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PRESENTED BY: SHALINI VERMA(01) VIKRAM CHOUDHARY(02) ANKITA BHATTA(17) RAJA BABU(20)
WHERE: Ct= Cash Flows K= Opportunity cost of capital C0= initial cost of inv. t= expected life of investment
Question: Assume a project x costs 2500 now and is expected to generate a year end cash inflow of Rs 900,800,700,600,500 in the years 1 to 5 and opportunity cost of capital is assumed to be 10%.
Question: Let us assume an investment that would cost 20000 and provide annual cash flow of 5430 for 3 years. and the opportunity cost of capital is 10%. what will be the IRR?
STEP1:CALCULATION OF NPV: NPV=-20000+5430(PVFA 6,0.10) =-20000+5430*4.355=3648 STEP 2: CALCULATION OF IRR: NPV= -20000+5430(PVFA 6,0.10)=0 20000=5430(PVFA 6,0.10) hence,(PVFA 6,0.10)= 20000/5430=3.683 STEP 3 : LOOK UP FOR THE VALUE OF PVFA IN TABLE. THE VALUE IS APPROXIMATELY 16%. thus , 16% is the project IRR that equates the present value of initial cash outlay (20000) with a constant annual cash inflow (5430 per year) for 6 years.
Key differences between the most popular method the NPV (Ne Present Value) Method and IRR (Internal Rate of Return) Method include:
NPV is calculated in terms of currency while IRR is expressed in terms of the percentage return firm expects the capital project to return; Academic evidence suggests that the NPV Method is preferred over other methods since it calculates additional wealth and the IRR Method does not;
The IRR Method cannot be used to evaluate projects where there are changing cash flows (e.g an initial outflow followed by in-flows and a later out-flow, such as may be required in the case of land reclamation by a mining firm);
However, the IRR Method does have one significant advantage -- managers tend to better understand the concept of returns stated in percentages and find it easy to compare to the required cost of capital; and, finally,
While both the NPV Method and the IRR Method are both DCF models and can even reach similar conclusions about a single project, the use of the IRR Method can lead to the belief that a smaller project with a shorter life and earlier cash inflows, is preferable to a larger project that will generate more cash. Applying NPV using different discount rates will result in different recommendations. The IRR method always gives the same recommendation.
Question: Assume a project x costs 2500 now and is expected to generate a year end cash inflow of Rs 900,800,700,600,500 in the years 1 to 5 and opportunity cost of capital is assumed to be 10%.
Evaluation of PI method
Time value : it recognizes the time value of money concept. Value maximisation : it is consistent with the shareholder value maximisation principle .A project with PI greater than1 will have positive NPV and if accepted , it will increase the shareholders wealth. Relative profitability: in the PI method , since the present value of cash inflows is divided by the initial cash outflows, it is a relative measure f a projects profitability.
The NPV and the IRR are both time-weighted, cash flow based measures of return for an investment and yield the same conclusion accept or reject- for an independent, stand-alone investment. When comparing or ranking multiple projects, though, the two approaches can yield different rankings, either because of differences in scale or because of differences in the reinvestment rate assumption.
Capital rationing
Capital Rationing: Refers to the choice of investment proposals under financial constraints in terms of a given size of capital expenditure budget . The objective to select the combination of projects would be the maximisation of total NPV . Project selection under capital rationing involves 2stages: (1) Identification of the acceptable projects (2) Selection of the combination of projects . The acceptability of projects can be based either on PI or IRR. The method of selecting investment projects under capital rationing situation will depend upon whether the projects are indivisible or divisible . In case the project is to be accepted or rejected in its entirety ,it is called an indivisible project ; a divisible project on the other hand can be accepted/rejected in part.
1. Project discovery: the implicit assumption that firms know when they have good projects on hand underestimates the uncertainty and the errors associated with project analysis. In very few cases can firms say with complete certainty that a prospective project will be a good one.
2. Credibility: financial markets tend to be sceptical about announcements made by firms, especially when such announcements contain good news about future projects because it is easy for any firm to announce that its future projects are good, regardless of whether this is true or not, financial markets often require more substantial proof of the viability of projects.
3.Market efficiency: if the securities issued by a firm are underpriced by markets, firms may be reluctant to issue stocks and bonds at these low prices to finance even good projects. In particular, the gains from investing in a project for existing stockholders may be overwhelmed by the loss from having to sell securities at or below their estimated true value.
4.Flotation costs: these are costs associated with raising funds in financial markets, and they can be substantial. If these costs are larger than the NPV of the projects considered, it would not make sense to raise these funds and finance the projects.
IRR is a measure of safety margin in a project. Higher IRR means more safety margin in the projects estimated cash flows PI is a measure of cost-benefit analysis. How much NPV for every dollar of initial investment