Net present Value
Net present value (NPV) of a project represents the change in a company's net worth/equity that
would result from acceptance of the project over its life. It is one of the most reliable techniques
used in capital budgeting because it is based on the discounted cash flow approach.
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.
An initial investment of 8,320 thousand on plant and machinery is expected to generate net cash
flows 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.
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
Net Cash Inflow
Salvage Value
Total Cash Inflow
× Present Value Factor
Present Value of Cash Flows
1
3,411
2
4,070
Total PV of Cash Inflows
− Initial Investment
Net Present Value
10,888
− 8,320
$2,568
thousand
3
5,824
4
2,065
900
3,411
4,070
5,824
2,965
0.8475
0.7182
0.6086
0.5158
2,890.68 2,923.01 3,544.67 1,529.31
PR Engineering is considering the purchase of a new machine. The following are the information
relating to 2 alternative models- MX and MY
Machines
Cost of
machine
Expected life
Scrap value
Machine
MX
8,00,000
Machine
MY
10,20,000
6 years
20,000
6 years
30,000
Estimated net income before depreciation
and tax
Year
Rs
Rs
1
2,50,000
2,70,000
2
2,30,000
3,60,000
3
1,90,000
3,80,000
4
2,00,000
2,80,000
5
1,80,000
2,60,000
6
1,80,000
1,85,000
The corporate tax rate is 30% and the company’s required rate of return on investment is 10%.
Depreciation on straight line method. You are required to
a) Calculate the pay back period of each proposal
b) Calculate the NPV if the PV factor at 10% is 0.909. 0.826. 0.751. 0.683 and 0.564
respectively for year 1 to 5
c) Which proposal would you recommend and why
PKJ Ltd. is considering two mutually – exclusive projects. Both require an initial cash outlay `
10,000 each for machinery and have a life of 5 years. The Company’s required rate of return is
10% and it pays tax at 50%. The projects will be depreciated on a straight line basis. The net
cash flows (before taxes) expected to be generated by the projects and the present value (PV)
factor (at 10%) are as follows:
You are required to compute NPV of each project.
Cost of capital is 10%. Decide which project is preferable from NPV point of view
Annual Cost Saving ` 4,00,000 Useful life 4 years Cost of the Project ` 11,42,000 The Pay back
period would be
(A) 2 years 8 months (B) 2 years 11 months (C) 3 years (D) 1 year 10
months
Five Projects M, N, O, P and Q are available to a company for consideration. The investment
required for each project and the cash flows it yields are tabulated below: Compute NPV and
Benefit cost ratio
PQR company is considering to select a machine out of two mutually exclusive machines. The
company’s cost of capital is 12% and tax rate is 30%. Other information relating to both
machines are as follows:
Particulars
Machine I
Machine II
Cost of machine
15,00,000
20,00,000
Expected life
5 years
5 years
Annual Income ( before Tax & depreciation) 6,25,000
8,75,000
Depreciation is charged on straight line basis. You are required to calculate
a.Discounted pay back
b.NPV c.Profitability index
The present value factors of Rs.1 @ 12% are as follows:
Year
PV factor @ 12%
01
0.893
02
03
0.797 0.712
04
05
0.636
0.567
The management of P Limited is considering selecting a machine out of two mutually exclusive
machines. The company’s cost of capital is 12% and tax rate is 30%. Details of the machines are
as follows:
Machine I
Machine II
Cost of machine
10,00,000
15,00,000
Expected life
5 years
6 years
Annual Income before Depreciation & Tax
3,45,000
Depreciation is on straight line basis.
You are required to calculate discounted pay pack, NPV and IRR
4,55,000
C Limited is considering investment in a project. The expected original investment in the project
will be Rs.2,00,000. The life of the project will be 5 years with no salvage value. The expected
profit after depreciation but before tax during the life of the project will be as follows:
Year
1
2
3
4
5
Rs.
85,000
1,00,000
80,000
80,000
40,000
The project will be depreciated at 20% on original cost. The company is subjected to 30% tax
rate.
Required:
a.Calculate PBP and ARR
b.Calculate NPV and NPV Index, if cost of capital is 10%
c.Calculate IRR
The PV factors are