We can use following methods to analyze potential projects and select most suitable project for the organization.
(1) Present Value (PV)
(2) Net Present Value (NPV)
(3) Internal Rate of Return (IRR)
(4)Payback Period
(5)Benefit/Cost Ratio
(6) Economic Value Added (EVA)
Lets we analyze above methods further.
Present Value
PV indicates the present value of future cash flow. Projects having higher PV will be better. Present value of a future cash flow is discounted to reflect the time value of money. We can use following equation for Present value calculation purpose.
PV = FV / (1+i)*n
Example 01
Assume that there have two investment opportunities as follows,
Project 01 - You will receive Rs: 90000 after 5 years.
Project 02 - You will receive Rs: 130000 after 10 years.
(The interest rate is 10%)
PV of Project 01 = PV = 90000/(1+.1)*5
= RS: 55883
PV of Project 02 = PV = 130000/(1+.1)*10
= RS: 50121
Project 01 is the most suitable project because it provide highest present value than project 02.
Net Present Value
NPV is the difference between cash inflow and out flow considering present value of both cash inflow and outflow. Again project with higher NPV is better. NPV should be positive for the project to be selected; negative NPV indicates negative cash flow.
Example 02
DD company is considering to purchase a machine. There have 2 alternatives and their cost and cash flows as follows,
Machine A Machine B
Cost = RS: 12000 Cost = RS:8000
Cash flows (RS) Cash flows (RS)
Year 1 = 5000 Year 1 = 4000
Year 2 = 3000 Year 2 = 300
Year 3 = 3500 Year 3 = 500
Year 4 = 4500 Year 4 = 5000
Machine 01
Year Cash flow DF@ 10% PV
0 (12000) 1 (12000)
1 5000 0.909 4545
2 3000 0.826 2478
3 3500 0.751 2629
4 4500 0.683 3074
NPV = RS: 726
Machine 02
Year Cash flow DF@ 10% PV
0 (8000) 1 (8000)
1 4000 0.909 3636
2 300 0.826 278
3 500 0.751 376
4 5000 0.683 3415
NPV = RS: (295)
Project 01 is suitable for invest as it has Positive NPV. If both project had positive values, we should select the project with highest positive value.
Internal rate of return
IRR is the rate at which the present value of investments is equal to the present value of return on all investments made. If there are multiple projects in consideration, project with higher IRR is better option.
IRR = r1 + NPVa (r2 – r1)
(NPVa – NPVb )
Example 03 -
Lets we consider above example,
Machine A Machine B
Cost = RS: 12000 Cost = RS:8000
Cash flows (RS) Cash flows (RS
Year 1 = 5000 Year 1 = 4000
Year 2 = 3000 Year 2 = 300
Year 3 = 3500 Year 3 = 500
Year 4 = 4500 Year 4 = 5000
NPV = 726 (i = 10%) NPV = (656) (i = 12%)
IRR = 0.1 + 726/ (726- (-656) * (0.12 – 0.1 )
IRR = 11.05%
Payback Period
Payback period is the time required to recover the cost of investment for the project. Payback period alone doesn’t consider time value of money or rate of return on the project. If other parameters are same, project with minimum payback period is better.
Following information are regarding two machines, DD company considering to buy which gives lowest payback period. Decide which machine the financial manager should buy?
Machine A Machine B
Cost = RS: 12000 Cost = RS:8000
Cash flows (RS) Cash flows (RS)
Year 1 = 5000 Year 1 = 4000
Year 2 = 3000 Year 2 = 1000
Year 3 = 4000 Year 3 = 500
Year 4 = 4500 Year 4 = 2500
Machine A Cumulative cash Flow
Cost = (12000 ) (12000)
Cash flows (RS
Year 1 = 5000 (7000)
Year 2 = 3000 (4000)
Year 3 = 4000 0
Year 4 = 4500 4500
• Payback period is 3 years.
Machine B Cumulative Cash flows (RS)
Cost = (8000) (8000)
Cash flows (RS)
Year 1 = 4000 (4000)
Year 2 = 1000 (3000)
Year 3 = 500 (2500)
Year 4 = 2500 0
Payback period is 4 years.
Benefit/cost Ratio
BCR is the ratio of benefit in terms of money to monetary cost of the project. If budget is not a constraint, higher the BCR better the project. All cost and benefits should be in terms of present value while comparing.
BCR = Benefit / Cost
EX --
DD company is considering to buy new plant which costs RS: 55000 and the estimated revenue for the year was RS:500000, Calculate BCR.
BCR = Benefit/cost
= 500000 / 55000
= 9.09
It means company will receive RS:9.09 for every RS:01 which company invested.
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