The financial executive compares the present values

Info icon This preview shows pages 236–238. Sign up to view the full content.

View Full Document Right Arrow Icon
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
Image of page 236

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
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-
Image of page 237
Image of page 238
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern