Interest Rate (Already covered before 1st term exam)

Interest rate is a percentage measure of interest, the cost of money, which accumulates to
the lender. The interest is either paid through periodic payments, for example in case of
bonds, or accumulated over the period of loan/investment such that it is paid at the maturity
date together with principal amount of loan/investment, for example in case of certificates of
deposit, etc. Other investment structures such as annuities are also based on interest. They
either represent (a) a single value today i.e. a present value that grows at an interest rate
while allowing equal cash flows after equal interval or (b) a stream of equal cash flows that
grow to a certain value to a single value in future i.e. the future value.

Time Value of Money (TVM)

Time value of money is the concept that the value of a dollar to be received in future is less
than the value of a dollar on hand today. One reason is that money received today can be
invested thus generating more money. Another reason is that when a person opts to receive
a sum of money in future rather than today, he is effectively lending the money and there are
risks involved in lending such as default risk and inflation. Default risk arises when the
borrower does not pay the money back to the lender. Inflation is the rise in general level of
prices.
Time value of money principle also applies when comparing the worth of money to be received
in future and the worth of money to be received in further future. In other words, TVM
principle says that the value of given sum of money to be received on a particular date is
more than same sum of money to be received on a later date.
Few of the basic terms used in time value of money calculations are:

Present Value
When a future payment or series of payments are discounted at the given rate of interest up
to the present date to reflect the time value of money, the resulting value is called present
value.

Future Value
Future value is amount that is obtained by enhancing the value of a present payment or a
series of payments at the given rate of interest to reflect the time value of money.

Interest
Interest is charge against use of money paid by the borrower to the lender in addition to the
actual money lent.
Application of Time Value of Money Principle
There are many applications of time value of money principle. For example, we can use it to
compare the worth of cash flows occurring at different times in future, to find the present
worth of a series of payments to be received periodically in future, to find the required amount
of current investment that must be made at a given interest rate to generate a required future
cash flow, etc.

1. Future Value of a Single Sum of Money

Future value of a present single sum of money is the amount that will be obtained in future if
the present single sum of money is invested on a given date at the given rate of interest. The
future value is the sum of present value and the compound interest.

Formula
The future value of a single sum of money is calculated by using the following formula.
Future Value (FV) = Present Value (PV) × (1 + i) n
Where,
i is the interest rate per compounding period; and
n are the number of compounding periods.

Example 1: An amount of $10,000 was invested on Jan 1, 2011 at annual interest rate of
8%. Calculate the value of the investment on Dec 31, 2013. Compounding is done on quarterly
basis.
Solution
We have,
Present Value PV = $10,000
Compounding Periods n = 3 × 4 = 12
Interest Rate i = 8%/4 = 2%
Future Value FV = $10,000 × ( 1 + 2% )^12
= $10,000 × 1.02^12≈ $10,000 × 1.268242
≈ $12,682.42
Example 2: An amount of $25,000 was invested on Jan 1, 2010 at annual interest rate of
10.8% compounded on quarterly basis. On Jan 1, 2011 the terms or the agreement were
changed such that compounding was to be done twice a month from Jan 1, 2011. The interest
rate remained the same. Calculate the total value of investment on Dec 31, 2011.
Solution
The problem can be easily solved in two steps:
STEP 1: Jan 1 - Dec 31, 2010
Present Value PV1 = $25,000
Compounding Periods n = 4
Interest Rate i = 10.8%/4 = 2.7%
Future Value FV1 = $25,000 × (1 + 2.7%) ^4
= $25,000 × 1.027^4
≈ $25,000 × 1.112453
≈ $27,811.33
STEP 1: Jan 1 - Dec 31, 2011
Present Value PV2 = FV1 = $27,811.33
Compounding Periods n = 2 × 12 = 24
Interest Rate i = 10.8%/24 = 0.45%
Future Value FV2 = $27,811.33 × ( 1 + 0.45% )^24
= $27,811.33 × 1.0045^24
≈ $27,811.33 × 1.113778
≈ $30.975.64

2. Future Value of an Annuity

The future value of an annuity is the value of its periodic payments each enhanced at a specific
rate of interest for given number of periods to reflect the time value of money. In other words,
future value of an annuity is equal to the sum of face value of periodic annuity payments and
the total compound interest earned on all periodic payments till the future value point.

Formula

There are two types of annuity. The one in which payments occur at the end of each period
is called ordinary annuity and the other in which payments occur at the beginning of each
period is called annuity due. Both types have different formulas for future value calculation:

(1 + i)n − 1
FV of Ordinary Annuity = R ×
i
(1 + i) − 1
n
FV of Annuity Due = R× × (1 + i)
i
In the above formulas,
i is the interest rate per compounding period;
n are the number of compounding periods; and
R is the fixed periodic payment.

Example 1: Mr A deposited $700 at the end of each month of calendar year 2010 in an
investment account of 9% annual interest rate. Calculate the future value of the annuity on
Dec 31, 2011. Compounding is done on monthly basis.
Solution
We have,
Periodic Payment R = $700
Number of Periods n = 12
Interest Rate i = 9%/12 = 0.75%
Future Value PV = $700 × {(1+0.75%)^12-1}/1%
= $700 × {1.0075^12-1}/0.01
≈ $700 × (1.0938069-1)/0.01
≈ $700 × 0.0938069/0.01
≈ $700 × 9.38069
≈ $6,566.48
Example 2: Calculate the future value of 12 monthly deposits of $1,000 if each payment is
made on the first day of the month and the interest rate per month is 1.1%. Also calculate
the total interest earned on the deposits if the whole amount is withdrawn on the last day of
12th month.
Solution
Periodic Payment R = $1,000
Number of Periods n = 12
Interest Rate i = 1.1%
Future Value = $1,000 × {(1+1.1%)^12-1}/1.1% × (1+1.1%)
= $1,000 × {1.011^12-1}/0.011 × (1+0.011)
= $1,000 × (1.140286-1)/0.011 × 1.011
≈ $1,000 × 0.140286/0.011 × 1.011
≈ $1,000 × 12.75329059 × 1.011≈ $12,893.58
Interest Earned ≈ $12,893.58 - $1,000 × 12≈ $893.58

3. Present Value of a Single Sum of Money

Present value of a future single sum of money is the value that is obtained when the future
value is discounted at a specific given rate of interest. In the other words present value of a
single sum of money is the amount that, if invested on a given date at a specific rate of
interest, will equate the sum of the amount invested and the compound interest earned on
its investment with the face value of the future single sum of money.

Formula
The formula to calculate present value of a future single sum of money is:

Future Value (FV)

Present Value (PV) =
(1 + i)n
Where,
i is the interest rate per compounding period which equals the annual percentage
rate divided by the number compounding periods in one year; and
n is the number of compounding periods.
1/(1+i)n is called the present value factor.

Examples
Example 1: Calculate the present value on Jan 1, 2011 of $1,500 to be received on Dec 31,
2011. The market interest rate is 9%. Compounding is done on monthly basis.
Solution
We have,
Future Value FV = $1,500
Compounding Periods n = 12
Interest Rate i = 9%/12 = 0.75%
Present Value PV = $1,500 / ( 1 + 0.75% )^12
= $1,500 / 1.0075^12
≈ $1,500 / 1.093807
≈ $1,371.36
Example 2: A friend of you has won a prize of $10,000 to be paid exactly after 2 years. On
the same day, he was offered $8,000 as a consideration for his agreement to sell the right to
receive the prize. The market interest rate is 12% and the interest is compounded on monthly
basis. Help him by determining whether the offer should be accepted or not.
Solution
Here you will compute the present value of the prize and compare it with the amount offered
to your friend. It will be good to accept the offer if the present value of the prize is less than
the amount offered.
So,
Future Value FV = $10,000
Compounding Periods n = 2 × 12 = 24
Interest Rate i = 12%/12 = 1%
Present Value PV = $10,000 / ( 1 + 1% )^24
= $10,000 / 1.01^24
≈ $10,000 / 1.269735
≈ $7,875.66
Since the present value of the prize is less than the amount offered, it is good to accept the
offer.

4. Present Value of an Annuity

An annuity is a series of evenly-spaced equal payments made for a certain amount of time.
There are two basic types of annuity known as ordinary annuity and annuity due. Ordinary
annuity is one in which periodic payments are made at the end of each period. Annuity due
is the one in which periodic payments are made at the beginning of each period.
The present value an annuity is the sum of the periodic payments each discounted at the
given rate of interest to reflect the time value of money. Alternatively defined, the present
value of an annuity is the amount which if invested at the start of first period at the given
rate of interest will equate the sum of the amount invested and the compound interest earned
on the investment with the product of number of the periodic payments and the face value of
each payment.

Formula
Although the present value (PV) of an annuity can be calculated by discounting each periodic
payment separately to the starting point and then adding up all the discounted figures,
however, it is more convenient to use the 'one step' formulas given below.

1 − (1 + i)-n
PV of an Ordinary Annuity = R ×
i
1 − (1 + i)-n
PV of an Annuity Due = R × × (1 + i)
i
Where,
i is the interest rate per compounding period;
n are the number of compounding periods; and
R is the fixed periodic payment.
Examples
Example 1: Calculate the present value on Jan 1, 2011 of an annuity of $500 paid at the end
of each month of the calendar year 2011. The annual interest rate is 12%.
Solution
We have,
Periodic Payment R = $500
Number of Periods n = 12
Interest Rate i = 12%/12 = 1%
Present Value PV = $500 × (1-(1+1%)^(-12))/1%
= $500 × (1-1.01^-12)/1%
≈ $500 × (1-0.88745)/1%
≈ $500 × 0.11255/1%
≈ $500 × 11.255
≈ $5,627.54
Example 2: A certain amount was invested on Jan 1, 2010 such that it generated a periodic
payment of $1,000 at the beginning of each month of the calendar year 2010. The interest
rate on the investment was 13.2%. Calculate the original investment and the interest earned.
Solution
Periodic Payment R = $1,000
Number of Periods n = 12
Interest Rate i = 13.2%/12 = 1.1%
Original Investment = PV of annuity due on Jan 1, 2010
= $1,000 × (1-(1+1.1%)^(-12))/1.1% × (1+1.1%)
= $1,000 × (1-1.011^-12)/0.011 × 1.011
≈ $1,000 × (1-0.876973)/0.011 × 1.011
≈ $1,000 × 0.123027/0.011 × 1.011
≈ $1,000 × 11.184289 × 1.011
≈ $11,307.32
Interest Earned ≈ $1,000 × 12 − $11,307.32
≈ $692.68
 Capital Budgeting
Capital budgeting (or investment appraisal) is the process of determining the viability to long-
term investments on purchase or replacement of property plant and equipment, new product
line or other projects.
Capital budgeting consists of various techniques used by managers such as:
1. Payback Period
2. Discounted Payback Period
3. Net Present Value
4. Accounting Rate of Return
5. Internal Rate of Return
6. Profitability Index
All of the above techniques are based on the comparison of cash inflows and outflow of a
project however they are substantially different in their approach.
A brief introduction to the above methods is given below:
 Payback Period measures the time in which the initial cash flow is returned by the project.
Cash flows are not discounted. Lower payback period is preferred.
 Net Present Value (NPV) is equal to initial cash outflow less sum of discounted cash inflows.
Higher NPV is preferred and an investment is only viable if its NPV is positive.
 Accounting Rate of Return (ARR) is the profitability of the project calculated as projected
total net income divided by initial or average investment. Net income is not discounted.
 Internal Rate of Return (IRR) is the discount rate at which net present value of the project
becomes zero. Higher IRR should be preferred.
 Profitability Index (PI) is the ratio of present value of future cash flows of a project to
initial investment required for the project.

1. Net Present Value (NPV)

Net present value (NPV) of a project is the potential change in an investor's wealth caused by
the project while time value of money is being accounted for. It equals the present value of
net cash inflows generated by a project less the initial investment on the project. It is one of
the most reliable measures used in capital budgeting because it accounts for time value of
money by using discounted cash flows in the calculation.
Net present value calculations take the following two inputs:
 Projected net cash flows in successive periods from the project.
 A target rate of return i.e. the hurdle rate.
Net cash flow equals total cash inflow during a period, including salvage value if any, less
cash outflows from the project during the period.
Hurdle rate is the rate used to discount the net cash inflows which is usually weighted average
cost of capital (WACC) in case of a company.
Formulas and Calculation
The first step involved in the calculation of NPV is the estimation of net cash flows from the
project over its life. The second step is to discount those cash flows at the hurdle rate.
The net cash flows may be even (i.e. equal cash flows in different periods) or uneven (i.e.
different cash flows in different periods). When they are even, present value can be easily
calculated by using the formula for present value of annuity. However, if they are uneven, we
need to calculate the present value of each individual net cash inflow separately.
Once we have the total present value of all project cash flows, we subtract the initial
investment on the project from the total present value of inflows to arrive at net present
value.
Thus we have the following two formulas for the calculation of NPV:
When cash inflows are even:

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

In the above formula,

R is the net cash inflow expected to be received in each period;
i is the required rate of return per period;
n are the number of periods during which the project is expected to operate and generate
cash inflows.
When cash inflows are uneven:

R1 R2 R3
NPV = + + + ... − Initial Investment
(1+i)1 (1+i)2 (1+i)3

Where,
i is the target rate of return per period;
R1 is the net cash inflow during the first period;
R2 is the net cash inflow during the second period; R3 is the net cash inflow during the third
period, and so on ...

Decision Rule
In case of standalone projects, accept a project only if its NPV is positive, reject it if its NPV
is negative and stay indifferent between accepting or rejecting if NPV is zero.
In case of mutually exclusive projects (i.e. competing projects), accept the project with higher
NPV.

Example 1: Even Cash Inflows

Calculate the net present value of a project which requires an initial investment of $243,000
and it is expected to generate a cash inflow 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%
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

Example 2: Uneven Cash Inflows

An initial investment of $8,320 thousand on plant and machinery is expected to generate
cash inflows of $3,411 thousand, $4,070 thousand, $5,824 thousand and $2,065 thousand
at the end of first, second, third and fourth year respectively. At the end of the fourth year,
the machinery will be sold for $900 thousand. Calculate the net present value of the
investment if the discount rate is 18%. Round your answer to nearest thousand dollars.
Solution
PV Factors:
Year 1 = 1 ÷ (1 + 18%)1 ≈ 0.8475
Year 2 = 1 ÷ (1 + 18%)2 ≈ 0.7182
Year 3 = 1 ÷ (1 + 18%)3 ≈ 0.6086
Year 4 = 1 ÷ (1 + 18%)4 ≈ 0.5158
The rest of the calculation is summarized below:

Year 1 2 3 4

Net Cash Inflow $3,411 $4,070 $5,824 $2,065

Salvage Value 900

Total Cash Inflow $3,411 $4,070 $5,824 $2,965

× Present Value Factor 0.8475 0.7182 0.6086 0.5158

Present Value of Cash Flows $2,890.68 $2,923.01 $3,544.67 $1,529.31

Total PV of Cash Inflows $10,888

− Initial Investment − 8,320

Net Present Value $2,568 thousand

Strengths and Weaknesses of NPV
Strengths
Net present value accounts for time value of money which makes it a better approach than
those investment appraisal techniques which do not discount future cash flows such
as payback period and accounting rate of return.
Net present value is even better than some other discounted cash flows techniques such
as IRR. In situations where IRR and NPV give conflicting decisions, NPV decision should be
preferred.

Weaknesses
NPV is after all an estimation. It is sensitive to changes in estimates for future cash flows,
salvage value and the cost of capital. NPV analysis is commonly coupled with sensitivity
analysis and analysis to see how the conclusion changes when there is a change in inputs.
Net present value does not take into account the size of the project. For example, say Project
A requires initial investment of $4 million to generate NPV of $1 million while a competing
Project B requires $2 million investment to generate an NPV of $0.8 million. If we base our
decision on NPV alone, we will prefer Project A because it has higher NPV, but Project B has
generated more shareholders’ wealth per dollar of initial investment ($0.8 million/$2 million
vs $1 million/$4 million).
 2. Internal Rate of Return (IRR)
Internal rate of return (IRR) is the discount rate at which the net present value of an
investment is zero. IRR is one of the most popular capital budgeting technique.
Companies invest in different projects to generate value and increase their shareholders
wealth, which is possible only if the projects they invest in generate a return higher than the
minimum rate of return required by the providers of capital (i.e. shareholders and debt-
holders). The minimum required rate of return is called the hurdle rate.
IRR is a discounted cash flow (DCF) technique which means that it incorporate the time value
of money. The initial outlay/investment in any project must be compensated by net cash flows
which far exceed the initial investment. The higher those cash flows when compared to the
initial outlay, the higher will be the IRR and the project is a promising investment.

Decision Rule
A project should only be accepted if its IRR is NOT less than the hurdle rate, the
minimum required rate of return. The minimum required rate of return is based on the
company's cost of capital (i.e. WACC) and is adjusted to properly reflect the risk of the project.
When comparing two or more mutually exclusive projects, the project having highest value
of IRR should be accepted.

IRR Calculation
There is no direct algebraic expression in which we might plug some numbers and get the
IRR.
IRR is most commonly calculated using the hit-and-trial method, linear-interpolation formula
or spreadsheets and financial calculators.
Since IRR is defined as the discount rate at which NPV = 0, we can write that:
NPV = 0; or
PV of future cash flows − Initial Investment = 0; or

CF1 CF2 CF3

+ + + ... − Initial Investment = 0
( 1 + r )1 ( 1 + r )2 ( 1 + r )3

Where,
r is the internal rate of return;
CF1 is the period one net cash inflow;
CF2 is the period two net cash inflow,
CF3 is the period three net cash inflow, and so on ...
But the problem is, we cannot isolate the variable r (=internal rate of return) on one side of
the above equation. Even though we can use the linear-interpolation formula, the simplest
method is to use hit and trial as described below:
1. STEP 1: Guess the value of r and calculate the NPV of the project at that value.
2. STEP 2: If NPV is close to zero then IRR is equal to r.
3. STEP 3: If NPV is greater than 0 then increase r and jump to step 5.
4. STEP 4: If NPV is smaller than 0 then decrease r and jump to step 5.
5. STEP 5: Recalculate NPV using the new value of r and go back to step 2.
Example#01:
Find the IRR of an investment having initial cash outflow of $213,000. The cash inflows during
the first, second, third and fourth years are expected to be $65,200, $96,000, $73,100 and
$55,400 respectively.

Sol:
Assume that r is 10%.
NPV at 10% discount rate = $18,372
Since NPV is greater than zero we have to increase discount rate, thus NPV at 13% discount
rate = $4,521
But it is still greater than zero we have to further increase the discount rate, thus NPV at
14% discount rate = $204
NPV at 15% discount rate = ($3,975)
Since NPV is fairly close to zero at 14% value of r, therefore IRR ≈ 14%

Limitations of IRR
Studies indicate that internal rate of return is one of the most popular capital budgeting tool,
but theoretically net present value, a measure of absolute value added by a project, is a better
indicator of a project’s feasibility. This is because sometimes where the cash flows
are unconventional i.e. there are net cash outflows other than the initial investment outlay,
we may get multiple results for internal rate of return. This phenomenon is called multiple
IRR problem. Further, internal rate of return technique assumes that all project cash flows
are reinvested at the internal rate of return, which is rarely the case because new investment
opportunities are seldom readily available. A variant of internal rate of return called
the modified internal rate of return, attempts to mitigate this problem by calculating the
internal rate of return where the net cash flows are reinvested at a rate lower than the internal
rate of return itself.
 3. Payback Period
Payback period is the time in which the initial outlay of an investment is expected to be
recovered through the cash inflows generated by the investment. It is one of the
simplest investment appraisal techniques.
Since cash flow estimates are quite accurate for periods in near future and relatively
inaccurate for periods in distant future due to economic and operational uncertainties,
payback period is an indicator of risk inherent in a project because it takes initial inflows into
account and ignores the cash flows after the point at which initial investment is recovered.
Projects having larger cash inflows in the earlier periods are generally ranked higher when
appraised with payback period, compared to similar projects having larger cash inflows in the
later periods.

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.
If the cash inflows are even (such as for investments in annuities), the formula to calculate
payback period is:
Initial Investment
Payback Period =
Net Cash Flow per Period

When cash inflows are uneven, we need to calculate the cumulative net cash flow for each
period and then use the following formula:
B
Payback Period = A+
C

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 sum of inflows to date, minus the initial outflow.

Example 1: 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
Example 2: Uneven Cash Flows
Company C is planning to undertake another project requiring initial investment of $50
million and is expected to generate $10 million net cash flow in Year 1, $13 million in Year
2, $16 million in year 3, $19 million in Year 4 and $22 million in Year 5. Calculate the
payback value of the project.
Solution
(cash flows in millions)
Year Annual Cumulative
Cash Flow Cash Flow

0 (50) (50)

1 10 (40)

2 13 (27)

3 16 (11)

4 19 8

5 22 30

Payback Period = 3 + 11/19 = 3 + 0.58 ≈ 3.6 years

Decision Rule
The longer the payback period of a project, the higher the risk. Between mutually exclusive
projects having similar return, the decision should be to invest in the project having the
shortest payback period.
When deciding whether to invest in a project or when comparing projects having different
returns, a decision based on payback period is relatively complex. The decision whether to
accept or reject a project based on its payback period depends upon the risk appetite of the
management.
Management will set an acceptable payback period for individual investments based on
whether the management is risk averse or risk taking. This target may be different for
different projects because higher risk corresponds with higher return thus longer payback
period being acceptable for profitable projects. For lower return projects, management will
only accept the project if the risk is low which means payback period must be short.

Advantages and Disadvantages

Advantages of payback period are:
1. Payback period is very simple to calculate.
2. It can be a measure of risk inherent in a project. Since cash flows that occur later in a
project's life are considered more uncertain, payback period provides an indication of
how certain the project cash inflows are.
3. For companies facing liquidity problems, it provides a good ranking of projects that
would return money early.
Disadvantages of payback period are:
1. Payback period does not take into account the time value of money which is a serious
drawback since it can lead to wrong decisions. A variation of payback method that attempts
to address this drawback is called discounted payback period method.
2. It does not take into account, the cash flows that occur after the payback period. This
means that a project having very good cash inflows but beyond its payback period may
be ignored.

4.Discounted Payback Period

Discounted payback period is a variation of payback period which uses discounted cash flows
while calculating the time an investment takes to pay back its initial cash outflow. One of the
major disadvantages of simple payback period is that it ignores the time value of money. To
counter this limitation, discounted payback period was devised, and it accounts for the time
value of money by discounting the cash inflows of the project for each period at a suitable
discount rate.

Calculation
In discounted payback period we have to calculate the present value of each cash inflow. For
this purpose the management has to set a suitable discount rate which is usually the
company's cost of capital . The discounted cash inflow for each period is then calculated using
the formula:
Actual Cash Inflow
Discounted Cash Inflow =
(1 + i)n

Where,
i is the discount rate; and
n is the period to which the cash inflow relates.
Sometimes, the above formula may be split into two components which are: actual cash inflow
and present value factor i.e. 1 / (1 + i)n. Discounted cash flow is then the product of actual
cash flow and the present value factor.
The rest of the procedure is similar to the calculation of simple payback period except that we
have to use the discounted cash flows as calculated above instead of nominal cash flows. Also,
the cumulative cash flow is replaced by cumulative discounted cash flow.
B
Discounted Payback Period = A +
C

Where,
A = Last period with a negative discounted cumulative cash flow;
B = Absolute value of discounted cumulative cash flow at the end of the period A; and
C = Discounted cash flow during the period after A.
Note: In the calculation of simple payback period, we could use an alternative formula for
situations where all the cash inflows were even. That formula is not applicable here since it is
extremely unlikely that discounted cash inflows will be even.
The calculation method is illustrated through the example given below.

Decision Rule
A shorter discounted payback period indicates lower risk. Given a choice between two
investments having similar returns, the one with shorter payback period should be chosen.
Management might also set a target payback period beyond which projects are generally
rejected due to high risk and uncertainty.
Often, the decision may not be an easy one though. For example, where a project with higher
return has a longer payback period thus higher risk and an alternate project having low risk
but also lower return. In such cases the decision mostly rests on management's judgment
and their risk appetite.

Example
An initial investment of $2,324,000 is expected to generate $600,000 per year for 6 years.
Calculate the discounted payback period of the investment if the discount rate is 11%.

Solution

Prepare a table to calculate discounted cash flow of each period by multiplying the actual cash
flows by present value factor. Create a cumulative discounted cash flow column.

Present Value Discounted Cumulative

Year Cash Flow
Factor Cash Flow Discounted
n CF
PV$1=1/(1+i)n CF×PV$1 Cash Flow

0 -2,324,000 1.0000 -2,324,000 -2,324,000

1 600,000 0.9009 540,541 -1,783,459

2 600,000 0.8116 486,973 -1,296,486

3 600,000 0.7312 438,715 -857,771

4 600,000 0.6587 395,239 -462,533

5 600,000 0.5935 356,071 -106,462

6 600,000 0.5346 320,785 214,323

Discounted Payback Period

= 5 + |-106,462| ÷ 320,785
= 5 + 106,462 ÷ 320,785
≈ 5 + 0.33
≈ 5.33 years
Advantages and Disadvantages
Advantage:
Discounted payback period is more reliable than simple payback period since it accounts for
time value of money. It is interesting to note that if a project has negative net present value
it won't pay back the initial investment.
Disadvantage:
It ignores the cash inflows from project after the payback period. An attractive project having
lower initial inflows but higher terminal cash flows might be rejected.

Some Important Factors:

1. Initial Investment
Initial investment is the amount required to start a business or a project. It is also called
initial investment outlay or simply initial outlay. It equals capital expenditures plus working
capital requirement plus after-tax proceeds from assets disposed off or available for use
elsewhere.
Capital budgeting decisions involve careful estimation of the initial investment outlay and
future cash flows of a project. Correct estimation of these inputs helps in taking decisions
that increase shareholders wealth.

Formula
Initial investment equals the amount needed for capital expenditures, such as machinery,
tools, shipment and installation, etc.; plus any increase in working capital, minus any after
tax cash flows from disposal of any old assets. Sunk costs are ignored because they are
irrelevant.
Initial Investment = CapEx + ΔWC + D
Where,
CapEx is capital expenditure,
∆WC is the change in working capital and
D is the net cash flow from disposed asset.

Example
Saindak Copper Company Ltd (SCCL) started a copper and gold exploration and extraction
project in Baluchistan in 20X5. In 20X6-20X7, it incurred expenditure of $200 million on
seismic studies of the area and $500 million on equipment, etc. In 20X8, the company
abandoned the project due to disagreement with the government. Recently, a new business
friendly government is sworn in. SCCL managing director believes the project needs
reconsideration. The company's financial analyst and chief engineer estimate that $1,500
million worth of new equipment is needed to restart the project. Shipment and installation
expenditures would amount to $200 million. Current assets must increase by $200 million
and current liabilities by $90 million. The equipment purchased in 20X6-20X7 is no longer
useful and is to be disposed of for after tax proceeds of $120 million. Find the initial
investment outlay.
Solution
Initial investment
= equipment purchase price + shipment and installation + increase in working capital −
disposal inflows
= $1,500 million + $200 million + ($200 million − $90 million) − $120 million
= $1,690 million.
SCCL needs $1,690 million to restart the project. It needs to estimate future cash flows
from the project, and calculate net present value and/or internal rate of return in order to
decide whether to go ahead with the restart or not.
$200 million expenditure on the seismic studies is not part of the initial investment because
it is a sunk cost.

2. Discount Rate
Discount rate is the rate of interest used to determine the present value of the future cash
flows of a project. For projects with average risk, it equals the weighted average cost of capital
but for project with different risk exposure it should be estimated keeping in view the project
risk.
Capital budgeting techniques such as net present value, internal rate of return, discounted
payback period and profitability index are based on the concept of time value of money. In
net present value, we discount the future incremental cash flows of a project to time 0 and
then subtract the initial investment to see if we the project adds value or not. In internal rate
of return technique, the IRR is compared with a rate called the hurdle rate which represents
the cost of capital of the company and the risk of the project and the project is accepted only
if the IRR is higher than the discount rate. The result we get from all the techniques is very
sensitive to the discount rate which makes it arguably the most important input in capital
budgeting process.

3. WACC
The WACC stands for weighted average cost of capital which is the minimum after-tax
required rate of return which a company must earn for all its investors. It is calculated as
the weighted average of cost of equity, cost of debt and cost of preferred stock.
WACC is an important input in capital budgeting and business valuation. It is the discount
rate used to find out the present value of cash flows in the net present value technique. It is
the hurdle rate to which the internal rate of returns of different projects are compared to
decide whether the projects are feasible. It is also used in the free cash flow valuation
model to discount the free cash flow to firm to find a company's intrinsic value.

Formula
For a company which has two sources of finance, namely equity and debt, WACC is
calculated using the following formula:
WACC = Cost of Equity × E/A + Cost of Debt × D/A × (1 – T)
Where E is the market value of equity, D is the market value of debt, A is the sum of
market values of equity and debt, T is the tax rate and E/A and D/A are the weights of
equity and debt in the company's capital structure.
Cost of Equity
Cost of equity is the required rate of return on common stock of the company. It is the
minimum rate of return which a company must earn to keep its common stock price from
falling.
Cost of equity is estimated using different models, such as dividend discount model (DDM)
and capital asset pricing model (CAPM).

After-Tax Cost of Debt

After-tax cost of debt represents the after-tax rate of return which the debt-holders need to
earn till the maturity of the debt. Cost of debt of a company is calculated by finding
the yield to maturity of the company's bonds and other loans. If no yield to maturity is
available, the cost can be estimated using the instrument's current yield, etc.
After-tax cost of debt is included in the calculation of WACC because debt offers a tax shield
i.e. interest expense on debt reduces taxes. This reduction in taxes is reflected in reduction
in cost of debt capital.

Equity and Debt Weights

E/A is the weight of equity in the company’s total capital. It is calculated by dividing the
market value of the company’s equity by sum of the market values of equity and debt.
D/A is the weight of debt component in the company’s capital structure. It is calculated by
dividing the market value of the company’s debt by sum of the market values of equity and
debt.
Ideally, WACC should be estimated using target capital structure, which is the capital
structure the company’s management intends to maintain in the long-run.

Example
Sanstreet, Inc. went public by issuing 1 million shares of common stock @ $25 per share.
The shares are currently trading at $30 per share. Current risk free rate is 4%, market risk
premium is 8% and the company has a beta coefficient of 1.2.
During last year, it issued 50,000 bonds of $1,000 par paying 10% coupon annually
maturing in 20 years. The bonds are currently trading at $950.
If the tax rate is 30%, calculate the weighted average cost of capital.
Solution
First we need to calculate the proportion of equity and debt in Sanstreet, Inc. capital
structure.
Calculating Capital Structure Weights

Current Market Value of Equity = 1,000,000 × $30 = $30,000,000

Current Market Value of Debt = 50,000 × $950 = $47,500,000
Total Market Value of Debt and Equity = $77,500,000
Weight of Equity = $30,000,000 / $77,500,000 = 38.71%
Weight of Debt = $47,500,000 / $77,500,000 = 61.29%, or
Weight of Debt = 100% minus cost of equity = 100% − 38.71% = 61.29%
Now, we need estimates for cost of equity and after-tax cost of debt.
Estimating Cost of Equity
We can estimate cost of equity using either the dividend discount model (DDM) or capital
asset pricing model (CAPM).
Cost of equity (DDM) = expected dividend in 1 year /current stock price + growth rate
Cost of equity (CAPM) = risk free rate + beta coefficient × market risk premium
In the current example, the data available allow us to use only CAPM to calculate cost of
equity.
Cost of Equity = Risk Free Rate + Beta × Market Risk Premium = 4% + 1.2 × 8% = 13.6%
Estimating Cost of Debt

Cost of debt is equal to the yield to maturity of the bonds. With the given data, we can find
that yield to maturity is 10.61%. It is calculated using hit and trial method. We can also
estimate it using MS Excel RATE function.
For inclusion in WACC, we need after-tax cost of debt, which is 7.427% [= 10.61% × (1 −
30%)].
Calculating WACC

Having all the necessary inputs, we can plug the values in the WACC formula to get an
estimate of 9.82%.
WACC = 38.71% × 13.6% + 61.29% × 7.427% = 9.8166%
It is called weighted average cost of capital because as you see the cost of different
components is weighted according to their proportion in the capital structure and then
summed up.
WACC represents the average risk faced by the organization. It would require an upward
adjustment if it has to be used to calculate NPV of projects which are riskier than the
company's average projects and a downward adjustment in case of less risky projects.
Further, WACC is after all an estimation. Further, different models for calculation of cost of
equity may yield different values.

4. Incremental Cash Flow

In capital budgeting, incremental cash flow is the net after-tax cash flow which a project
generates over its life. It is also called operating cash flow and it equals the excess of cash
inflows over cash outflows on account of operating expenditure and taxes.
Capital budgeting decisions require projecting cash flows into future and then using time
value of money techniques to identify whether the project is profitable or not.

Formula
Incremental Cash Flows = Cash Inflows − Cash Outflows − Taxes
Taxes = (Inflows − Outflows − Depreciation Expense) × Tax Rate

Example
Cricket South Asia is appraising construction of the world's largest cricket stadium in Delhi.
The project requires initial investment of INR 1,200 million. It is expected to host 150,000
people and generate annual cash inflows of INR 250 million each year for 10 years.
Maintenance expenditure is expected to be INR 100 million. For tax purposes, INR 900
million of the stadium value is allowable as a deduction on account of depreciation on
straight line basis. Applicable tax rate is 20%. Find the incremental cash flow of the project
over the useful life of the stadium.
Solution
Incremental Cash flows = Cash Inflows − Cash Outflows − (Inflows − Outflows −
Depreciation) × Tax Rate
Depreciation Expense = INR 900 million/10 = INR 90 million
Taxes per Year = (INR 250 million − INR 100 million − INR 90 million) × 20% = INR 12
million
Incremental Cash Flow = INR 250 million − INR 100 million − INR 12 million = INR 138
million

5. Normal Cash Flow

Normal cash flow is the cash flow stream that comprises of initial investment outlay and
then positive net cash flow throughout the project life. It is also called conventional cash
flow stream.
In normal cash flow stream, cash flows change direction only once. The nature of the cash
flow pattern is important in capital budgeting. Because when the cash flows stream is non-
normal, multiple-IRR problem arises.

Example
Following table shows cash flow pattern of Alpha and Beta:

USD in million

Year Alpha Beta

0 -900 -2000

1 200 500

2 200 -800

3 250 1500

4 300 800

5 150 500
Alpha has normal cash flow stream because it changes direction only once (in Year 1).
Beta has non-normal cash flow stream because it changes direction thrice (in Year 1, 2 and
3).

6. Non-Normal Cash Flow

Non-normal cash flow stream (also called unconventional cash flow) is a pattern of cash
flows in which the direction of cash flows changes more than once. It is also termed as
unconventional cash flow.
Non-normal cash flow stream leads to what is called multiple-IRR problem.

Example
Alpha Beta is analyzing cash flows stream of Project Gamma which is given below:

Year Gamma

0 (550,000)

1 1,000,000

2 (900,000)

3 1,500,000

The project has non-normal cash flow stream because cash flows change direction thrice (in
Year 1, 2 & 3).

7. Certainty Equivalent Cash Flow

Certainty equivalent cash flow is the risk free cash flow which an investor considers
equivalent to a higher but risky expected cash flow.
An investor might be indifferent between $20 million guaranteed annual net cash flow from
a project, and an opportunity to earn $25 million with 60% probability and $18 million with
40% probability. Though the expected cash flows in second option is $22.2 million (0.6×$25
million + 0.4×$18 million), the investor may actually prefer the first option of guaranteed
cash flow of $20 million because that first option is risk free. $20 million is the certainty
equivalent cash flow.

Formula
Certainty equivalent cash flow is calculated using the following formula:

Certainty Equivalent Cash Flow

Expected Cash Flow

=
1 + Risk Premium
Where risk premium is the excess of risk-adjusted discount rate over the risk free rate.

Example
You are the senior financial analyst at Schon Real Estate which invested heavily in Dubai
real estate in 20X5. Unfortunately, the projects did not turn out as profitable as they were
expected. The company's board of director recently appointed Al-Fatih Al-sisi as the new
CEO to turn the company around. He has requested Subramanian Ramasamy, the finance
director, to brief him on the extent to which the projects fell behind on profitability. You
prepared a report for the finance director in which you talked about risk-adjusted discount
rate, expected NPV built into the investment appraisals back in 20X5 and how they compare
with actual performance. Subramanian sent you memo: “The CEO is from general
management background and I fear he might not digest all the complex rate stuff we are
talking about. I would like to brief him in simple cash flow. Please find me certainty
equivalent cash flow for the IT Tower project.”
A risk-adjusted rate of return of 13% was used to discount the uniform expected annual net
cash flows of $2.3 million. The project had a useful life of 15 years and relevant risk free
rate was 5%.
Solution:
Risk Premium
= Risk Adjusted Rate of Return − Risk Free Rate
= 13% − 5%
= 8%
Certainty Equivalent Cash Flow
= $2.3 million ÷ (1 + 8%)
= $2.13 million
You can send the following memo back to the finance director:
IT Tower project was expected to generate $2.13 million certainty equivalent cash flow per
year for 15 years.

8. Terminal Cash Flow

Terminal cash flow is the net cash flow that occurs at the end of a project and represents
the after-tax proceeds from disposal of the project assets and recoupment of working
capital.
Terminal cash flow is an important input in the capital budgeting process. While uniform
periodic net cash flows are discounted using the present value for annuity formula, terminal
cash flow is treated separately from other cash flows and discounted using the present
value of a single sum formula.

Formula
Terminal cash flow has two main components:
a. proceeds from disposal of project equipment, etc. and
b. cash flows associated with reversion of working capital to the level that prevailed before
the start of the project.
It is calculated using the following formula:
Terminal Cash Flow = After-tax Proceeds from Disposal ± Change in Working Capital
After-tax Proceeds from Disposal = Pre-tax Proceeds from Disposal − Tax on gain on
Disposal
Tax on Gain on Disposal = (Pre-tax Proceeds from Disposal − Ending Book Value) × Tax
Rate

Example
Safe Energy is appraising a new solar energy project. They expect the installed equipment
to have an economic life of 5 years after which it is to be replaced by newer technology. The
initial investment on the project amounts to $200 million, $20 million of which is on account
of increased working capital. For tax purposes, the equipment is to be depreciated on a
straight line basis over 5 years with expected residual value of $20 million. The company's
financial analyst projects that the machinery can be disposed of for $40 million. Working
capital will revert back to its initial level at the end of 5 years. Applicable interest rate on
gain on disposal is 20%. Calculate the terminal cash flow.
Solution
Tax on Disposal
= (Proceeds − Book Value) × Tax Rate
= ($40 million − $20 million) × 20%
= $4 million
After Tax Proceeds from Disposal
= $40 million − $4 million
= $36 million
Terminal Cash Flow
= After-tax Proceeds from Disposal + Working Capital Recouped
= $36 million + $20 million
= $56 million