MEASURES OF FINANCIAL

EFFECTIVENESS

1
 Measures of financial
effectiveness
 The investment and financing plans show the
core of what an engineering organizations or
others do. They raise the funds to invest in
projects. They also raise capital, which are
the financing activities, and they allocate that
capital, which are the investment activities.
The analysis, planning and evaluation of
these opportunities are intimately tied to the
company’s strategic objectives. The
investment and financing decisions are at the
top of the hierarchy, and contain significant
strategic content. Investment decision
precedes the financing decision. They are
long-term, have significant cost and risk, and
set the course for the business for some
years to come.

2
 Measures of financial
effectiveness
Investment means to put money in
any endeavor for additional income. It
seems to be fascinating to many
engineers or individuals because
through investment their involvement
in taking decisions is possible.
Engineers can practice decision
making and thus they can judge their
ability of taking correct decisions by
analysing these results. We know
that the financial decision makers in
households and firms all have to
evaluate whether investing money
today is justified by the expected
benefits in the future.
3
 Time Value of Money
Which would you prefer --
$10,000 today or $10,000 in
5 years?

Of course, $10,000 today.

You already recognize that

there is
TIME VALUE TO MONEY!

4
 Time Value of Money (TYM)
The preceding example focus
on two concepts
1. Money is preferred now
then later
2. There may be a mechanism
to adjust for time differences

Finally, time value of money

simply refers to the fact that
$1 today has more value then
$1 at some future time.

5
 BASIC TERMINOLOGY IN TYM

1) Present value (PV) - This is your current starting amount. It is the

money you have in your hand at the present time, your initial
investment for your future.
2) Future value (FV) - This is your ending amount at a point in time in
the future. It should be worth more than the present value, provided it is
earning interest and growing over time.
3) The number of periods (N or n) - This is the timeline for your
investment (or debts). It is usually measured in years, but it could be
any scale of time such as quarterly, monthly, or even daily.
4) Interest rate (I) - This is the growth rate of your money over the
lifetime of the investment. It is stated in a percentage value, such as
8% or .08.
5) Payment amount (PMT) - These are a series of equal, evenly-
spaced cash flows.

6
 BASIC TERMINOLOGY
6) Cash Flows: Initial Cash Outlay - amount of capital spent to get
project going. If spend $10 million to build new plant then the Initial
Outlay (IO) = $10 million
7) Net Present Value: Present Value of all costs and benefits of a
project.
8) Payback Period: Number of years needed to recover your initial
outlay.
9) Internal Rate of Return (IRR): Measures the rate of return that will
make the PV of future CF equal to the initial outlay. The IRR is that
discount rate at which NPV = 0
10) Profitability Index (PI): Very Similar to Net Present Value. Instead
of Subtracting the Initial Outlay from the PV of Inflows, the Profitability
Index is the ratio of Initial Outlay to the PV of Inflows.

7
 BASIC TERMINOLOGY
11) Payback Period: Number of years needed to recover your initial
outlay.

12) Internal Rate of Return (IRR): Measures the rate of return that will
make the PV of future CF equal to the initial outlay. The IRR is that
discount rate at which NPV = 0.

13) Profitability Index (PI): Very Similar to Net Present Value. Instead
of Subtracting the Initial Outlay from the PV of Inflows, the Profitability
Index is the ratio of Initial Outlay to the PV of Inflows.
The number of time periods between the present value and the future
value is represented by ‘t’ or ‘n’.The rate of interest for discounting or
compounding is called ‘r’ or ‘i’. All time value questions involve four
values: PV, FV, n and i.
8
 Present value (PV)
Present value (PV) is the
current value of future
cash flows of an
investment. (for present
value you always
discount)
We know that
FV= PV (1+i)^n……………..1
Or PV=
FV/(1+i)^n…………….2
9
 Significance of PV
The present value (PV) is the current
value of a payment that will be
received in the future. Discounting is
the process of determining the
present value of a payment from a
known future payment, or future
value. This is the reverse of
determining the future value of a
payment, because in this case, we
already know the future value. It is
found by dividing the future value by
the same interest factor, (1 + r)n,
used to determine future value.
10
 Example-1: Present value?
Suppose engineers are depositing an amount today in an account that
ears 5 % interest annually. If engineers goals is to have $ 5,000 in the
account at the end of six years, how much they deposit in the account
today?
Data:
FV= $ 5,000, interest rate = 5%, years = n = 6
Solution
We know that
FV= PV (1+i)^n……………..1
Or PV= FV/(1+i)^n…………….2
Putting the values in equation (2)
PV= 5000/ (1+0.05)^6
PV= $3,331 …………ANSWER

11
 Example-2: Present value?
Suppose Engineers are to receive $ 100 at
the end of two years. How do they calculate
the present value of amount, assuming the
interest rate is 8% per year compounded
annually.
Solution:
PV= FV/(1+i)^n…………….1
PV= 100/(1+0.08)^2
PV = $ 85.73……..Answer
12
 Example-3: Present value?
Suppose Engineers need $1,000 in 2 years. Let’s
examine the process to determine how much they
need to deposit today at a discount rate of 7%
compounded annually.

Solution:
PV = FV / (1+i)2
= 1,000 / (1.07)2
= $873.44…….Answer

13
 Example-4: Present value?
Your rich grandmother promises to give you
$10000 in 10 years’ time. If interest rates are 12%
per annum, how much is that gift worth today?

Solution:
PV = $10 000 (1+ 0.12)^-10
PV = $10 000 * 0.321973
PV= $3 219.73……Answer

14
 Example-5: Present value?
If engineers wish to accumulate $140,000 in 13
years, how much must they deposit today in an
account that pays an annual interest rate of 14%?
Data:
n = 13
i = 14%
FV = 140000
Solution:
PV = $25,489.71……Answer

15
 Example-6: Present value?
Mr. Engineer wants to know how large of a
deposit to make so that the money will grow
to $10,000 in 5 years at a discount rate of
10%.
Solution:
PV = FV / (1+i)n
PV = $10,000 / ( 1+ 0.10)5
PV = $6,209.21…….Answer
16
 Example-7: Present value?
(Quarterly)
What is the PV of receiving a single amount of $ 5000 at
the end of 3 years, if the time value of money is 8% per
year compounded quarterly.
Data:
FV= $ 5000, PV?,
i= 8% = 8/4 = 2
n= 3*4 (3-years & 4-quarters) = n = 12
Solution:
PV= FV/(1+i)^n…………….a
PV= 5000/(1+0.02)^12
PV= $ 3,942.45…….Answer
17
 Example-8: Present value?
(Semiannually)
What is the PV of receiving a single amount of $ 10,000 at
the end of 5- years, if the time value of money is 6%,
compounded semiannually.
Data:
FV=$ 10,000, i =6% = 6/2 = 3%
n= (5*2) (5-years & 2-semiannually)
Solution:
PV= FV/(1+i)^n…………….a
PV = 10000/(1+0.03)^10
PV= $ 7,440.90…….Answer

18
 Example-9: Present value?
Engineers need to calculate the PV of
receiving a single amount of $1,000 in 20
years. The interest rate for discounting the
amount is estimated at 10 % per year
compounded annually.
Solution:
PV= FV/(1+i)^n…………….a
PV = 1000/(1+0.10)^20
PV = $ 148.64….Answer
19
 Future value (FV)
Future value (FV) is
the amount an
investment is worth
after one or more
periods. (for future
value you always
compound)

20
 Significance of Future value?
Future value is the value of an asset at a specific
date. It measures the nominal future sum of money
that a given sum of money is "worth" at a specified
time in the future assuming a certain interest rate,
or more generally, rate of return; it is the present
value multiplied by the accumulation function. The
value does not include corrections for inflation or
other factors that affect the true value of money in
the future. This is used in time value of money
calculations.

21
 Example-1: Future value?
Mr. Engineer wants to know how large his
deposit of $10,000 today will become at a
compound annual interest rate of 10% for 5
years.
Solution:
We know that
FV = PV (1+i)n
FV = $10,000 (1+ 0.10)5
FV = $16,105.10..Answer
22
 Example-2: Future value?
Find the future value of $100 in 5 years at
5%.
Solution:
We know that
FV= PV (1+i)^n……………..1

The answer is: $127.63

23
 Example-3: Future value?
Find the future value of $500 in 6 years at
9%.
Solution:
We know that
FV= PV (1+i)^n……………..1
The answer is: $838.55

24
 Example-4: Future value?
Find the future value of $1,800 in 3 years at
8%.
Solution:
We know that
FV= PV (1+i)^n……………..1
The answer is: $2,267.48

25
 Example-5: Future value?
Mr. Engineer has just bought a scratch lottery ticket and won €10,000.
He wants to finance the future study of his newly born daughter and
invests this money in a fund with a maturity of 18 years offering a
promising yearly return of 6%. What is the amount available on the 18th
birthday of his daughter? Calculate future value.
Data
PV = €10,000
i = 6%
n = 18 years
Solution :
FV = €10,000 * 1.0618
FV = €10,000 * 2.854339
FV = €28,543.39 ………Answer

26
 Example-6: Future value?
Invest $100 now at 5%. How much will
engineers have after a year?
Solution
FV = $100 × (1+0.05)
= $100 × (1.05)
= $105…..Answer

27
 Example-7: Future value?
What will $247,000 grow to be in 9 years if it is invested
today in an account with an annual interest rate
of 11%?
Data:
n=9
i = 11
PV = 247000
Solution:
FV= $631,835.12.....Answer

28
 Example-8: Future value?
Suppose engineers are depositing an $,5000 today in an
amount that ears 5% interest, compounded annually. What
will be the balanced in the account at the end of 6- years if
they make no withdrawals?
Data:
PV= $5000, n= 6, i=5%
Solution:
We know that
FV= PV (1+i)^n……………..1
= 5000 (1+0.05)^6
= $ 6,701.47………..Answer
29
 Example-9: Future value? (annually &
quarterly )
What is the balanced in an account at the end of
10 years if $ 2500 is deposited today by engineers
and the account ears 4% interest, compounded
annually & quarterly.
Solution:……..for annually
We know that
FV= PV (1+i)^n……………..1
=2,500 (1+0.04)^10
=3,700.61…..Answer

30
 Continue
Solution:……..for quarterly
=10 years*4 quarter =40 =n
=1+1+1+1= 4 quarter (means every quarter has 1
% interest rate)
We know that
FV= PV (1+i)^n……………..a
= 2500 (1+0.01)^40
= 3,722.1……Answer

31
 Example-10: Future value?
If engineers deposit $ 10 in an account that pays
5% interest , compounded annually. How much will
they have at the end of 10 years? 50 years? 100
years?
Solution:
FV = $ 16.28…when n= 10 years…Answer
FV = $ 114.67…when n= 50 years…Answer
FV = $ 1315.01…when n= 100 years…Answer

32
 Example-11: Future value?
(semiannually)
How much will be in an account at the end of 5 years, the amount
deposited by engineers today is $10,000 and interest rate is 8% per
year compounded semiannually?
Solution:
Here we have semiannually case so:
= 5*2 (5- years and 2 quarters)= 10 = n
= 8/2 = 4% = i
We know that
FV= PV (1+i)^n……………..a
FV= 10,000 (1+ 0.04)^10
FV= 14,802.44….Answer

33
 Profitability Index
The profitability index (PI) is the present
value of future cash flows divided by the
initial cost.
FORMULA:
Profitability Index = 1 + Net Present Value/
Initial Investment

Profitability Index = (Net Present Value+

Initial Investment/ Initial Investment)

Profitability Index = (Present value future

cash fllows/ Initial Investment)
OR
Profitability Index = (Present value inflows /
present value outflow)

34
 Measurement of PI
Profitability index (PI), also known as profit
investment ratio (PIR) and value investment
ratio (VIR), is the ratio of payoff to
investment of a proposed project.
Conditions:
If PI > 1……….so project would be accepted
If PI < 1……….so project would be rejected
If PI = 1……….so project would be on
breakeven
35
 Understanding the PI
 The profitability index is an appraisal technique applied
to potential capital outlays. When using the profitability
index to compare the desirability of projects, it's essential
to consider how the technique disregards project size.
Therefore, projects with larger cash inflows may result in
lower profitability index calculations because their profit
margins are not as high. Because profitability index
calculations cannot be negative, they consequently must
be converted to positive figures before they are deemed
useful. Calculations greater than 1.0 indicate the future
anticipated discounted cash inflows of the project are
greater than the anticipated discounted cash outflows.

36
 Interpreting the PI
 Calculations less than 1.0 indicate the deficit of the
outflows is greater than the discounted inflows, and the
project should not be accepted. Calculations that equal
1.0 bring about situations of indifference where any
gains or losses from a project are minimal. When using
the profitability index exclusively, calculations greater
than 1.0 are ranked based on the highest calculation.
When limited capital is available, and projects are
mutually exclusive, the project with the highest
profitability index is to be accepted as it indicates the
project with the most productive use of limited capital.

37
 Interpreting the PI
 Profitability index is also called the benefit-
cost ratio for this reason. Although some
projects result in higher net present
values, those projects may be passed over
because they do not have the highest
profitability index and do not represent the
most beneficial usage of company assets.

38
 Application of PI

 The profitability index is often used to rank a firm's

investments and/or projects alongside others. For the
sake of maximizing limited financial resources and profits
for shareholders, investors naturally want to spend
money on projects with high short-term growth potential.
When there are a multitude of investment projects
available, would-be investors can use the profitability
index (alongside other formulas) to rank the projects
from high to low before deciding which is the best
opportunity.

39
 Example-1 of PI?
Example: an engineering firm invested $20,000 for a
project and expected NPV of that project is $5,000.
Solution:
We know that

Profitability Index = (20,000 + 5,000) / 20,000

= 1.25…Answer
Results: That means a company should perform
the investment project because profitability index is greater
than 1.

40
 Example-2 of PI
Engineering company has $100
million available for investment in the Initial
Project NPV
following potential investment Investment
opportunities. Rank the projects A
$5
$15 million
million
based on profitability and identify the
$15
projects that should be accepted B
million
$50 million
keeping in view the company’s
$10
capital budget constraints. C
million
$10 million

Solution: D
$20
$60 million
million
Profitability Index = 1 + Net Present $12
E $35 million
Value/ Initial Investment million

41
 Continue
Let’s first find profitability
indices of each project: Project Profitability Index
The ranking based on
profitability index is: A 1 + 5/15 = 1.33
Project C, Project E,
Project A and D and B 1 + 15/50 = 1.30
Project B. Now, Engineers
C 1 + 10/10 = 2.00
need to maximize total
net present value that can D 1 + 20/60 = 1.33
be achieved using $100
million investment by E 1 + 12/35 = 1.34
applying the concept of
capital rationing capital
rationing. 42
 Example-3 of PI?
An engineering firm Enterprise has decided to invest in a
project for which the initial investment would be $100
million. As it is considering whether it’s a good deal to
invest in, it has found out that the present value of the
future cash flow of this project is 130 million. Is it a good
project to invest in in the first place? Calculate Profitability
Index to prove that.
Solution:
PI = Present Value of Future Cash Flow / Initial Investment
PI = US $130 million / US $100 million
PI = 1.3…Answer

43
 What is Discounted Cash Flow Valuation?

Discounted cash flow analysis is method of

analyzing the present value of company or
investment or cash flow by adjusting future cash
flows to the time value of money where this
analysis assesses the present fair value of assets
or projects/company by taking into effect many
factors like inflation, risk and cost of capital and
analyze the company’s performance in future.

44
 Example-4 of PI?
Let’s say that engineering company invests in a new
project. Their initial investment is US $10000.
Condition required:
Engineers need to calculate the Profitability Index and find
out whether this project is worthy of their investment or not.
So, they can find out the present value of future cash flows
in two ways. Firstly, they can compute by adding up all the
present values of future cash flows and secondly, the
relatively easier way is to find out the discounted cash flow
each year. So, the engineers will take the second approach
and add another column to the above statement, and that
would be of discounted cash flows
45
 continue
SOLUTION
ABC COMPANY
Now, engineers may wonder how they
got these figures under the head Year Cash flow (US $) Discounted
discounted cash flows. They simply Cash flow
took separate present values of future (US $)
cash flows. For example, in the first
year, the future cash flow is $4000,
0 -10,000 -
the cost of capital is 10% and the
1 4000 3636.36
number of the year is 1. So the
2 4000 3305.78
calculation would be like this –
3 4000 3005.26
4 2000 1366.02
PV = FV / (1+i) ^1
5 2000 1241.84
PV = 4000 / (1+0.1) ^1 Total (PV of cash flows) 12555.26
PV = 4000 / 1.1
PV = 3636.36…. Answer 46
 continue
We found out all of the above-discounted cash flows by
using the same method. Only the cost of capital changed
due to the increase in the number of years.
We know that PI formula:
PI Formula = PV of Future Cash Flows / Initial Investment
Here we have:
PV of cash flows: $12555.26
Initial investment: $10,000
PI=12555.26/10,000
= 1.26….Answer
Result: PI is greater than 1 it means project is accepted.
47
 Example-5 of PI?
Let’s taken an example to understand how
profitability index is calculated. Assume that Year Cash Flow Discounte
a company invests $5,000 in a project, d Cash
which generates the following cash flow in Flows
the next 5 years. The firm has a cost of
capital of 10%. Column 3 presents the 0 -5000
discounted cash flows. 1 2000 1818.18
Solution: 2 2,000.00 1652.89
Initial Investment = $5000 3 2,000.00 1502.63
PI = 6277.64/5000 4 1,000.00 683.01
= 1.25….. Answer 5 1,000.00 620.92
Result: Total (PV of cash 6277.64
flows)
Since PI > 1, the project can be accepted.

48
 PAYBACK PERIOD

 The number of years

required to recover a
project’s cost.

 orhow long does it

take to get the
business’s money
back?
49
Explanations of Payback Period
formula
The formula to calculate the payback period
of an investment depends on whether the
periodic cash inflows from the project are
even or uneven.
For even cash flows:
Payback period=PB = Initial investment
outlay/annual cash inflows

50
Explanations of Payback Period
formula
For Uneven cash flows:
When cash inflows are uneven, we need to calculate the
cumulative net cash flow for each period and then use the
following formula:

PB= (No, of years before full recovery of original investment) +

(uncovered cost at start of full –recovery year) / (total cash flow during
full-recovery year)

PB = A + B/C

51
Explanations of Payback Period
formula
Where,
 A is the last period number with a negative cumulative cash flow;
 B is the absolute value (i.e. value without negative sign) of
cumulative net cash flow at the end of the period A; and
 C is the total cash inflow during the period following period A.

Cumulative net cash flow is the sum of inflows to date, minus the
initial outflow.

52
53
Significance of Payback period?
 The payback period is an effective measure of
investment risk. The project with a shortest payback
period has less risk than with the project with longer
payback period. The payback period is often used when
liquidity is an important criteria to choose a project.

 The shortest payback period is generally considered to

be the most acceptable. This is a particularly good rule
to follow when a company is deciding between one or
more projects or investments. The reason being, the
longer the money is tied up, the less opportunity there is
to invest it elsewhere.
54
 Payback period?

 Decision rule in payback period

 Advantages of payback period

 Disadvantages of payback period

55
 Example-1 of PB?
Consider engineering project with an initial investment of $
500,000 and an expected cash inflow of $ 100,000 per year
for 10 years. Find payback period.
Solution:
Payback period = Initial investment outlay/annual cash
inflows
Payback period = 500,000 / 100,000
Payback period = 5 years………Answer
Result:
Thus, in 5 years, the initial investment is recovered.

56
 Example-2 of PB?
A firm may decide to invest in an asset with an initial cost of $1 million.
The opening and closing period cumulative cash flows are $900,000
and $1,200,000, respectively. This is because, as we noted, the initial
investment is recouped somewhere between periods 2 and 3.
Solution:
We know that
Payback period = initial investment-opening cumulative cash flows /
closing cumulative cash flows - opening cumulative cash flows
= 100000-900,000/1,200,000-900,000
= 0.33
= 2.33 years …..Answer
Result:
As such, the payback period for this project is 2.33 years. The decision
rule using the payback period is to minimize the time taken for the
return of investment.
57
 Example-3 of PB? (Even cash flows)

Company C is planning to undertake a project requiring

initial investment of $105 million. The project is expected to
generate $25 million per year in net cash flows for 7 years.
Calculate the payback period of the project.

Solution

Payback Period = Initial Investment / Annual Cash Flow

= $105M / $25M
= 4.2 years….Answer

58
 Example-4 of PB? (Uneven cash flows)

Company X is planning to undertake

another project requiring initial (cash flows in millions)
investment of $50 million and is Year Annual Cumulative
expected to generate $10 million net Cash Flow Cash Flow
cash flow in Year 1, $13 million in
Year 2, $16 million in year 3, $19 0 (50) (50)
million in Year 4 and $22 million in
Year 5. Calculate the payback value 1 10 (40)
of the project. 2 13 (27)
Solution:
3 16 (11)
Payback Period = 3 + 11/19
= 3 + 0.58 4 19 8
= 3.6 years…..Answer
5 22 30

59
 Example-5 of PB?
Jimmy’s Jackets, based out of Cleveland, produces high quality down filled
jackets for the winter season. They are extremely popular and Jimmy wants to
expand his operation to include spring wear too. To do so, he will need a
special machine that can exclusively manufacture this new wear.
Solution:
The machine costs $720,000.
It is predicted that the machine will generate $120,000 in net cash flow every
year.
we know that
Payback Period = Investment/Annual Net Cash Flow
Payback Period = $720,000/$120,000
=6 years…….Answer
Result:
Jimmy learns from this that it will take him 6 years to recoup his initial
investment. That may be too long for Jimmy to tie up his money, and maybe
he’d rather spend the money on other resources.
60
 Example-6 of PB?

0 1 2 2.4 3

CFt -100 10 60 80
Cumulative -100 -90 -30 0 50

PaybackL = 2 + $30/$80 = 2.375 years

61
 Example-7 of PB?

0 1 1.6 2 3

CFt -100 70 50 20

Cumulative -100 -30 0 20 40

PaybackS = 1 + $30/$50 = 1.6 years

62
 Example-8 of PB? (Uneven cash flows)

Company X is planning to undertake

another project requiring initial (cash flows in millions)
investment of $ 50,000 and is Year Cumulative
Net Cash
expected to generate the net cash Flow
Net Cash
flow during the years which have Flow
explained in the table. Calculate the 0 (50,000) (50,000)
payback value of the project.
Solution: 1 10,000 (40,000)

Payback Period = 2 + 10,000/40,000 2 30,000 (10,000)

= 2.25…Answer
3 40,000 30,000
OR
= 2 years and 3 months…..Answer 4 40,000 ?

5 30,000 ?

63
NET PRESENT VALUE (NPV)

64
 Net Present value (NPV)
NPV is the difference between
the present value of cash inflows
and the present value of cash
outflows over a period of time.
(NPV = PVinflows - PVoutflows)
It is an indicator of how much
value an investment or project
adds to the firm.
It also measures the excess or
shortfall of cash flows, in present
value terms, once financing
charges are met.
65
 Measurement of Net Present Value
(NPV)

CF1 CF2 CFN

NPV = + + ··· + − Initial cost
(1 + r )1 (1 + r)2 (1 + r)N

66
 Acceptance Rules of NPV
If answer is +ve, so project is accepted.
If answer is -ve, so project is rejected.
If answer is zero, so project is on
breakeven/ no profit no loss.
Managers increase shareholders’ wealth by
accepting all projects that are worth more
than they cost.
Therefore, they should accept all projects
with a positive net present value

67
 Net Present Value?

 Significance of NPV

 Advantages of NPV

 Disadvantages of NPV

68
 NPV when cash flows are
even?
When net cash flows are even, i.e. when all net cash flows
are equal: so we will use the following formula

NPV = R ×1 − (1 + i)^-n / i - Initial Investment

Here :
 R is the net cash inflow expected to be received in each
period;
 i is the required rate of return per period (i.e. the hurdle
rate, discount rate);
 n are the number of periods during which the project is
expected to operate and generate cash inflows.

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Example-1 of NPV when cash flows are
even?
Calculate the net present value of a project which requires an initial investment of
$243,000 and it is expected to generate a net cash flow of $50,000 each month for 12
months. Assume that the salvage value of the project is zero. The target rate of return
is 12% per annum.
Solution:
We have, Initial Investment = $243,000, Net Cash Inflow per Period = $50,000, Number
of Periods = 12, Discount Rate per Period = 12% ÷ 12 = 1%

NPV = R ×1 − (1 + i)^-n / i - Initial Investment

Net Present Value
= $50,000 × (1 − (1 + 1%)^-12) ÷ 1% − $243,000
= $50,000 × (1 − 1.01^-12) ÷ 0.01 − $243,000
= $50,000 × (1 − 0.887449) ÷ 0.01 − $243,000
= $50,000 × 0.112551 ÷ 0.01 − $243,000
= $50,000 × 11.2551 − $243,000
= $562,754 − $243,000
= $319,754…..Answer………Result: Project is accepted
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 Example-2 of NPV?

Suppose that project A cost $ 2,500 now and

is expected to generate year-end cash
inflows of $ 900, 800, 700, 600 and 500 in
year 1 through 5 respectively. The
discount rate may be assumed to be 10 %.
Solution:
NPV= 900/ (1+0.10)^1 + 800/ (1+0.10)^2 + 700/ (1+0.10)^3
+ 600/ (1+0.10)^4 + 500/ (1+0.10)^5 – 2,500
= $ 225……..Answer ….
So project is ?
 Example-3 of NPV?
 Suppose we can invest $50 today and
receive $60 in one year. What is our
increase in value given a 10% expected
return?
Solution:
NPV = -50 + 60/1.10
= $4.55…Answer
So, projet is ?
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 Example-4 of NPV?
If the cost of any project is = - $ 200,000 and
the Market value (Present value future
cash flow) = $ 201,036
Solution
The difference between the market value
and its cost = value added.
NPV = 201,036 – 200,000
= $ 1,036….Answer
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 Example-5 of NPV?
Suppose Company A is comparing two projects to invest
in. The discount rate for both projects is 10%.

Solution: for Project 1:

Initial investment: $10,000, Discount rate: 10%
Year 1: $5,000
Year 2: $15,000
Year 3: $9,000
Year 4: $18,000

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 Continue
Let’s calculate the present values for each year of the project:

Year 1: 5,000/(1 + .10)^1 = $4,545

Year 2: 15,000/(1 + .10)^2 = $12,397
Year 3: 9,000/(1 + .10)^3 = $6,762
Year 4: 18,000/(1 + .10)^4 = $12,294
so we know that
NPV = PVinflows - PVoutflows
NPV = ($4,545 + $12,397 + $6,762 + $12,294) - $10,000
NPV = $25,998…..project-1

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 Continue
Project 2
Initial investment: $5,000, Discount rate: 10%
Year 1: $8,000 , Year 2: $16,000
so calculate the present values for each year of the project-2:

Year 1: 8,000/(1 + .10)^1 = $7,273

Year 2: 16,000/(1 + .10)^2 = $13,223
We know that
NPV = PVinflows - PVoutflows
NPV = ($7,273 + $13,223) - $5,000
NPV = $15,496…….project-2
Result:
The NPV for Project 1 is $25,998 which is higher than the NPV of Project 2
which is $15,496. Company A would definitely invest in project-1

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 Example-6 of NPV?
You have the opportunity to purchase an office building. You have a
tenant lined up that will generate $16,000 per year in cash flows for
three years. At the end of three years you anticipate selling the
building for $450,000. If the building is being offered for sale at a
price of $350,000, would you buy the building?
Discount rate: 7%

Solution

NPV= 16000/ (1.07)^1 + 16000/ (1.07)^2 + 466,000/ (1.07)^3 –

350,000
= $ 59,323….Answer
So, project would be accepted.

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 Example-7 of NPV?
Suppose a company is planning to invest $ 9,000 in a
project today. The project is expected to have a life of 4
years. The expected cash flows at the end of each of the
next 4 years are $ 2000, 3000, 3000 and 4000. The
discount rate is 10%.
Solution
NPV = 2000/ (1.1)^1 + 3000/ (1.1)^2 + 3000/ (1.1)^3 +
4000/ (1.1)^4 – 9000
NPV = $ 283.51…Answer
Project is accepted

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 Example-8 of NPV?
Suppose company X wants to
expand its business and so it is
willing to invest $ 10,00,000.
The investment is said to bring COMPANY-X
an inflow of Rs. 100,000 in Year Flow Present Computation
first year, 250,000 in the value
second year, 350,000 in third
year, 265,000 in fourth year 0 -1000000 -1000000 -
and 415,000 in fifth year.
Assuming the discount rate to 1 100000 91743 100000/(1.09)
be 9%.
2 250000 210419 250000/(1.09)^2
Solution:
3 350000 270264 350000/(1.09)^3
NPV is Rs. 29881….Answer
Result : 4 265000 187732 265000/(1.09)^4
Since the NPV is positive the
investment is profitable and 5 415000 269721 415000/(1.09)^5
company X can go ahead with
the expansion.
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 Example-9 of NPV?
Solve the example
Discount rate: 20%

Year 0 1 2 3 4 5

Cash flow -1000 120 280 360 600 800

NPV: $113.63….Answer
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INTERNAL RATE OF RETURN
(IRR)
IRR is the discount rate
that makes NPV of a project
zero. In other words, it is
the expected compound
annual rate of return that
will be earned on a project
or investment.

Internal Rate of Return

Used For?
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IRR Formula

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 Internal Rate of Return: IRR

0 1 2 3

CF0 CF1 CF2 CF3

Cost Inflows

IRR is the discount rate that forces

PV inflows = PV costs. Same
as i that creates NPV= 0.
::i.e., project’s breakeven interest rate.
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 Advantages of IRR
 Finds the Time Value of Money

 Simple to Use and Understand

 Hurdle /discount rate Not Required

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 Disadvantages of IRR
The IRR ignores the followings:

 Size of Project

 Future Costs

 Reinvestment Rates

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 Conclusion
 The Role of finance professionals are changing. There is
an expectation for finance organisations to take on a
broader role in terms of providing management
information and analysis and become more influential in
how the organisation is managed. In forward-looking
organisations, finance is evolving from a focus on
transactions and cost efficiency to a broader focus that
covers decision support and strategy. How finance takes
on this broader role in serving the business in the future
has implications for the types of skills needed and the
development of those skills.

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THANK YOU

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