In the evaluation of investment projects the discounted cash flow method can provide a useful means of testing financial feasibility. The discount rate will generally be the minimum rate of return required by the investor over the period of the cash flow. If the total of the discounted cash flow over the period is zero or a positive figure, then the proposal will be acceptable. If a negative discount flow value results, the proposal will be unacceptable.
Using the net present value approach all cash flows are discounted to present value using the required rate of return which is the minimum investors require on their investment.
To calculate the present value of a cash flow the following information is necessary
- Net cash flow during each period, e., estimated cash inflow or outflow.
- Discount factors for each period – this can be calculated by using the expression
1/(1+R)n
where, R = Rate of return per period (expressed as a decimal) n = Number of periods.
Multiplication of the anticipated future cash flow by the appropriate discount factor gives the present value.
3. Rate of return required.
4. Number of periods
EXAMPLE
Mr. A agrees to sell a property to Mr. B for Rs. 5,00,000. Mr. B however, asked for some concessions in payment by allowing him to pay in instalments. The first instalment of 20% was made immediately. The other instalments were to be made in equal amounts every two months. Discuss the benefits that Mr. B. obtained from his friend Mr. A by requesting him to accept this scheme of payment assuming that interest rate in the market is 13.5 per cent per annum.
Solution:The easiest way to do this problem is to bring all payments to present value.
| INST. NO. | AMOUNT ( RS ) | R PER MONTH | N | 1/(1+R)n | PRESENT VALUE ( RS) |
| 1 | 100000 | 0.01125 | 0 | 1.000 | 100000 |
| 2 | 100000 | 0.01125 | 2 | 0.977 | 97787 |
| 3 | 100000 | 0.01125 | 4 | 0.956 | 95624 |
| 4 | 100000 | 0.01125 | 6 | 0.935 | 93508 |
| 5 | 100000 | 0.01125 | 8 | 0.914 | 91439 |
| 478358 |
Instead of paying an amount of Rs. 5,00,000 at a time, Mr. B gets the opportunity of paying in instalments, the present value of which is Rs. 4 , 78,358. He therefore, benefits to the tune of Rs. 5,00,000- Rs. 4,78,358 =Rs. 21,642.
Two characteristics of the NPV method are:
- The NPV method is based on the assumption that the intermediate cash inflows of the project are at the same rate of return as the project’s cost of capital.
- The NPV of a project generally decreases as the discount rate increases. The decrease in the NPV, however , is at a decreasing rate.
The net present value criterion has considerable merits:
- It takes into consideration the time value of money
- The cash flow stream is taken into account in its entirety.
- The net present value represents the wealth of investors (in present day money terms} after adjusting for the return on the project.
- The net present value of different projects, evaluated in terms of today‘s rupees, can be For example, the net present value of a group of three projects, A, Band C will simply be the sum of the net present value of these projects taken individually.