Cost Benefit Analysis

Sony Thomas
Critical Decisions for a Firm

Investment Decisions
Financing Decisions

Dividend Decisions
Present and Future Value
Future Value
Amount to which an
investment will grow
after earning interest
Present Value
Value today of a
future cash
flow.
 Future Values

Future Value of Rs 100 = FV

FV = Rs100 × (1 + r ) t
 Future Values
FV = 100 × (1 + r ) t

Example - FV
What is the future value of Rs 100 if interest is
compounded annually at a rate of 6% for five years?

FV = 100 × (1 + .06) = 133.82 5

 Present Value

Present Value = PV

PV = discount factor × FV
 Consider following case

You are manager of a Company responsible for

identifying projects. Current investment
required is Rs 3.7 lakh. The project is suppose
to give you Rs 4.2 lakh next year. Is it
worthwhile to invest in the project?(assume 5%
Discount rate)
 Valuation
Step 1: Discount future cash flow s

PV = C1
(1+r ) = 420 , 000
(1+.05 ) = 400,000
Step 2: Go ahead if PV of payoff ex ceeds
investm ent

NPV = 400 ,000 − 370 ,000

= 30 ,000
 Risk and Present Value

 Higher risk projects require a higher rate

of return
 Higher required rates of return cause
lower PVs
 Risk and Present Value
PV of C1 = 420,000 at 12%
420,000
PV = = 375,000
1 + .12

PV of C1 = 420,000 at 5%
420,000
PV = = 400,000
1 + .05
 Net Present Value Rule
 Accept investments that have positive
net present value
Example
Suppose we can invest 50 today and receive 60
in one year. Should we accept the project given a
10% expected return?
60
NPV = -50 + = 4.55
1.10
 Internal Rate of Return
Ex am ple
You can purchase a turbo powered machine tool
gadget for 4,000. The investment will generate
2,000 and 4,000 in cash flows for two years,
respectively. What is the IRR on this
investment?
 Internal Rate of Return
Ex am ple
You can purchase a turbo powered machine tool gadget for 4,000.
The investment will generate 2,000 and 4,000 in cash flows for two
years, respectively. What is the IRR on this investment?

2,000 4,000
NPV = −4,000 + + =0
(1 + IRR ) (1 + IRR )
1 2

IRR = 28.08%
 Internal Rate of Return
2500
2000
1500
IRR=28%
1000
NPV (,000s)

500
0
-500
10

20

30

40

50

60

70

80

90

0
10
-1000
-1500
-2000
Discount rate (%)
 CFO Decision Tools
Survey Data on CFO Use of Investment Evaluation Techniques

NPV, 75%

IRR, 76%

Payback, 57%

Book rate of
return, 20%

Profitability
Index, 12%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

SOURCE: Graham and Harvey, “The Theory and Practice of Finance: Evidence from the Field,”
Journal of Financial Economics 61 (2001), pp. 187-243.