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EVALUATION OF INVESTMENT PROPOSALS Lect

The document discusses several methods for evaluating capital investment projects: 1) Net Present Value (NPV) which discounts future cash flows to determine if the present value of a project's cash inflows will exceed the present value of its cash outflows. 2) Internal Rate of Return (IRR) which is the discount rate that makes the NPV of a project equal to zero. 3) Cost-Benefit Analysis which determines the net benefits of a project by quantifying and comparing all associated costs and benefits.

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Simranjeet Singh
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33 views

EVALUATION OF INVESTMENT PROPOSALS Lect

The document discusses several methods for evaluating capital investment projects: 1) Net Present Value (NPV) which discounts future cash flows to determine if the present value of a project's cash inflows will exceed the present value of its cash outflows. 2) Internal Rate of Return (IRR) which is the discount rate that makes the NPV of a project equal to zero. 3) Cost-Benefit Analysis which determines the net benefits of a project by quantifying and comparing all associated costs and benefits.

Uploaded by

Simranjeet Singh
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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EVALUATION OF INVESTMENT PROPOSALS

 The most important basis of making an investment or capital


budgeting decision is to determine whether a particular capital
project will earn the desired rate of return.
 A number of methods for evaluating capital investment projects are
available.
 Most of these evaluate projects on one criteria besides profitability
such as its public image , market share , future growth, excellence in
quality

The commonly used methods are -

a) Net Present Value (NPV)


b) Internal Rate Of Interest (IRR)

NET PRESENT VALUE (NPV)


 It is a modern method of evaluating.
 This method takes in consideration the time value of money.
 It recognises a rupee earned today is worth more than the same
rupee tomorrow.
 The net present values of all inflows and outflows of cash
occurring during the entire life of the project is determined
separately for each year.
 The following are the necessary steps-
a) The first step is to determine the rate of discount. this
discount rate is the rate of return /Interest desired by the
firm on its investments.
b) Once this discount rate is determined - the present value
of rupee 1 due in any no of years can be found with the
use of following mathematical formula.

PV=1/ (1+ r)n

PV=Present Value

r= rate of interest/ rate of return

n= no. of years
The present value for all the cash inflows for a number of years is thus
found as follows- (A1= Future net cash flow)

PV= A1 + A2 + A3 + .............. + An

(1 + r) (1 + r)2 (1 + r)3 (1 + r)n

c) The third step is to determine the present value of cash inflows


expected to be generated . In estimating the cash inflows,
depreciation is disregarded. All other direct and indirect expenses
are deducted from the total cash receipts

Thus cash inflows = Total revenue receipts - All cash expenses

d) The fourth and final step in capital project evaluation is to compare the
present value of cash outlays with the present value of cash outflows
.The difference is the NPV

IF NPV IS NEGATIVE , THE PROJECT RESULTS INTO A


FINANCIAL LOSS AND IF NPV IS POSITIVE , IT RESULTS
INTO FINANCIAL GAIN AND IF ITS ZERO IT IS NO PROFIT
NO LOSS SITUATION.

ADVANTAGES OF NPV

 It recognises time value of money


 it takes into consideration the objective eg maximum profitability.

DISADVANTAGES OF NPV

 It is more difficult to understand and operate.


 It may not give good results
 It is not easy to determine an appropriate discount rate.
INTERNAL RATE OF INTEREST (IRR)
 Is the investors required rate of return at which present value of cash
outflows equals the present value of expected cash inflow.
 In other words, IRR is the rate at which the difference between initial
cash outlay and present value of inflows is zero.
 It is determined internally so it is called internal rate of return method.
 If investment outlay occurs only once and that too at time zero then IRR
is computed by this formula-

A0= A1 + A2 + A3 +............................................. + An

(1+ r)1 (1 + r)2 (1 + r)3 (1 + r)n

A= net cash flow

r= rate of discount =IRR

n= total no. of period during which cash flow is expected

ADVANTAGES OF IRR

 Like NPV Method, it takes into account the time value of money and can
be usefully applied in situations with even cash flow in different periods
of time
 it considers profitability of the project.
 it is better than NPV.
 It is considered as more reliable technique of capital budgeting.

DISADVANTAGES OF IRR

 It is difficult to understand
 The results of IRR and NPV may differ when the projects under
evaluation differ in their size, life and timings of cash flows.
COST BENEFIT ANALYSIS
 It is done to determine how good or poorly, a planned action will turn out.
 it can be used for almost anything.
 This analysis relies on the addition of positive factors and the subtraction
of negative ones to determine a net result.
 In a cost benefit analysis make sure you include all the costs and all the
benefits and properly quantify them .
Example-
As a product manager, you want to propose a stamping machine for
your company .Before you can present the proposal you need to go to
Vice President , you know you may need some facts ,so you decide to do
a cost benefit analysis
With new machine you can produce 100 more units per hour. The
three workers can be replaced who are carrying out stamping. The units
will be of higher quality as they will be more uniform.
Cost to purchase the machine will consume some electricity.
Calculate the selling price of 100 additional units per hour multiplied
by the number of production hours per month.
Add monthly salaries of three workers . That's a good total benefit.
Then you calculate the cost of machine ,dividing the purchase price
by 12 months and divide that by the 10 years the machine would last.
The manufacture will tell you the consumption of power and you can
get power cost numbers (cost of electricity) and get a total cost figure.
Subtract your total cost figure from your total benefit value and your
analysis shows a good profit.

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