UNIT -5 FINANCIAL ACCOUNTING AND CAPITAL BUDGETING

Financial Ratio Analysis:

1. Liquidity ratios
2. Leverage ratios
3. Turnover ratios
4. Profitability ratios
5. Valuation ratios

1.Liquidity ratios:
Liquidity refers to the ability of a firm to meet its obligations in the short run (usually one year
period). Liquidity Ratios can be classified as
CURRENT RATIO and
ACID TEST RATIO.

Current Ratio = Current Assets / Current Liabilities

Current Assets include Cash, Marketable Securities (Stocks, bonds, preferred shares, are among
the most common examples of marketable securities. These short-term liquid securities can be
bought or sold on a public stock exchange or a public bond exchange. These securities tend to
mature in a year or less. ),

Debtors [A debtor is an individual or organisation that owes the money who got loan from a
financial institution ], Inventories (Stocks), Loans and Advances(to be received from money
borrowers) and Prepaid expenses. In our example Current Ratio for the year end 2001 =
234/105= 2.23 [Industry Average is 2.15]

Creditors are individuals/businesses that have lent funds to another company and are therefore
owed money.
By contrast, debtors are individuals/companies that have borrowed funds from a business and
therefore owe money.

Prepaid expenses are future expenses that are paid in advance, such as rent or insurance.
On the balance sheet, prepaid expenses are first recorded as an asset. As the benefits of the
assets are realized over time, the amount is then recorded as an expense

Current Ratio measures the ability of the firm to meet its current liabilities. Higher the Current
Ratio the greater the short term Solvency [possession of Assets in excess to Liability]. Current
Assets in the form of Cash and Debtors are more liquid than inventories. General norm given by
Bank is 1.33

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 Acid Test Raitio: It is also called as Quick Ratio
Acid Test Ratio = Quick Assets / Current Liabilities
Quick Assets = Current Assets - Inventories
Acid Test Ratio = 129 /105 = 1.23. [1.20]
This test is a stringent measure of Liquidity.{because high liquidity assets only taken}

2. Leverage Ratios:
This refers to the use of Debt Finance. Debt capital is cheaper but riskier source of Finance.
Leverage Ratio helps in assessing this Risk.
Debt is Bank Loans and Equity is contributed by Promoter or entrepreneur himself.

i) Debt Equity Ratio : This shows the relative contributions of Lenders and Owners.
Debt Equity Ratio = Debt / Equity where Debt is Loan Funds and Equity is Share holders’
Fund.
212 /262 = 0.81
Lower the Debt Equity Ratio, higher is the degree of protection enjoyed by Creditors. ie., Equity
is to be more.
Creditor: a person or company from whom you have borrowed money

ii) Interest Coverage Ratio (Time interest earned)

Interest Coverage Ratio = Profit before Interest and Taxes / Interest
89 / 21 = 4.23
Higher this ratio means that the firm can easily meet its interest burden.
ie., Profit is to be more or numerator is to be more.

3. Turnover Ratios:
It is also known as Activity Ratios or Asset Management Ratios.
This measures how efficiently the assets are employed by a Firm.

4 types are there:

i. Inventory Turnover Ratio:
Also called as Stock Turnover Ratio.
This measures how fast inventory is moving through the Firm and generate Sales
Inventory Turnover Ratio = Cost of Goods sold / Inventory.
552 / 105 = 5.26
This shows efficiency of Inventory Management.
Higher the ratio, more is efficient in management of Inventories.

ii) Debtors Turnover Ratio:

This shows how many times Accounts Receivables (Debtors) turnover during the year.
Debtors Turnover Ratio = Net Credit Sales / Debtors
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 [If credit sales is not available then use Net sales figure]
701 / 114 = 6.15
Higher the Debtors Turnover greater is the efficiency of Credit management.

iii) Fixed Assets Turnover Ratio :

This measures Sales per rupee of investment in Fixed Assets.
Fixed Assets Turnover = Net Sales / Net Fixed Assets
701 / 330 = 2.12
High Ratio indicates high efficiency in Asset Utilisation.
iv) Total Assets Turnover Ratios:
Total Assets Turnover Ratio = Net Sales / Total Assets
701 / 488 = 1.44
This measures how efficiently Assets are employed overall.

Gross Profit = Sales Revenue – Cost of Goods sold

Net Profit = All Revenues - All expenses including cost of Goods sold
(Selling, General and Administration expenses S,G and A) and Non operating expenses [unrelated
to Core operation], Depreciation, Amortization (paying of Loans or Debts in regular installments
over a period of time)

4. Profitability ratios: This is final result of business operations. There are two types under
this.1.Profit Margin ratios and 2. Rate of return ratios.

Profit margin ratios shows the relationship between profit and sales. Two types of Profit margin ratios
are a. Gross profit margin ratios and b. Net profit margin ratios.

Gross profit margin ratio = Gross profit / Net sales 149/701 =0.21 or 21% . This ratio shows the margin
left after meeting Manufacturer’s cost. This measures the efficiency of production and pricing.
Numerator is to be more.

Net profit margin ratio = Net profit / Net sales 34/701= 0.049 or 4.9% Here also numerator is to be
more. This ratio shows the earnings left for share holders (both equity and preference) as a % of net
sales . this measures the over all efficiency of the firm.

GROSS PROFIT= SALES REVENUE – COST OF GOODS SOLD

NET PROFIT = ALL REVENUES – ALL EXPENSED INCLUDING COST OF GOODS SOLD, SELLING COST,
GENERAL AND ADMINISTRATIVE EXPENSES, NON OPERATING EXPENSES [UNRELATED TO CORE
OPERTIONS], DEPRECIATION, AMORTIZATION [paying of depts. In equal instalments over a time
period], INTEREST CHARGES, ETC.,

Rate of return ratios: This is also called Return on capital employed ratios (ROCE)

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ROCE is used to measure the profitability.

ROCE 1 = Profit after Tax / Total Assets 34/488 = 7%

ROCE 2 = Profit before interest and tax / Total Assets 89/488=18.2%

ROCE 1 is widely used

ROCE2 is also called Earning Power . It is a measure of Business performance not affected by interest
charges and Tax burdens.

Return on equity ratios:

Return on equity ratio = Equity earnings / Networth = Profit after Tax – Preference dividends / Networth
Networth = paidup capital + Reserves and surplus

34/262 = 0.130 or 13% It reflects the productivity of the ownership capital employed in the firm.

5.Valuation ratios:

This indicates how the equity stock of the company is assessed in the capital market.

a. Price earning ratio = market price per share /earnings per share 21/ 2.27 = 9.25.
Market price per share is current measure of price of that share in the market and earnings per
share is the portion of company’s profit allocated to each share.
b. Yield: this is the measure of the rate of return earned by share holders.

Yield = [Dividend + Price change] / Initial price

c. Market value to Book value ratio

This is a stock market statistic.

Market value to Book value ratio = Market value per share / Book value per share 21/17.07 =1.23
if this ratio exceeds 1, it means the firm has contributed to the creation of wealth in the society.

FUND FLOW ANALYSIS AND CASH FLOW ANALYSIS:

It is necessary to have sufficient amount of liquidity in the business. Engineers and Managers spend lot
of time and efforts to maintain proper liquidity position in business and to know and analyse liquidity
position of the firm.

Proper positioning of Networking capital (NWC) of the firm, cash and cash equivalents position of the
firm is called Business Liquidity. [ Net working capital (NWC) is the difference between a company’s current assets
and current liabilities. ... For example, if current assets are $85,000 and current liabilities are $40,000, the NWC is $45,000.] .

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FUND FLOW STATEMENT and FUND FLOW ANALYSIS:

During an accounting period, working capital or Funds flow from one element of balance sheet to
another. Ultimately, it is the amount of Networking capital available to the firm as liquid resource.

Networking capital = Gross working capital - Current liabilities

Working capital: the capital of a business which is used in its day-to-

day trading operations, calculated as the current assets minus the
current liabilities.
Gross Working capital:

The sum of a firm’s all (total) current assets (assets able to be converted into cash within a
year).

Gross working capital includes assets such as cash, savings bank account balances, account
receivables, short term investments, inventory, marketable securities.

Networking capital = Gross working capital - Sum of all Company’s current liabilities

Networking capital is used to measure the short term liquidity of a business.

A statement that use Networking capital as a measure of liquidity

position is called Fund flow statement and its analysis is Fund flow
analysis. Cash and Market securities are taken as liquidity position.
Fund flow analysis:

 It is the detailed analysis of the Networking capital (NWC) position of the firm.

 It helps management to control Networking capital amount.

 It analyses the critical review of the liquidity position .

For effective Fund flow analysis the following are to be understood:

 Concepts of Sources and Uses of funds

 Effects of changes in various Balance sheet items on the networking capital position of the firm.

 The rearrangement and consolidation of information taken from Balance sheet as indicated
above and relevant information from Profit and Loss account in the form of Fund statement.

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Concept of Sources and Uses of funds:

First step in Fund flow is to classify the business transaction into Sources and Uses of funds.

Increase in Assets, decrease in Liabilities or increase in Networking capital balance are USES OF FUNDS.

Decrease in Assets, increase in Liabilities or decrease in Networking capital balance are SOURCES OF
FUNDS.

The above analysis tells about sources and uses of funds but it does not tell about over-all impact on

Networking capital of the firm.

An increase in NWC means, its amount at the end of the period is greater than its amount at the
beginning of the period.

An increase in NWC balance during the accounting period denotes the

deployment of more funds by the amount of increase and hence it is called USE
OF FUNDS.

A decrease in NWC balance denotes the availability of funds with the business,
hence it is SOURCES OF FUNDS.

Uses of Fund flow analysis:

1. How much is the amount on NWC deployed in business.

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 2. How much change has taken place in NWC over the period.

3. Is the ratio between the sources of short term finance and long term finance reasonable.

4. How much funds are provided by business operations in order to finance fixed assets.

5. Is the balance between funds from operations and other long term sources reasonable.

6. Which long term sources of funds can be further tapped to finance current assets.

7. What corrective action should be initiated by Management, if problems are spotted both in
investment and financing.

Management uses Fund flow analysis to answer the above questions. These questions are pertinent to
manage liquidity and the structure of working capital in a business.

Further, periodic fund flow analysis is useful, rather essential to avail working capital loan from Banks.

CASH FLOW STATEMENT AND CASH FLOW ANALYSIS:

Analysis based on Fund flow statement does not take into account the off-setting movements among
the individual current assets and liabilities.

An increase or decrease in the individual elements of current assets (other than cash) and liabilities
affect cash in different ways.

For example, an increase in Sundry creditors and Bank over draft have different implications in terms
of repayment of cash.

Sundry creditor’s bill may fall due after one or two months. But Bank overdraft facility may be for a long
duration (6 to 18 months). So with the records the firm may be in a sound financial position as reflected
by the amount of NWC but it has difficulty in meeting its short term commitments.

For this purpose , cash flow statement is prepared and its analysis is conducted to assess the ability
of the firm to meet its obligations to trade creditors, bankers and to pay interest to debenture holders
and dividend to its shareholders.

The statement prepared on cash basis is called cash flow statement and its
analysis is referred to as cash flow analysis.
Cash, marketable securities are taken as liquidity position. The change in the amount of cash and its
equivalent s during the accounting period reflects liquidity position.

That is, here, items which do not change NWC position but affect cash position of the firm are analysed.
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Example: collection of money from accounts receivables does not change the NWC of the firm, as it
neutralizes the impact of an increase in one element of working capital (cash) by an equivalent decrease
in another element (ie., accounts receivables). But it does affect the cash position of the firm and
therefore included in the cash basis analysis.

Cash analysis takes care about the liquidity position of the firm by taking a limited view of the pool of
funds available to the firm.

It is cash and cash equivalent items only that form the liquidity position of the firm.

Hence, instead of NWC, the focus shifts to change in the cash account. Cash flow statement is focusing
on cash instead of NWC.

Cash flow statement helps to answer the following questions:

1. How much is the amount of cash

2. How much change has taken place in cash over time

3. How much cash is provided by the operations of the business

4. Is there a proper balance between various sources of cash.

5. How much cash is used

6. For which purpose the cash is used

7. How much more cash has to be obtained as compared with what the firm has and from what
source, etc.,

The answers to the above questions facilitate the management to know the structural health and
liquidity aspects of working capital effectively.

Short notes on Fund flow analysis and Cash flow analysis:

Fund flow analysis refers to the flow of permanent capital (networking capital) analysis.
This analysis takes Net working capital view of the liquidity position . A statement that uses
Networking capital as a measure of liquidity position is called Fund flow statement and its
analysis as Fund flow analysis.

Cash flow analysis refers to the changes in cash or cash equivalent items between two
balance sheet data. This analysis takes a more conservative view of it ie., cash basis only.
The statement prepared on cash basis is called Cash flow statement and its analysis is
referred to as Cash flow analysis.

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Example: collection of money from accounts receivables does not change the NWC of the firm, as it
neutralizes the impact of an increase in one element of working capital (cash) by an equivalent
decrease in another element (ie., accounts receivables). But it does affect the cash position of the
firm and therefore included in the cash basis analysis.

Cash analysis takes care about the liquidity position of the firm by taking a limited view of the pool of
funds available to the firm.

It is cash and cash equivalent items only that form the liquidity position of the firm.

Hence, instead of NWC, the focus shifts to change in the cash account. Cash flow statement is
focusing on cash instead of NWC.

Fund flow and Cash flow analysis are two most important tools available to management to
analyse the liquidity position of the firm.

Both approaches, though take two different views of the liquidity position, in fact one
complements and supplements each other.

Both fund flow and cash flow analysis can provide rich insights to the management to take
informed working capital decisions in order to accomplish the goals of the organization
efficiently and effectively.

Comparative financial statements

Analysis and interpretation of Financial statements:

After calculating all the financial ratios we have to analyze the firm’s condition with these financial
ratios.

For judging whether the ratios are high or low, we may do comparative analysis such as a cross section
analysis by either of two methods:

1. Comparing with industry averages which are used as bench marks for comparison
2. Time series analysis may be done in which the ratios of the firm are compared over time
1. Comparison with Industry average:
a. Liquidity ratio are to be equal or higher than the industry average
b. Leverage ratios are to be more or less equal to industry average
c. Turnover ratios are to be equal or more than the industry average
d. The profit margin ratios and rate of return are to be higher than the industry average
e. The valuation ratios are to be more than the industry average

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 2. Time series analysis

Instead of looking at the above said financial ratios for one year, we can look at these ratios for
several years. This helps in detecting secular changes and avoiding the bias introduced by the
transitory forces.

3. Du-pont Analysis

Du-pont company of US found out a system of financial analysis. It blends information from profit
and loss account and balance sheet into key measures of performance.

Du-pont system expresses return on equity as a product of two basic ratios:

i. Return on total assets

ii. Financial leverage multiplier

The return on total assets, is the product of two key ratios,, net profit margin and total assets turnover.

So, Profit after Tax/Networth =Profit after Tax/Net sales x Net sale/Total assets x Total assets/Networth
[ie., Return on equity = Net profit margin x Total assets turnover x Financial leverage multiplier]

Profit and loss account information provides details underlying the net profit margin. Examining them
may indicate areas where cost reduction may be effected to improve the net profit margin. The balance
sheet information tells on how turnover may be improved and what scope exists for exploiting financial
leverage.

Standardized Financial statements

When comparing a company’s financial statement with other competitive company it may not give good
result since different companies differ in sizes. Even when comparing with the same company in time
series method, it may go wrong since the company’s size changes over time.

So we have to standardize the financial statements. A simple way is to work with percentages rather
than rupees.

Two methods are there in this

1. Common size financial statements: Here express each item on the profit and loss account
as a % of sales and each item on the balance sheet as a % of total assets. The resulting
financial statements are called ‘common size statement’
2. Common-Base year financial statements: Suppose we are looking at the financial
statements of a company over a period of time and trying to figure out trends in revenues,
profit, networth, debt, etc., A usual way of doing this is to select a base year and then
express each item relative to the amount in the base-year. The resulting statements are
called ‘Common-Base year statement.

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Problems in Financial statements:

1. Heuristicand intutivecharacter- the ratios are not often related logically to a well defined
theoretical framework.
2. Improper development by bench marks: large and wide range of industries and diversity of
product lines it is difficult to find suitable bench marks for evaluating their financial
performance and condition.
3. Window dressing: this is projecting a favourable financial picture. Ex: a
firm may prepare balance sheet when the inventory level is very low. As a
result, it may appear that the firm has very comfortable liquidity position
and high turnover of inventories. When window dressing of this type is
suspected, financial analysts should look at average level of inventories
over a period of time and not level of inventory at that one point of time.
4. Price level changes: this is not taken into consideration in India. So balance sheet may get
distorted and profits misreported.
5. Variation in accounting policies: firms have some latitude in accounting treatment like
depreciation, valuation of stock, R&D expenses, instalment sales, provision of reserves, pre-
operative expenses, etc., this results to variation in accounting policy.
6. Interpretation of result: industry averages and other yard sticks may not be suitable for all
processe and productions.

Guidelines for Financial statement analysis:

1. Use ratios to get clues to ask right questions

2. Be selective in the choice of ratios
3. Employ proper bench marks
4. Know the tricks used by the accountants
5. Read foot notes as they may contain some valuable information
6. Remember that financial statements analysis is an odd mixture of art and science.

INVESTMENTS
Investment is an asset of item which is purchased with the hope that it will generate income or
appreciate in the future.

In economic sense, an investment is the purchase of goods that are not consumed today but are used in
the future to create wealth.

In finance, the investment is a monetary asset purchased with the idea that the asset will provide
income in the future or appreciate and be sold at a higher price.

Investments usually involves the creation or addition of wealth.

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 RISKS and RETURN evaluation of Investment decision:

Risk is present in virtually every decision. Assessing risk and incorporating the same in the final decision
is done in financial analysis.

The risk of a security is of two parts: 1. UNIQUE RISK 2. MARKET RISK

Unique risk stems from firm-specific factors .

Market risk emanates from economy wide factors.

Portfolio diversification washes away unique risk but not market risk. Hence, the risk of a fully
diversified portfolio is its market risk.

The contribution of a security to the risk of a fully diversified portfolio is measured by its β (beta)which
reflects its sensitivity to the general market movements .

Since β is the relevant measure of a security’s risk, we want to know what is the relationship between the
risk of security as measured by its β (beta), and its expected return.

According to the Capital asset pricing method, Risk and Return are related in a linear fashion:

E R(j) = Rf + βj [E (Rm) – Rf]

where E R(j) = expected return on security j

Rf = Risk free return

Βj = beta of security j

E (Rm) = expected return on the market portfolio

As per the above relationship, referred to as the security market line, the required return on a security
consists of two components:

Risk free return = Rf and risk premium = βj [E (Rm) – Rf]

Note that the Risk premium is the product of the level of risk, βj and the compensation per unit of risk
[E (Rm) – Rf] .

Problem -1:

Stock j has a beta β of 1.4. If the risk free rate is 10% and the expected return on the market portfolio
is 15%, what is the return on stock j?

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E R(j) = Rf + βj [E (Rm) – Rf]

where E R(j) = expected return on security j

Rf = Risk free return
Βj = beta of security j
E (Rm) = expected return on the market portfolio .

Given: Rf = 10%, βj= 1.4, E (Rm) = 15%, E R(j) = ?

10 + 1.4{15 – 10} = 17%

Higher the β, higher is the expected return.

Problem-2:

Risk free return is 8%

Expected return on Market portfolio is 12%

If the required return on a stock is 15%, what is Beta βj ?

E R(j) = Rf + βj [E (Rm) – Rf]

where E R(j) = expected return on security j

Rf = Risk free return
Βj = beta of security j
E (Rm) = expected return on the market portfolio .

Rf = 8, E (Rm) = 12, E R(j) = 15, Βj =?

15 = 8 + Βj [12 – 8] = 8 + 4 Βj

4 Βj = 15 -8 =7

Βj = 7/4 =1.75

Problem -3:

Risk free return = 9%

The required return on a stock whose β is 1.5 is 15%. What is the return on the market portfolio?

E R(j) = Rf + βj [E (Rm) – Rf]

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Rf =9, β= 1.5, E R(j) = 15, E (Rm) =?

15 = 9 + 1.5 [E (Rm) - 9]

E (Rm) = 19.5 /1.5 =13%

SECURITY MARKET LINE

Above graph shows the Security Market Line for the basic data given above.

Expected return on 3 Securities A, B and C are shown in the graph.

Security A is Defensive Security with a β of 0.5. Its expected rate of return is 12.5%.

Security B is a Neutral Security with a β of 1. Its expected rate of return = Rate of return on the
Market Portfolio which is 15%.

Security C is an Aggressive Security with a β of 1.5. Its expected rate of return is 17.5%.

In general, if β of a Security is <1, it is characterized as DEFENSIVE.

If it is = 1, it is characterized as NEUTRAL.

If it is > 1, it is characterized as AGGRESSIVE.

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 Average rate of return or Accounting rate of return

Average rate of return = Profit after Tax / Book value of the investment
The numerator of this ratio may be measured on the average annual post tax profit over the life of the
investment and denominator is the average book value of fixed assets committed to the project.

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The higher the average rate of return , the better is the project. In general, projects which have an
average rate of return equal to or greater than a pre specified cut off rate of return –which is usually
between 20% to 30% are accepted. Others are rejected.

ANS:49.09%

Since this is above 20% to 30% project is accepted.

dvantages of Average Rate of return:

1. It is simple to calculate
2. It is based on accounting information which is readily available and familiar to businessmen.
3. It considers benefits over the entire life of the project.

Disadvantages of Average Rate of return:

1. It is based upon accounting profit and not cash flow

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 2. It does not take into account the time value of money
3. The measure of average rate of return is inconsistent

Numerator represents profit belonging to equity and preference stockholders. Its denominator
represents fixed investment which is rarely, if ever = contribution of equity and preference
stockholders.

PAY BACK PERIOD

Pay back period is the length of time required to recover the initial cash outlay on the project.

If the annual cash flow is a constant sum, the pay back period is simply the initial outlay divided by the
annual cash inflow.

Shorter the pay back period is , the more desirable is the project.

Firms will specify the maximum acceptable pay back period, say ‘n’ years.

Projects with a pay back period of ’ n’ years or less are worthy and above ’ n’ years are unworthy.

Problem -1:

A project involves a cash outlay of Rs.6,00,000/- and generate cash in flows of Rs.1,00,000/-,
Rs.1,50,000/-, Rs. 1,50,000/-, Rs. 2,00,000/- and Rs.1,00,000/- in the 1 st, 2nd, 3rd, 4th and 5th Years, what
is the pay back period?

Answer: The cash in flow of the sum of first 4 years = the initial outlay.

If the annual cash flow is a constant sum, the pay back period is simply the initial outlay divided by the
annual cash inflow.

Roblem-2:

Ex: A project has initial cash outlay of Rs.10,00,000/- and a constant annual cash inflow of Rs.
3,00,000/- has a pay back period of 10,00,000 / 3,00,000 = 3 1/3 years.

Problem-3:

The cash inflows for 2 Projects A and B are given below. Calculate the Pay back period. Point out
which project is preferred based on Pay back period method.

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Cash flow of ‘A’ project in 1st year = 50,000

Cash flow of ‘A’ project in 2nd year = 30,000

Cash flow of ‘A’ project in 3rd year

near end =20,000

----------------

1,00,000

Cash flow of ‘B’ project in 1st year = 20,000

Cash flow of ‘B’ project in 2nd year = 20,000

Cash flow of ‘B’ project in 3rd year =20,000

Cash flow of ‘B’ project in 4t year = 40,000

----------------

1,00,000

Since Project ‘A’ is having earlier cash in flow with near end of 3 years [comparing to Project ‘B’ which
has 4 years] , Project ‘A’ is preferred.

Problem-4:

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 50,000

Shorter the pay back period is , the more desirable is the project.
Firms will specify the maximum acceptable pay back period, say ‘n’ years.
Projects with a pay back period of ’ n’ years or less are worthy and above ’ n’ years are unworthy.

Advantages of Pay back period:

1. Simple in concept and application

2. No tedious calculations and hidden assumptions

3. It is a rough and readymade method for dealing with risk

4. It favours projects which gives more cash inflows in the earlier years. This is good when at later
years risk may tend to go up.

5. More cash inflow in earlier years is good for company to solve problems of liquidity.

Disadvantages of Pay back period:

1. It fails to consider the time value of money

2. No discount factor is incorporated, which means violation of basic principles of financial

analysis.

3. It ignores cash flows beyond pay back period. This leads to discrimination against projects
which generate substantial cash inflows in later years.

4. It is a measure of projects’ capital recovery, not profitability.

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 Calculation of discounted pay back period:

Conventional pay back period is not taking into consideration about the TIME
VALUE OF MONEY.

To overcome this drawback, discounted pay back period is suggested.

In this method, cash flows are first converted into their present values (by
applying suitable discounting factors) and then added to ascertain the period
of time required to recover the initial outlay on the project.

PVIF [Present Value Interest Factor] is a factor that is utilized to provide a

simple calculation for determining the Present value dollar amount of a sum
of money to be received at some future point in time.
PVIF [k,n] = [1 + K]¯ᵑ where k is the effective discount rate and ᵑ is the number of payment
periods or years.

Problem-1:

Using the Discounted Pay back period method of calculation, find out the year and month when
the cashoutlay will be taken from the cash in flow.

Discount factor or Discount rate is 10%.

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 PVIF [k,n] = [1 + K]¯ᵑ

1st Year= [1+0.1] ¯¹ = [1.1] ¯¹ = 1 / [1.1] = 0.909

2nd Year = [1+0.1] ¯² = [1.1] ¯ ² = 1 / [1.1] ² = 1 / [1.1] x [1.1] = 1 / 1.21 = 0.826 and so
on …….

From the above table , it is clear that the Discounted Pay back period is between 3 rd and 4th year.

To find the exact time period in years:

1791/[1791 + 941] = 1791 /2732 =0.6556

Ie., 3.655 years or 0.655 x 12 = 7.87 months.

Ie., 3 years and 7.87 months.

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 Proceed as done in the previous problem.

Answer : 3.38 years or 3years and 4.56 months.

3+ 23300/[23300 +38000] =0.38 yrs .

NET PRESENT VALUE (NPV)

The Net present value (NPV) of a project is the sum of the present values of all the cash flows – positive
as well as negative – that are expected to occur over the life of the project.

Net present value is the present value of net cash inflows generated by a project including
salvage value, if any, less the initial investment on the project. It is one of the most reliable
measures used in capital budgeting because it accounts for time value of money by using
discounted cash inflows.

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 FORMULA FOR NPV CALCULATION
Problem-1:

NPV = - 10,00,000 + 2,00,000 +2,00,000 +

[1.10 ]˚ [1.10 ]¹ [1.10 ]²

3,00,000 + 3,00,000 + 3,50,000

[1.10 ] ³ [1.10 ] ⁴ [1.10 ]⁵

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= - 10,00,000 + 2,00,000 +2,00,000 +

1 1.1 1.21

3,00,000 + 3,00,000 + 3,50,000

1.331 1.464 1.611

= -1000000 + 181818 + 165289 + 225394 + 204918 + 217256

= - 1000000 + 994645 = - 5355

NPV is negative. So this Project is to be REJECTED.

The decision rule for NPV criterian is:

ACCEPT the project if NPV is Positive

REJECT the project if NPV is Negative

If NPV is ‘0’, it is matter of INDIFFERENCE.

Problem-2:

Ans: +19044.

Since NPV is positive, this project can be ACCEPTED.

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Salvage value is the estimated resale value of an asset at the end of its useful life.

Salvage value is subtracted from the cost of a fixed asset to determine the amount of the
asset cost that will be depreciated.

Thus, salvage value is used as a component of the depreciation calculation.

Advantages of Net present value:

1.It takes into account the time value of money

2.It considers the cash flow stream in it entirely

3.It represents the contribution to the wealth of stockholders

Disadvantages of Net present value:

1.NPV rule does not consider the life of the project. Hence, when mutually exclusive projects with
different lives are being considered, the NPV rule is biased in favour of longer term project.

INTERNAL RATE OF RETURN (IRR)

The internal rate of return of a project is the discount rate which makes its NPV equal to zero.

Put differently, it is the discount rate which equates the present value of future cash flows with the
initial investment. It is the value of ‘r’ in the given equation.

In the NPV calculation we assume that the discount rate (cost of capital) is known and determine the
NPV.

In the IRR calculation, we set the NPV equal to zero and determine the discount rate that satisfies this
condition.

The decision rule for IRR is

ACCEPT: if the IRR is greater than the cost of capital

REJECT: if the IRR is less than the cost of capital

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Problem-1:

The IRR is the value of ‘r’ which satisfies the following equation.
1,00,000 = 30,000 +30,000 +
[1+r ]¹ [1+r ]²

40,000 + 45,000
[1+r ] ³ [1+r ] ⁴
The calculation of ‘r’ involves a process of Trial and Error. We try
different values of ‘r’ till we find that RHS of above equation is
1,00,000.
Let us try with r= 15%
this makes RHS equation as
30,000 + 30,000 +
[1.15 ] [1.15 ]²

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 40,000 + 45,000
[1.15 ] ³ [1.15 ] ⁴

= 100800
This value is slightly higher than our LHS value of 1,00,000.
So let us increase the value of ‘r’ from 15% to 16% .
[A higher ‘r’ lowers and smaller ‘r’ increases the RHS value.]
This value is slightly higher than our LHS value of 1,00,000.
So let us increase the value of ‘r’ from 15% to 16% .
[A higher ‘r’ lowers and smaller ‘r’ increases the RHS value.]
Since the this value of 98,637 is less than 1,00,000 which is cash
outlay we have invested in the business, we conclude that the value
of ‘r’ lies between 15% and 16%.
Since the this value of 98,637 is less than 1,00,000 which is cash
outlay we have invested in the business, we conclude that the value
of ‘r’ lies between 15% and 16%.
To calculate the value of ‘r’ exactly,
1. Determine the NPV of two closest
Rate of return.
NPV of 15% = 100800 – 100000= 800
NPV of 16% = 98637– 100000= [1363]

2. Find the sum of the absolute

values of the NPVs obtained in Step 1.

800 + 1363 = 2163

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3. Calculate the ratio of the NPV of the smaller discount rate,
identified in step 1, to the sum obtained in step 2.

800 / 2163 = 0.37

4. ADD the number obtained in step 3 to the smaller discount rate
to get the actual discount rate or Internal Rate of Return.

15 + 0.37 = 15.37%
The decision rule for IRR is
ACCEPT: If the IRR is > the cost of capital.

REJECT: If the IRR < the cost of capital.

If we calculate the above problem with IRR of 15.37% we get
answer as 100026 which is > the cash outlay or cost of the initial
capital invested.

So, this project can be accepted.

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