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The document discusses various investment evaluation methods, including Discounted Payback, Accounting Rate of Return (ARR), and Profitability Index (PI). It explains how Discounted Payback incorporates the time value of money, while ARR is based on average net income and ignores this aspect. The Profitability Index is defined as the ratio of the present value of future cash flows to the initial investment, with a PI greater than 1 indicating a viable project.

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Dr. Amanat Ali
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12 views

3 - Lecture Slides

The document discusses various investment evaluation methods, including Discounted Payback, Accounting Rate of Return (ARR), and Profitability Index (PI). It explains how Discounted Payback incorporates the time value of money, while ARR is based on average net income and ignores this aspect. The Profitability Index is defined as the ratio of the present value of future cash flows to the initial investment, with a PI greater than 1 indicating a viable project.

Uploaded by

Dr. Amanat Ali
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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DISCOUNTED PAYBACK

METHOD

–The only difference between simple


and discounted Pay Back is
discounting.
–Cash Flows expected over period of
time are discounted using a Discount
Rate.
–Interestingly, if a project Pays Back on
a discounted basis, then it must have a
positive NPV.
• Example:
– A company is considering to undertake an
investment opportunity from one of the
following options;
– Option A: Initial investment is Rs.
103,000/- and cash flow from the
opportunity will be Rs. 45,000, Rs.
40,000, Rs. 36,000, Rs.20,000 and Rs.
10,000 for year one to five.
– Option B: Initial investment of Rs.
103,000/- will generate cash flow of Rs.
15,000/-, 25,000/-, 35,000/-, 54,000/- &
60,000/- from year one to five.
SOLUTION: DISCOUNTED PAYBACK PERIOD
Option A
Pay
Year Cash Cum DF PV of Bac Mont Yea
s Flow . CF 10% CF k h r

(103,00 (103,000.
0 0) 00)
40,905.0
1 45,000 45,000 0.9090 0 12 1
33,056.0
2 40,000 85,000 0.8264 0 12 2
121,00 27,046.8
3 36,000 0 0.7513 0 12 3
141,00 13,660.0 1,666.
4 20,000 0 0.6830 0 67 1.20
151,00
5 10,000 0 0.6209 6,209.00
SOLUTION: DISCOUNTED PAYBACK PERIOD
Option B
Pay
Year Cash Cum DF PV of Bac Mont Ye
s Flow . CF 10% CF k h ar

(103,00
0 0) 1
13,635.0
1 15,000 15,000 0.91 0 12 1
20,660.0
2 25,000 40,000 0.83 0 12 2
26,295.5
3 35,000 75,000 0.75 0 12 3
129,00 36,882.0
4 54,000 0 0.68 0 12 4
189,00 37,254.0 5,000.
5 60,000 0 0.62 0 00 1.11
• ACCOUNTING RATE OF RETURN – ARR
• ALSO AVERAGE ACCOUNTING RATE –
AAR

ARR = Average Net Income/Average Investment

Some Issues relevant to ARR


• Its Simple and needed information is readily available
• Its ignores time value of money
• Its based on book values
• Its not a true appraisal method
Profitability Index

• Profitability Index is a relationship


between present value of all future
cash flows and initial investment.
PROFITABILITY INDEX

• Cost-Return Ratio or Benefit-Cost Ratio of


an investment opportunity’s present value
of future cash flow to initial investment
cost.
Formula:
• PI = PV of Future Cash Flows
Initial Investment
Decision Rule:
– If PI is greater than 1, project land in green
zone or can be undertaken otherwise it is not
viable.
– Accept the project if PI is greater than 1,
which means that NPV is positive.
Example: Capital Budgeting

• NPV = Rs 137,997
• Total PV of Cash Flow = 2.437 million
• Initial Investment = 2.00 million

• PI = PV of Future Cash Flows


Initial Investment
• PI = 2.437/2.00
• PI = 1.22
• 1.22 > 1
Example Capital Budgeting

• Acceptance Rule:
• Benefit Cost Ratio > 1
• Project is undertaken
Evaluation Method

• NPV
• IRR
• Pay Back Period Method
• Discounted Pay Back Period
• Accounting Rate of Return (ARR)
• Profitability Index
Net Present Value (NPV)
• NPV states, if NPV is positive then project
is under taken.
• In case of more than one project, the
project with higher NPV can be
undertaken.
• If the project has negative NPV, it does
not add value to the company so rejected.
Internal Rate of Return

• Decision Rule
• If IRR is grater than targeted return the
project is viable, we can undertake the
project.
• If project yield less than targeted rate of
return then it is not accepted.
Pay Back Period Method

• Acceptance Rule
• If it return you the initial investment
to cash flows then it is acceptable
and if it is not reject the project.
Discounted Pay Back Period

• Acceptance Rule
• Same as Pay Back
• Just consider time value
Accounting Rate of Return
(ARR)

• Acceptance Rule
• If project yield more than target
return than project acceptable
otherwise vice versa.
Profitability Index

• Relationship between Cash Flows and


initial Investment.
• PI = PV of Future Cash Flows
Initial Investment
• Benefit cost ratio greater than 1
project land in green zone or can be
undertaken otherwise it is not viable.

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