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    NPV, Payback Period, PI

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    Ayush Bankar
    The document discusses capital budgeting techniques for evaluating investment projects. It describes estimating cash flows, traditional methods like payback period and accounting rate of return, and discounted cash flow methods like net present value, internal rate of return, and profitability index. It provides details on calculating and applying each technique, and highlights their advantages and limitations.

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    NPV, Payback Period, PI

    Uploaded by

    Ayush Bankar
    6 views3 pages
    The document discusses capital budgeting techniques for evaluating investment projects. It describes estimating cash flows, traditional methods like payback period and accounting rate of return, and discounted cash flow methods like net present value, internal rate of return, and profitability index. It provides details on calculating and applying each technique, and highlights their advantages and limitations.

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    NPV, Payback period, PI

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    The document discusses capital budgeting techniques for evaluating investment projects. It describes estimating cash flows, traditional methods like payback period and accounting rate of return, and discounted cash flow methods like net present value, internal rate of return, and profitability index. It provides details on calculating and applying each technique, and highlights their advantages and limitations.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    6 views3 pages

    NPV, Payback Period, PI

    Uploaded by

    Ayush Bankar
    The document discusses capital budgeting techniques for evaluating investment projects. It describes estimating cash flows, traditional methods like payback period and accounting rate of return, and discounted cash flow methods like net present value, internal rate of return, and profitability index. It provides details on calculating and applying each technique, and highlights their advantages and limitations.

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    CAPITAL BUDGETING AND INVESTMENT DECISION ANALYSIS

    The extent to which the capital budgeting process needs to be formalised and systematic procedures to
    be established depends on the size of the organisation; number of projects to be considered; direct
    financial benefit of each project considered by itself; the composition of the firm's existing assets and
    management's desire to change that composition; timing of expenditures associated with the projects
    that are finally accepted.

    ESTIMATION OF PROJECT CASH FLOWS:


    Capital Budgeting analysis considers only incremental cash flows from an investment likely to result
    due to acceptance of any project. Therefore, one of the most important tasks in capital budgeting is
    estimating future cash flows for a project.
    Depreciation: Depreciation is a non-cash item and itself does not affect the cash flow. However, we
    must consider tax shield or benefit from depreciation in our analysis. Since this benefit reduces cash
    outflow for taxes, it is considered as cash inflow.

    CAPITAL BUDGETING TECHNIQUES:

    CAPITAL BUDGETING
    TECHNIQUES

    Discounted Cash
    Traditional
    flows

    Accounting Rate Net Present Profitability


    Payback period
    of Return (ARR) Value (NPV) Index (PI)

    Internal Rate of Discounted


    Return (IRR) Payback Period

    Modified IRR
    Payback Period:
    Time required to recover the initial cash-outflow is called pay-back period. The payback period of an
    investment is the length of time required for the cumulative total net cash flows from the investment
    to equal the total initial cash outlays. At that point in time (payback period), the investor has
    recovered all the money invested in the project.
    Net Present Value Technique (NPV):
    The net present value technique is a discounted cash flow method that considers the time value of
    money in evaluating capital investments. An investment has cash flows throughout its life, and it is
    assumed that an amount of cash flow in the early years of an investment is worth more than an
    amount of cash flow in a later year. The net present value method uses a specified discount rate to
    bring all subsequent cash inflows after the initial investment to their present values (the time of the
    initial investment is year 0). The net present value of a project is the amount, in current value of
    amount, the investment earns after paying cost of capital in each period.
    Net present value = Present value of net cash inflow - Total net initial investment
    Since it might be possible that some additional investment may also be required during the life time of
    the project, then appropriate formula shall be:
    Net present value = Present value of cash inflows - Present value of cash outflows

    Advantages of NPV

    • NPV method takes into account the time value of money


    • The whole stream of cash flows is considered
    • The net present value can be seen as the addition to the wealth of shareholders. The criterion
    of NPV is thus in conformity with basic financial objectives
    • The NPV uses the discounted cash flows i.e., expresses cash flows in terms of current rupees.
    The NPVs of different projects therefore can be compared. It implies that each project can be
    evaluated independent of others on its own merit

    Limitations of NPV

    • It involves difficult calculations.


    • The application of this method necessitates forecasting cash flows and the discount rate. Thus,
    accuracy of NPV depends on accurate estimation of these two factors which may be quite
    difficult in practice
    • The decision under NPV method is based on absolute measure. It ignores the difference in
    initial outflows, size of different proposals etc. while evaluating mutually exclusive projects

    Profitability Index /Desirability Factor/Present Value Index Method (PI):


    Profitability Index (PI)= Sum of discounted cash in flows

    Initial cash outlay or Total discounted cash outflow (as the case may)
    Advantages of PI

    • The method also uses the concept of time value of money.


    • In the PI method, since the present value of cash inflows is divided by the present value of
    cash outflow, it is a relative measure of a project’s profitability.

    Limitations of PI

    • Profitability index fails as a guide in resolving capital rationing where projects are indivisible.
    • Once a single large project with high NPV is selected, possibility of accepting several small
    projects which together may have higher NPV than the single project is excluded.
    • Also, situations may arise where a project with a lower profitability index selected may
    generate cash flows in such a way that another project can be taken up one or two years later,
    the total NPV in such case being more than the one with a project with highest Profitability
    Index.

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