• Time value of money.
• Financial feasibility of a project.
Years
0(today) 1 2 3 4 5
Capital Investment(Factory) -1000
Cash inflow before interest 200 300 400 300 400
Total cash flow before interest -1000 200 300 400 300 400
IRR= 16.30%
NPV at IRR= 0.00 $0
Loan amount 1000
Interest rate 16.30%
Simplifying assumption is that every year the cash inflow is fully utilised to
pay interest and principal.Also the repayment of principal is limited to the
amount of cash available.
Years
0(today) 1 2 3 4 5 Total (1-5)
Total cash flow -1000 200 300 400 300 400 1600
Interest paid 163 157 134 90 56 600
Principal repaid 37 143 266 210 344 1000
Cash balance after interest and loan repayment 0 0 0 0 0
Loan at the beginning of the year 1000 963 820 554 344
Repaid during the year on last day 37 143 266 210 344
Loan at the end of the year 963 820 554 344 0
Interest on loan 163 157 134 90 56 0
Years
0(today) 1 2 3 4 5
Capital Investment(Factory) -1000
Cash inflow before interest 200 300 400 300 400
Total cash flow before interest -1000 200 300 400 300 400
IRR= 16.30%
NPV at IRR= 0.00 $30
Loan amount 1000
Interest rate 15.00%
Simplifying assumption is that every year the cash inflow is fully utilised to
pay interest and principal.Also the repayment of principal is limited to the
amount of cash available.
Years
0(today) 1 2 3 4 5 Total (1-5)
Total cash flow -1000 200 300 400 300 400 1600
Interest paid 150 143 119 77 43 531
Principal repaid 50 158 281 223 288 1000
Cash balance after interest and loan repayment 0 0 0 0 69
Loan at the beginning of the year 1000 950 793 511 288
Repaid during the year on last day 50 158 281 223 288
Loan at the end of the year 950 793 511 288 0
Interest on loan 150 143 119 77 43 0
Years
0(today) 1 2 3 4 5
Capital Investment(Factory) -1000
Cash inflow before interest 200 300 400 300 400
Total cash flow before interest -1000 200 300 400 300 400
IRR= 16.30%
NPV at IRR= 0.00 ($15)
Loan amount 1000
Interest rate 17.00%
Simplifying assumption is that every year the cash inflow is fully utilised to
pay interest and principal.Also the repayment of principal is limited to the
amount of cash available.
Years
0(today) 1 2 3 4 5 Total (1-5)
Total cash flow -1000 200 300 400 300 400 1600
Interest paid 170 165 142 98 64 639
Principal repaid 30 135 258 202 336 961
Cash balance after interest and loan repayment 0 0 0 0 0
Loan at the beginning of the year 1000 970 835 577 375
Repaid during the year on last day 30 135 258 202 336
Loan at the end of the year 970 835 577 375 39
Interest on loan 170 165 142 98 64 0
What is Net Present Value (NPV)?
• Shows the difference between the projects’s financial
benefits and costs.
• Summarizes a lifetime of cash flow values into a single
figure (PV), allowing easy comparison of value between
different projects.
• Comparison of NPVs of different projects must be
assessed using same discount rate.
• Discounted net cash flow which takes into account cost of
capital (discount rate).
• Projects with positive NPV should be developed further
because benefits exceed costs
• If a project has a negative NPV costs exceed benefits. Do
not develop or review.
NPV Calculation and discount rate
• NPV= (-)Initial investment + DCF year 1 + DCF
year 2 + …….+ DCF Last year of project.
• Discount rate is a critical input to the estimation
process of the PV of risk adjusted cash flows
• The discount rate to be used is the risk adjusted
cost of capital or WACC , depending on the cash
flows being considered.
What is Internal Rate of Return(IRR)?
• IRR is related to NPV, but expressed as a
percentage.
• Shows what interest rate would lead to a NPV of
zero. Break Even (hurdle rate)in PV terms.
• Should be compared with the investors required
rate of return.
• If required rate is lower than the IRR project is
attractive, and vice versa.
• By comparing against a required rate of return,
IRR is useful for testing the viability of a project.
What is Internal Rate of Return(IRR)?
• Represents the time adjusted earnings over the
life of the project.
• The rate that equates the PV of cash inflows to
the PV of cash outflows. The discount rate that
sets NPV of cash flows to zero.
• However, IRR does not give enough information
to say whether one project should be pursued
ahead of another.
• NPV should be used to compare different
projects.
Project IRR(PIRR) vs Equity IRR(EIRR)
• A distinction is made in Project IRR and Equity IRR
• They differ in terms of cash flows.
• PIRR signifies returns to all investors (providers of
capital) in the project. Cash flows are the ones
benefitting the entire project.
• EIRR measures the returns for the shareholders of
the project company, after the debt has been
paid off. It is based on free cash flows available to
equity holders.
Project IRR(PIRR) vs Equity IRR(EIRR)
• PIRR must be able to cover the weighted average
cost of capital (WACC) of the project.
• WACC is calculated as the post-tax weighted
average cost of the mix of funds employed for
the project
• Hence when studying the financial feasibility of
the project as a whole we must compare PIRR
with WACC.
• EIRR should be able to cover the cost of equity,
for the project to provide adequate returns to the
equity holders.
WACC
• WACC = (Post-Tax Cost of Debt X proportion of
debt) + (Cost of Equity X proportion of Equity) +
(Cost of Quasi-Equity X proportion of Quasi-
Equity).
Project IRR = Returns to all Investors.
Is the Discount Rate that Makes
Initial Cash Outflow = Operating Cash Inflows + Terminal Value
where
Operating cash inflows = PAT + D + A +Post tax interest + change in Net Working Capital
PAT=Profit After Tax. D=Depreciation. A= Ammortization
Equity IRR = Returns to Equity holders
Is the Discount Rate that Makes
Initial Equity Outflow = Free Cash Flows to Equity + Terminal Value
where
Free Cash Flows to Equity = PAT + D + A -Loan Repayment
+ Change in Net Working Capital
How do we find IRR by trial and error?
Dis. Factor Dis. Factor
Cash Flows 9% PV 11% PV
Year 1 beginning -1000000 1.0000 -1000000 1.0000 -1000000
Year 1 end 150000 0.9174 137615 0.9009 135135
Year 2 end 125000 0.8417 105210 0.8116 101453
Year 3 end 100000 0.7722 77218 0.7312 73119
Year 4 end 75000 0.7084 53132 0.6587 49405
Year 5 end 1050000 0.6499 682428 0.5935 623124
Net Cash Flow 500000 55603 -17764
1.Gap between discount rates is 2%
2. Gap between NPVs is 73367
3.We want discount rate which will give zero NPV
4.This should lie between 9% and 11%
9% ?% 11%
55603 0 -17764
5.We add an arithmetic proportion of the difference between the two trial
rates, to the lower rate,depending on how much its NPV is from zero
55603 = 0.76
73367
6.IRR= 9%+(0.76*2%)=10.52%
How do we find IRR by trial & error?
Dis. Factor
Cash Flows 10.50% PV
Year 1 beginning -1000000 1.0000 -1000000
Year 1 end 150000 0.9050 135750
Year 2 end 125000 0.8190 102379
Year 3 end 100000 0.7412 74122
Year 4 end 75000 0.6708 50311
Year 5 end 1050000 0.6071 637438
Net Cash Flow 500000 0
Project Cost= 1000
Project period = 1 year construction + 5 years operations
Operating profit(PBDIT) is provided in the table below
Tax, depreciation assumed to be deducted from operating profit.
Debt to Equity Ratio = 1:1 ( i.e. 50% each)
Loan 500 Repayable 5 equal installments
Interest rate on loan 12%
Tax rate 33.3%
Post Tax cost of debt(Kd) = 8%
Post Tax cost of equity(Ke) = 25% WACC= 17%
Loan and interest 0 1 2 3 4 5
Opening Balance 0 500 400 300 200 100
Loan taken 500
Loan repaid 100 100 100 100 100
Closing Balance 500 400 300 200 100 0
Interest on loan 60 48 36 24 12
Cash flow analysis
Years 0 1 2 3 4 5
Project Cost -1000
PBDIT(A) 260 350 450 500 650
Interest @ 12%(B) 0 60 48 36 24 12
Depreciation(C) 200 200 200 200 200
Profit before Tax(D) 0 102 214 276 438
Tax(E) 0 34 71 92 146
PAT( F) 0 68 143 184 292
Post Tax Interest-PTI(G) 40 32 24 16 8
Project Cash Flow -1000 240 300 367 400 500
(A-B-E+G) or(F+G+C) 240 300 367 400 500
Project IRR= 20.6%
Project NPV at WACC= 93.65
Loan Repayment(H) 100 100 100 100 100
FCF to Equity(F+C-H) -500 100 168 243 284 392
Equity IRR = 29.3%
Assessment: Project is feasible because Project IRR 20.6% is greater
than WACC(17%). Equity IRR (29.3%)is more than post tax cost of
equity-25%
Benefit Cost ratio or profitability index
• It is the present value of future net cash flows
over the initial cash outlay.
• As long as the index is greater than 1, the
proposal is acceptable. It indicates a positive NPV.
If it is less than 1 it indicates a negative NPV.
Pay back period
• Number of years it takes for the initial investment
in a project to be paid back. (PG education)
Cash Flows
C0 C1 C2 C3 Payback
A -2000 500 500 5000 3 years
B -2000 500 1800 0 2 years
C -2000 1800 500 0 2 years
Payback can give misleading answers
1.It ignores all cashlows after the cutoff date. If cutoff date is two
years,it rejects project A, regardless of the size of the cash inflow in
year 3.
2. It gives equal weight to all cash flows before the cutoff date and
ignores time value of money. B & C are equally attractive.
Accounting rate of return
• Measures the ratio of the average annual profits
after taxes to the investment in the project.
• It is easy to calculate making use of readily
available accounting information.
• It is compared with the required or cut-off rate to
decide if a particular project should be accepted.
• Shortcomings-
1. Based on accounting income rather than cash
flows.
2. Does not take into account time value of money.
Accounting rate of return
We have three investment proposals , each costing Rs. 9000, having
an economic and depreciable life of 3 years.They are expected to
provide following book profits and cash flows over the next 3 years
Project A Project B Project C
Book Net Cash Book Net Cash Book Net Cash
Period Profit Flow Profit Flow Profit Flow
1 3000 6000 2000 5000 1000 4000
2 2000 5000 2000 5000 2000 5000
3 1000 4000 2000 5000 3000 6000
Each proposal will have the same average rate of return:2000/9000 or
22.22%. But the three projects are not equally favourable. Most will
prefer A which provides large portion of total cash benefits in the
first year.
