FINANCE FUNCTION
PROCUREMENT OF FUND
DEBT
EQUITY
DEPLOYMENT OF FUND
LONG TERM
CAPITAL
BUDGETING
SHORT TERM
WORKING
CAPITAL MGT.
TECHNIQUES
TRADITINAL
Ignore time value of
money
•ARR
•PAYBACK PERIOD
MODERN
Consider Time
Value Of Money
•NPV
•PROFITABILITY INDEX
•IRR
•DISCOUNTED PAYBACK PERIOD
DISCOUNTING TECHNIQUES
The discounting or present value is the exact opposite of
compound or future value. While future value shows how much a
sum of money becomes at some future period ,present value shows
what the value is today of some future sum of money. In compound
Or future value approach the money invested today appreciates
because the compound interest is added to the principal. The
present value of money to be received on future date will be less
because we have lost the opportunity of investing it at some
interest .
Thus , the present value of money to be received in future will
always be less. It is for this reason that the present value technique
is called DISCOUNTING.
The discounted cash flow technique
Adjustments for
Nonrecurring
Items
Historical
Financial
Results
Cash
Flow
Adjustments
Projected Sales
And Operation Profit
Year 1
Cash Flow
From Operations
Present Value
Cash Flow
From Operations
1 Years
Prospects
For the
Future
Year 3
Cash Flow
From
Operations
Year 2
Cash Flow
From Operations
2 Years
Year 4
And Beyond
Cash Flow
From
Operations
3 Years
+
Present Value
Of Residual
Value
4 Years +
+
Marketable
Securities and
Excess Assets
-
Market
Value Of Debt
-
Shareholder
Value
*The discounted cash flow value (or what the total capital employed in the business is worth)
Has been calculated based on operating profits that do not consider financing costs (for
Example, interest expense) or income from nonoperating assets. As a result, the net value
Of the equity is derived by subtracting the market value of debt and adding the market value
Of nonoperating assets.
AVERAGE RATE OF RETURN
ARR is the rate of return which is very simple and subjectively
Used in CAPITAL BUDGETING. ARR is compared with the
required rate of return to decide upon project acceptance or
rejection . ARR is calculated by dividing average PAT by either
capital invested or average capital invested .
•ARR is NON – DISCOUNTED TECHNIQUE.
•ARR is not calculated on CFAT but calculated on PAT
ARR is method of evaluating proposed capital expenditure is
also known as the ACCOUNTING RATE OF RETURN . ARR is
based upon accounting information rather than cash flows .
CALCULATED AS- ON INITIAL INVESTMENT
Average PAT
ARR = Initial
* 100
Investment
 ON AVERAGE INVESTMENT
ARR=
Average PAT
Average
Investment
* 100
EXAMPLE
C Ltd. Is considering investing a project. The expected original
Investment in the project will be Rs. 2,00,000. the life of the
project will be 5 year with no salvage value . The expected
Average profit after tax is Rs. 53.900 . Calculate the ARR .
SOLUTION--
ARR =
53,900
2,00,000
= 26.95%
*100
PAY BACK PERIOD
Pay back period is the period within which
The project will pay back its cost.
 Smaller the pay back period . Better the project .
 The main advantage of method is its SIMPLICITY .
 The main disadvantage is that it does not consider
the post pay back period profitability.
Payback period can be calculated on the basis of
simple cash flow or discounted cash flow.
PBP method is quite suitable when rate of becoming
obsolete is quite high.
EXAMPLE
In project A the initial investment is Rs.1,00,000. The
Cash flows for 4 years are respectively 30,000 , 40,000,
50,000 and 30,000. Calculate the PAYBACK PERIOD OF
PROJECT A.
SOLUTION-1st year = 30,000
2nd year = 40,000
70,000
should earn= 1,00,000 – 70,000
3rd year =30,000
time of 3rd year = 30,000/ 50,000
= 6 months
PAYBACK PERIOD = 2 YEARS 6 MONTHS
NET PRESENT VALUE
This is the first discounted cash flow techniques . NPV can be
described as the summation of the present values of cash
proceeds (CFAT ). In each year minus the summation of
present value of the net cash outflows in each year .
The decision rule for a project under NPV is to accept
the project if the NPV is positive and reject if it is
negative. Symbolically,
(a).NPV>0 = ACCEPT
(b).NPV<0 = REJECT
ZERO NPV implies that the firm is indifferent to
accepting or rejecting the project.
Net Present Value
(NPV)
NPV is the present value of an
investment project’s net cash flows
minus the project’s initial cash
outflow.
CF1
CF2
+
NPV =
1
(1+k) (1+k)2
CFn
+...+
(1+k)n
- ICO
EXAMPLE
Basket Wonders has determined that the
appropriate discount rate (k) for this project is
13%.
$10,000
$12,000
$15,000
+
NPV =
+
+
1
2
3
(1.13)
(1.13)
(1.13)
$10,000 $7,000
+
4
(1.13)
(1.13)5
- $40,000
SOLUTION
NPV =
$10,000(PVIF13%,1) + $12,000(PVIF13%,2) +
$15,000(PVIF13%,3) + $10,000(PVIF13%,4) + $
7,000(PVIF13%,5) – $40,000
NPV = $10,000(0.885) + $12,000(0.783) +
$15,000(0.693) + $10,000(0.613) +
$ 7,000(0.543) – $40,000
NPV = $8,850 + $9,396 + $10,395 +
$6,130 + $3,801 – $40,000
= - $1,428
NPV Acceptance
Criterion
The management of Basket Wonders has
determined that the required rate is 13%
for projects of this type.
Should this project be accepted?
No! The NPV is negative. This means that the
project is reducing shareholder wealth. [Reject
as NPV < 0 ]
Profitability Index
(PI)
PI is the ratio of the present value of a
project’s future net cash flows to the
project’s initial cash outflow.
Method #1:
PI =
CF1
CF2
+
1
(1+k) (1+k)2
CFn
+...+
(1+k)n
<< OR >>
Method #2:
PI = 1 + [ NPV / ICO ]
ICO
PI Acceptance Criterion
PI
= $38,572 / $40,000
= .9643 (Method #1, previous slide)
Should this project be accepted?
No! The PI is less than 1.00. This
means
that the project is not profitable. [Reject as PI
< 1.00 ]
Internal Rate of Return
(IRR)
IRR is the discount rate that equates the present
value of the future net cash flows from an
investment project with the project’s initial
cash outflow.
CF1
CF2
+
ICO = (1 + IRR)1 (1
+ IRR)2
CFn
+...+
(1 + IRR)n
IRR Solution
$40,000 =
$10,000
(1+IRR)1
$12,000
+
(1+IRR)2
+
$15,000
$10,000
$7,000
+
+
3
4
(1+IRR)
(1+IRR) (1+IRR)5
Find the interest rate (IRR) that causes the discounted
cash flows to equal $40,000.
IRR Solution (Try 10%)
$40,000 =
$10,000(PVIF10%,1) + $12,000(PVIF10%,2) +
$15,000(PVIF10%,3) + $10,000(PVIF10%,4) +
$7,000(PVIF10%,5)
$40,000 = $10,000(0.909) + $12,000(0.826) +
$15,000(0.751) + $10,000(0.683) +
$7,000(0.621)
$40,000 = $9,090 + $9,912 + $11,265 +
$6,830 + $4,347
= $41,444
[Rate is too low!!]
IRR Solution (Try 15%)
$40,000 =
$10,000(PVIF15%,1) + $12,000(PVIF15%,2) +
$15,000(PVIF15%,3) + $10,000(PVIF15%,4) +
$ 7,000(PVIF15%,5)
$40,000 = $10,000(0.870) + $12,000(0.756) +
$15,000(0.658) + $10,000(0.572) +
$7,000(0.497)
$40,000 = $8,700 + $9,072 + $9,870 +
$5,720 + $3,479
= $36,841
[Rate is too high!!]
IRR Solution (Interpolate)
0.05
X
0.05
X
=
0.10 $41,444
IRR $40,000
0.15 $36,841
$1,444
$4,603
$1,444
$4,603
IRR Solution (Interpolate)
0.05
X
0.05
X
=
0.10 $41,444
IRR $40,000
0.15 $36,841
$1,444
$4,603
$1,444
$4,603
IRR Solution (Interpolate)
0.05
X
0.10 $41,444
IRR $40,000
0.15 $36,841
($1,444)(0.05)
X=
$4,603
$1,444
$4,603
X = 0.0157
IRR = 0.10 + 0.0157 = 0.1157 or 11.57%
IRR Acceptance Criterion
The management of Basket Wonders has
determined that the hurdle rate is 13% for
projects of this type.
Should this project be accepted?
No! The firm will receive 11.57% for each
dollar invested in this project at a cost of
13%. [ IRR < Hurdle Rate ]
DISCOUNTED PAYBACK PERIOD
DPB refers to a period within which the
PRESENT VALUE OF CASH INFLOWS
completely recover the PRESENT VALUE of
cash outflow.
NOTE- COC is the cost of capital which refers to
the minimum rate of return a firm must earn on
its investments.
RELATIONSHIP b/w NPV, IRR & PI ?
(a) IF NPV IS +VE , PI>1
IRR>COC
ACCEPT
(b) IF NPV IS –VE, PI<1
IRR<COC
REJECT
(c) IF NPV =0, PI=1
IRR=COC
IRRELEVANT
ANNUITIES
ANNUITY refers to a series of equal periodical periods . If the
Payments are made at the end of each period, we call it
REGULAR ANNUITY . If the payments are made at the beginning
of each period, we call it ANNUITY DUE.
ANNUITY
PRESENT VALUE OF
FUTURE AMOUNT
TABLE A3+ A4
PVIF
PVIFA
FUTURE VALUE OF
PRESENT AMOUNT
TABLE A1+ A2
FVIF
FVIFA