NPV

What is 'Net Present Value - NPV'

Net Present Value (NPV) is the difference between the present value of cash inflows and the present
value of cash outflows. It is also defined as the difference between an investments market value and
its cost. NPV is used in capital budgeting to analyze the profitability of a projected investment or
project.
To Calculate NPV:

Ct = net cash inflow during the period t

Co = total initial investment costs
r = discount rate, and
t = number of time periods

If Cashflow is constant then

NPV = Initial Cost + Cashflow(PVIFA%,N)

Decision: An investment should be accepted if the net present value is positive and rejected if it is
negative. But the investment with more positive value should be chosen first.
If we say an investment has an NPV of $1,000, what exactly do we mean?
NPV of 1000 means that taking this new investment will increase the value of stock by $1000. So, for
example if a company has 100 shares the value will increase by $1000 / 100 = $10 per share by taking
this project.
Advantages & Disadvantages:
Advantages:
1. It considers both the timing of cash flows and the size of them in arriving at an
appraisal.
2. The rate of discount can be varied to allow for different economic circumstances. For
instance, it could be increased if there is a general expectation that interest rates were
about to rise.
3. It considers the time value of money and takes the opportunity cost of money into
account.
Disadvantages:
1. It is reasonably complex to calculate and to explain to non-numerate managers!
2. The final result depends greatly on the rate of discount used, and expectations about
interest rates may be inaccurate.

3. Net present value can only be compared with other projects, but only if the initial capital
cost is the same. This is because the method does not provide a percentage rate of
return on investment.
Example Sum:
Suppose we are asked to decide whether a new consumer product should be launched.
Based on projected sales and costs, we expect that the cash flows over the five-year life
of the project will be $2,000 in the first two years, $4,000 in the next two, and $5,000 in the
last year. It will cost about $10,000 to begin production. We use a 10 percent discount rate
to evaluate new products. What should we do here?
Given the cash flows and discount rate, we can calculate the total value of the product
by discounting the cash flows back to the present:
Present value = ($2,000/1.1) + (2,000/1.12) + (4,000/1.13) +(4,000/1.14) + (5,000/1.15)
= $1,818 1 1,653 1 3,005 1 2,732 1 3,105
=$12,313
The present value of the expected cash flows is $12,313, but the cost of getting those cash
flows is only $10,000, so the NPV is $12,313 - 10,000 5 $2,313. This is positive; so, based on
the net present value rule, we should take on the project.

IRR
Internal rate of return (IRR) is a metric used in capital budgeting measuring the profitability of
potential investments. Internal rate of return is a discount rate that makes the net present value (NPV)
of all cash flows from a particular project equal to zero. IRR calculations rely on the same formula as
NPV does.
To Calculate IRR:

Ct = net cash inflow during the period t

Co = total initial investment costs
r = discount rate, and
t = number of time periods
Can Also Be calculated Using

IRR=Lower Rate +

NPV at Lower Rate

( Higher RateLower Rate)
Npv at LowerNPV at higher

Decision: Based on the IRR rule, an investment is acceptable if the IRR exceeds the
required return. It should be rejected otherwise.
Advantages and Disadvantages
ADVANTAGES

IRR method takes time value of money into account.

It takes into account on the entire earnings over the economic life asset.

Cost of capital is considered for decision making.

if IRR is high an estimated Required Rate of Return is not needed

DISADVANTAGES.

The process of computation of IRR is rather difficult.

It does not consider the variation in the life span assets

The method ignores the aspect of liquidity.

Does not account for project size

Possible to get multiple IRRs if a project has non-normal cash flows

Example Sum:

A project has a total up-front cost of $435.44. The cash flows are $100 in the first year,
$200 in the second year, and $300 in the third year. Whats the IRR? If we require an 18
percent return, should we take this investment?
Well describe the NPV prof le and find the IRR by calculating some NPVs at different
discount rates. You should check our answers for practice. Beginning with 0 percent, we
have:
Discount Rate
0%
5%
10%
15%
20%

NPV
$164.56
100.36
46.15
0.00
-39.61

The NPV is zero at 15 percent, so 15 percent is the IRR. If we require an 18 percent

return, then we should not take the investment. The reason is that the NPV is negative
at 18 percent (verify that it is 2$24.47). The IRR rule tells us the same thing in this case.
We shouldnt take this investment because its 15 percent return is below our required
18 percent return.
Practice Question
Page 296 ( 7,8,9,10)

Mutually Exclusive Investments

Mutually exclusive investment decisions are a situation in which taking one investment prevents the
taking of another. If two investments, X and Y, are mutually exclusive, then taking one of them means
that we cannot take the other. Two projects that are not mutually exclusive are said to be
independent. For example, if we own one corner lot, then we can build a gas station or an apartment
building, but not both.
Example Sum:

PQR, Inc. has $40 million at its disposal and the management is considering the
following projects for investment. The CFO has prepared the following table for the
board of which you are a member.
Project A

Project B

Project C

Initial investment

$10,000,000 $15,000,000 $15,000,000

Net present value

$20,000,000 $15,000,000 $21,000,000

IRR

25%

15%

20%

The CFO further told the board that the companys cost of capital is 12%.
What would be your decision if the projects are (a) mutually exclusive, or (b)
independent?
Solution
If the project is mutually exclusive, it means the company can select any one of the
projects. It cant invest simultaneously in all the three projects. In such situation, the
company should opt for projects generating the maximum net present value i.e. Project
B. Although Project A has higher IRR, in case of mutually exclusive projects, a decision
based on net present value is theoretically sounder.
If these were independent projects, PQR would invest in all of these projects because
they all have positive NPVs and their respective IRRs are higher than the hurdle rate (i.e.
the cost of capital, which is 12%).

The Modified internal Rate of Return (MIRR)

To address some of the problems that can crop up with the standard IRR, it is often proposed that a
modified version be used. It Basically means modify the cash flows & then calculate the IRR. MIRR has
3 approaches:
1. Discounting Approach
2. Reinvestment Approach
3. Combination Approach
We will use the Reinvestment Approach: In the reinvestment approach, we find the future value of
all cash except the initial cash flow at the end of the project.
Example Sum:
Slow Ride Corp. is evaluating a project with the following cash flows:
Year
0
1
2
3
4
5

Cash Flow
- $12000
$5800
$6500
$6200
$5100
- $4300

The company uses a 10 percent interest rate on all of its projects. Calculate the MIRR of the
project using all three methods.
Answer:
Time Value = $5,800(1.104) + $6,500(1.103) + $6,200(1.102) + $5,100(1.10) $4,300
Time Value = $25,955.28
So, the MIRR using the discounting approach is:
Initial C.F = P.V. of Time Value
12000 = $25,955.28/(1+MIRR)5
$25,955.28 / $12,000 = (1+MIRR)5
MIRR = ($25,955.28 / $12,000)1/5 1
MIRR = 0.1668 or 16.68%

Why Should We Calculate MIRR?

The MIRR is used to rank investments or projects of unequal size. The calculation is a solution to two
major problems that exist with the popular IRR calculation. The first main problem with IRR is that

multiple solutions can be found for the same project. The second problem is that the assumption that
positive cash flows are reinvested at the IRR is considered impractical in practice. With the MIRR, only
a single solution exists for a given project, and reinvestment rate of positive cash flows is much more
valid in practice.
Advantages & Disadvantages
Advantages:

Considers all cash flow of the project.

Considers Time Value of Money
A better capital budgeting tool than IRR as it assumes cash inflows are reinvested
at the cost of capital

Disadvantages:

Requires an estimate of cost of capital in order to make a decision

Cannot be used in situation where sign of cashflow of the project change more
than once during the projects life.

Scenario Analysis & Sensitivity Analysis

Scenario Analysis: The determination of what happens to NPV estimates when we ask what-if
questions like What if unit sales realistically should be projected at 5,500 units instead of 6,000?
Sensitivity analysis: Investigation of what happens to NPV when only one variable is changed.
Difference Between Scenario & Sensitivity Analysis:
Sensitivity analysis is a method for estimating project risk that involves changing a key variable to
evaluate the impact the change will have on the results whereas Scenario Analysis similar to sensitivity
analysis, but it takes into consideration the changes of several important variables simultaneously.

Example Sum:
The project under consideration costs $200,000, has a five-year life, and has no salvage value.
Depreciation is straight-line to zero. The required return is 12 percent, and the tax rate is 34
percent.
Unit Sales
Price Per Unit
Variable Cost / Unit
Fixed Cost Per Year

Base
6000
80
60
50000

Worst Case
5500
75
58
45000

Best Case
6500
85
62
55000

So Scenario Would Be:

Scenario
Base

Net Income
$19,800

Cashflow
59800

NPV
15567

IRR
15.1%

Worst

-15,510

24490

-111719

-14.4

Best

59,730

99730

159504

40.9

To illustrate how sensitivity analysis works, we go back to our base case for every item except
unit sales. We can then calculate cash fl ow and NPV using the largest and smallest unit sales
figures.
Scenario
Base

Unit Sales
6000

Cashflow
59800

NPV
15567

IRR
15.1%

Worst

5500

53200

-8226

10.3

Best

6500

66400

39357

19.7

When Fixed Cost Is Changed, Other thing made constant:

Scenario
Base

Unit Sales
50000

Cashflow
59800

NPV
15567

IRR
15.1%

Worst

55000

56500

3670

12.7

Best

45000

63100

27461

17.4

What we see here is that given our ranges, the estimated NPV of this project is more sensitive
to changes in projected unit sales than it is to changes in projected fixed costs. In fact, under
the worst case for fixed costs, the NPV is still positive.

Ratio Analysis
Liquidity
Current Ratio
Current ratio, also known as liquidity ratio and working capital ratio, shows the proportion of current
assets of a business in relation to its current liabilities. The Formula:

Current Ratio =

Current Assets
Current Liabil i ties

Quick ratio
The quick ratio is a measure of how well a company can meet its short-term financial liabilities. It is
also known as the acid-test ratio. Therefore, a higher ratio means a more liquid current position.

Quick Ratio=

Liquid Asset
Current Liability

Cash ratio
The cash ratio is an indicator of a company's liquidity that further refines both the current ratio and
the quick ratio by measuring the amount of cash, cash equivalents or invested funds there are in
current assets to cover current liabilities.

Cash R atio=

Absolute Liquid Assets

Current Liabilities

Net Working Capital to Total Asset

The Working Capital to Total Assets ratio measures a company's ability to cover its short term financial
obligations (Total Current Liabilities) by comparing its Total Current Assets to its Total Assets.

Net WorkingCapital Total Asset=

Net Working Capital

Total Asset

Interval Measure
A calculation to measure the approximate number of days a company could operate simply on the
cash it currently has on hand. It is equal to Current assets divided by daily operating expenses, and
the value it returns is the average number of days that company could use those assets to meet all its
expenses.

Inerval Measure=

Current Asset
Average Daily Operating Cost

Profitability
Gross Profit Margin
The gross profit margin looks at cost of goods sold as a percentage of sales. This ratio looks at how
well a company controls the cost of its inventory and the manufacturing of its products and
subsequently pass on the costs to its customers. The Formula:

Gross Profit Margin=

Gross Profit
X 100
Net Sales

Profit Margin
Profit margins are expressed as a percentage and, in effect, measure how much out of every dollar of
sales a company actually keeps in earnings. The Formula:

Profit Margin=

Net Income
Sales

Return on Assets
Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets. ROA
gives an idea as to how efficient management is at using its assets to generate earnings. The Formula:

Return on Asset=

Net Income
Total Asset

Return on Equity
Return on equity (ROE) is the amount of net income returned as a percentage of shareholders equity.
Return on equity measures a corporation's profitability by revealing how much profit a company
generates with the money shareholders have invested.

Returnon Equity=

Net Income
Total Equity

EPS
Earnings per share, also known as EPS, is a very important number in business. It tells shareholders
how much money each share of their stock earned for the company. It is important because, usually,
when a company has high earnings per share, it also has a high stock price, which makes investors
happy.

Net IncomeDividend Payable

EPS= preferred Stock

Average Outstanding Shares

Leverage Ratio
Total Debt ratio
The Total debt ratio is defined as the ratio of total long-term and short-term debt to total assets,
expressed as a decimal or percentage. It can be interpreted as the proportion of a company's assets
that are financed by debt. The Formula:

Total Debt Ratio=

(Total As s etTotal Equity)

Total Asset

Debt Equity Ratio

Debt/Equity Ratio is a debt ratio used to measure a company's financial leverage, calculated by
dividing a companys total liabilities by its stockholders' equity. The Formula:

Debt Equity Ratio=

Total on Term Debts

Shareholders Fund

Equity multiplier
The equity multiplier is calculated by dividing a company's total asset value by total net equity, and it
measures financial leverage. Companies finance their operations with equity or debt, so a high equity
multiplier indicates that a larger portion of asset financing is attributed to debt. The Formula:

Equity Multiplier=

T o tal Asset
Total Equity

Long term debt Ratio

The long-term debt to total assets ratio is a measurement representing the percentage of a
corporation's assets financed with loans or other financial obligations lasting more than one year. The
Formula:

LongTerm Debt ratio=

LongTerm Debt
( LongTerm DebtTotal Equity )

Times Interest earned ratio

The times interest earned ratio, sometimes called the interest coverage ratio, is a coverage ratio that
measures the proportionate amount of income that can be used to cover interest expenses in the
future. The Formula:

Interest Earned Ratio=

EBIT
Interest

Cash Coverage Ratio

The cash coverage ratio is useful for determining the amount of cash available to pay for a borrower's
interest expense, and is expressed as a ratio of the cash available to the amount of interest to be paid.
The Formula:

CashCoverage Ratio=

EBIT + Depreciation
Interest

Turnover
Inventory Turnover
The Inventory turnover is a measure of the number of times inventory is sold or used in a time period
such as a year. The equation for inventory turnover equals the cost of goods sold or net sales divided
by the average inventory.

Inventory Turnover=

Cost of goods sold

Inventory

Receivables Turnover
An accounting measure used to quantify a firm's effectiveness in extending credit and in collecting
debts on that credit. The receivables turnover ratio is an activity ratio measuring how efficiently a firm
uses its assets.

Receivables Turnover=

Sales
Accounts Receivable

Fixed Asset Turnover

The fixed-asset turnover ratio is, in general, used by analysts to measure operating performance. It is
a ratio of net sales to fixed assets. This ratio specifically measures how able a company is to generate
net sales from fixed-asset investments, namely property, plant and equipment (PP&E), net of
depreciation. In a general sense, a higher fixed-asset turnover ratio indicates that a company has
more effectively utilized investment in fixed assets to generate revenue.

Net
Sales
Turnover= Asset
Total Asset Turnover
Asset turnover ratio is the ratio of the value of a companys sales or revenues generated relative to
the value of its assets. The Asset Turnover ratio can often be used as an indicator of the efficiency with
which a company is deploying its assets in generating revenue.

Total Asset Turnover=

Sales
Total Asset

DU point
According to DuPont analysis, ROE is affected by three things: operating efficiency, which is measured
by profit margin; asset use efficiency, which is measured by total asset turnover; and financial
leverage, which is measured by the equity multiplier.

ROE=

Sales Net Income Assets

X
X
Asset
Sales
Equity

Break Even Analysis

Break-even analysis entails the calculation and examination of the margin of safety for an entity based
on the revenues collected and associated costs. Analyzing different price levels relating to various
levels of demand, an entity uses break-even analysis to determine what level of sales are needed to
cover total fixed costs. A demand-side analysis would give a seller greater insight regarding selling
capabilities.
Components in Variable Cost
Total Variable Cost = Total Quantity of Output X Cost per Unit of output
TVC = Q x Vc per unit
Total Cost = Total Variable Cost + Total Fixed Cost
TC = TVC + FC
Semi-variable costs, also called semi-fixed costs, comprise a mixture of fixed and variable
components. Costs are fixed for a set level of production or consumption then become variable after
that level is exceeded. With semi-variable costs, greater levels of production increase total cost, but if
no production occurs, then a fixed cost is still incurred.

Accounting Breakeven
Accounting breakeven: It occurs when the sales level results in zero project net income.

Total

Break EvenUnits=Cost

Selling price per unitVariable cost per unit

Break Even Dollar=Break evenunits X Selling Price

Break EvenUnits ( 2 )=

FC + OCF
Selling Price Per UnitVariable Cost Per Unit

Example:
Question
Selling Price Per Unit = 5
Variable Cost per Unit = 3
Accounting Expense = 600
Depreciation = 300

So,
Total Fixed cost = 600+300 = 900
Break Even In Units = 900 / (5 3)
= 450 Units
Break Even in Dollar = 450 Units X 5
= 2250

Income Statement
Sales
Variable Cost
Fixed Cost
Depreciation
EBIT
Taxes (34%)
Net Income
At Break-Even Net Income is zero. So as EBIT is also Zero we can say
OCF = EBIT +Depreciation -Tax
OCF = 0 + Depreciation 0
OCF = Depreciation

At Breakeven Sometimes we calculate DOL

DOL=

1+ FC
OCF

2250
(1350)
(600)
(300)
______
0
0
______
0

Cash Break Even

The sales level that results in a zero-operating cash flow.
To calculate the cash break-even (the point where operating cash fl ow is equal to zero), we put in a
zero for OCF:
Q = (FC + 0) / (P - v)
= $500 / 20
= 25

Financial Break Even

The sales level that results in a zero NPV.
Initial Investment = OCF x Annuity
OCF = Initial Investment / Annuity
Q = (FC + OCF) / (P-V)

Operating Cash Flow

Bottom-up Approach
OCF = EBIT + Depreciation Taxes
Or
OCF = Net Income + Depreciation (if no interest is in the problem)

Top-Down Approach
OCF = Sales Cost Taxes

Tax Shield Approach

If tax rate is given, we should apply tax shield approach to OCF:

OCF=[ Q ( PV )FC ] ( 1t ) +t Depreciation

Common Size Statements

Common size income statement is an income statement in which each account is expressed as a
percentage of the value of sales. This type of financial statement can be used to allow for easy
analysis between companies or between time periods of a company. Common size income statement
analysis allows an analyst to determine how the various components of the income statement affect a
company's profit.