempts to make the present value of earnings equal to the investment, this approach is also called the Trial and Error Method, iii. Profitability Index (PI) Method This method is otherwise called benefit cost ratio method or Desirability Factor. One major disadvantage of the present value method is that it is not easy to rank projects on the basis of net present value particularly when the cost of projects differs significantly. To compare such projects the present value profitability index is prepared. The index establishes relationship between cash-
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• Spring '12
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