November 25

Project
Managem
201
ent
0
1st
Assignment
(IRR, NPV,
Abidullah Khan, MBA 4th (A) {BUITEMS}
Depreciation,
Payback
Period)
PRESENT VALUE
Net present value (NPV), is simply the sum of present values for an
investment's anticipated returns over time offset by its up-front costs. This is
an important decision-making tool because an investment may appear
lucrative in today's money, but once its returns are discounted it may reveal
the investment would yield a net loss for the company compared to other
options.

The NPV method is used for evaluating the desirability of investments or

projects.

Where

Ct = the net cash receipt at the end of year t

Io = the initial investment outlay

r = the discount rate/the required minimum rate of return on investment

n = the project/investment's duration in years.

IMPORTANCE OF NPV

Net present value (NPV) is the true measure of an investment’s profitability.

It provides the most acceptable investment rule for the following reasons:

TIME It recognizes the time value of money-a $ received today is worth

VALUE
more than a $ received tomorrow.

MEASURE OF TRUE PROFITABILITY It uses all cash flows occurring over the
entire life of the project in calculating its worth. Hence, it is a measure of the
project’s true profitability. The net present value method relies on estimated
cash flows and the discount rate rather than any arbitrary assumptions, or
subjective considerations.

VALUE The discounting process facilitates measuring cash flows in

ADDITIVELY
terms of present values that is in terms of equivalent, current $. Therefore,
the net present values of projects can be added. For example, NPV (A+B)
=NPV (A) +NPV (B). This is called the value additively principle. It implies
that if we know the net present values (NPV) of individual projects, the value
of the firm will increases by the sum of their net present values (NPVs). We
can also say that if we know values of individual assets, the firm’s value can
simply be found by adding their values. The value additively is an important
property of an investment criterion because it means that each project can
be evaluated, independent of others, on its own merit.

SHAREHOLDER VALUE The net present value (NPV) method is always consistent
with the objective of the shareholder value maximization. This is the greatest
virtue of the method

NET FUTURE VALUE

Net Future Value (NFV) is the total future value of all cash flows. Net Future
Value is an estimate of what the principal will become over time. A positive
Net Future Value indicates a profitable investment. However, given that
future cash flows are estimates, the Net Future Value is only as accurate as
the estimated future cash flows.
NFV = FV1+FV2+FV3+ …. +FVn

INTERNAL RATE OF RETURN (IRR)

Internal rate of return (IRR) is a rate of return on an investment. The IRR of a
project is the discount rate that will give it a net present value of zero. Or it
is the discount rate that equates net present value of an investment
opportunity with $0 because the present value of cash inflows equals the
initial investment.
FORMULA:
As we know that
NPV = n∑t=1 (CFt−CF0) / (1+k)t because (k =IRR)

$0 = n∑t=1 (CFt−CF0) / (1+IRR)t because NPV = $0

Decision criteria:
 If the IRR is greater than the cost of capital, accept the project.
 If the IRR is less than the cost of capital, reject the project.
IMPORTANCE OF IRR
The internal rate of return is basically a capital budgeting technique. This is
used extensively by companies to determine whether or not they should
make a particular investment.
It reflects the quality of an investment. It is also used to make comparisons
among different investment options. An investment is a good option if its IRR
is higher than the rate of return that can be earned by investing the money
elsewhere at equal risk.
The IRR can be used to calculate the time by which your money will devalue
completely. So, if the IRR is say 9%, you would want to put your money into
an investment that offers a rate of return that is more than 9%. If this is not
the case, then your money will devalue.
While the internal rate of return is an important indicator of the quality of an
investment, it is not a good measure in case a project is likely to have cash
outflows after generating cash inflows for a while. The main pitfall of the
internal rate of return is that it does not take into consideration the cost of
the investment.
PROFITABILITY INDEX
Profitability index is the ration of the present value of cash inflows, at the
required rate of return, to the initial cash outflow of the investment.
Profitability index is another time adjusted method of evaluating the
investment proposals is the benefit-cost (B/C) ratio or profitability index (PI).

PI = Present value of cash inflows/ Initial cash outflow

IMPORTANCE OF PROFITABILITY INDEX

The following are the profitability index (PI) acceptance rules:

• Accept the project when profitability index is greater than one

• Rejected the project when profitability index is less than one
• May accept the project when profitability index equal one

The project with positive net present value will have profitability index
greater than one. Profitability index less than one means that the project’s
net present value is negative
Evaluation of profitability index (PI) method

Profitability index (PI) is a conceptually sound method of appraising

investment projects. It is a variation of the net present value (NPV) method,
and requires the same computations as the net present value (NPV) method.

• Time value. It recognizes the time value of money.

• Value maximization. It is consistent with the shareholder value
maximization principle. A project with profitability index greater than
one will have positive net present value (NPV) and if accepted, it will
increase shareholders wealth.
• Relative profitability. In the profitability index (PI) method, since the
present value of cash inflows is divided by the initial cash outflow, it is
a relative measure of a project’s profitability.
DEPRECIATION
Depreciation is the method used by companies to the allocate cost of an
asset over a period of time the asset would be used to earn revenue for the
business. The idea to match the cost of the asset over the period it is being
used up to generate revenue is dictated by the matching concept.
Companies would have to do this so that the financial statements get
reported accurately.

Depreciation is done for 2 purposes

1. To match the revenue earned by the asset during a period and its cost.
2. Without distributing the cost the total assets would reflect the original
cost for all the years until the asset becomes unavailable even though
generally, the asset loses values over period of time.

The cost of an asset should be the delivered and installed cost of the asset.
It should be the cost involved in getting the asset to be productive for the
company. A machine that the company buys would need to be installed and
tuned to the company's specifications before it can be put to use for
generating revenue for the company. The cost should include the money
spent on these preparations for arriving at the cost of an asset.

The useful life of an asset is the period of time the company thinks it's
going to use the product or the period the company thinks the product could
be put to generate revenue for the company.

The salvage value is the value the company expects to realize when an
asset is sold at the end of the estimated useful life of the asset. Salvage
value is the market value the asset is supposed to fetch after the useful life.
It is similar to the tax deduction people get on the tax returns when they
donate a car, the salvage amount is determined as the current market price
of the car. The salvage amount is sometimes tricky to calculate because of
market conditions and demand of the product. It also depends on the
industry the asset is or the amount of customization the asset has gone
through and if it would have any demand on the market. Sometimes the
asset could also become obsolete within the period of useful life making it
very difficult to calculate the salvage value. For example software the
company buys. The company might use it for 10 years but technology
products usually become obsolete very soon.

The 2 most commonly used method of calculation is

• Straight line-method of calculation is a more direct method where
the depreciation amount is constant thought the life of the asset. The
asset is gradually depreciated throughout the life of the asset.
• Accelerated Methods of calculation depend on the straight line
method for the rate of depreciation and then apply that depreciation at
a faster rate. The amount of depreciation is not constant and the
product depreciates faster.