Chapter 3: The Economic

Evaluation of Investment
Proposals
1. Time Value of money
2. Net present value (NPV)
3. Graphical representation of NPV
4. Internal rate of return (IRR)
5. An economic rationale for IRR rule
6-1

Time Value of Money

Definition: A rationale human being would not value

the opportunity to receive a specific amount of money
today equally with the opportunity to have the same
amount at some future date. Most human beings
value the opportunity to receive money now higher
than receive one or two years from now the same
amount. The additional amount that is required for
receiving after a certain time period in future than the
amount received today is known as time value of
money. That is this additional amount is given as
value of time waiting. Actually the percentage change
in value of a certain amount of money for a certain
time period gap is known as time value of money
6-2

Rationale for Time Value of

Money

Time value of money is existed for the

following reasons:

Future uncertainty
Sacrifice present consumption or preference
for higher consumption in future period
Alternative investment opportunities i.e.
opportunity cost.
Sacrifice of cash holding preference
Inflation
6-3

Terminologies
Present value: The value of today that is
obtained by discounting a future cash flow
or a series of cash flows by the opportunity
cost of fund as discount rate.
Future value: The amount or value will be
obtained at a certain time point in future of
a cash flow or a series of cash flows by
compounding at a given interest rate or
opportunity cost over a certain time period.
6-4

Terminologies
Discounting: The process of finding the
present value of a cash flow or a series
of cash flows by using a given discount
rate.
Compounding: The arithmetic process of
determining the final value of a cash
flow or a series of cash flows by using a
certain interest rate
6-5

Terminologies

Simple interest rate: The interest rate

that charged only on the principal
amount for a specific period is called
simple interest rate.
Compound interest rate: The interest
rate that is charged both on principal
and interest amount period to period is
called compound interest rate.
6-6

Terminologies

Installment: Periodic payments or receipts related

to any transaction or contract are known as
installment.
Annuity: The equal amount of cash flow incurred at
equal time interval is called annuity.
Annuity due: The annuity under which the cash
flow is incurred at the beginning of each period is
called annuity due.
Annuity immediate: The annuity under which the
cash flow is incurred at the end of each period is
called annuity immediate.
6-7

Terminologies

Perpetuity: The annuity under which the cash flow

is incurred for a infinite period of time is called
Perpetuity..
Nominal interest rate: Rate of interest stated in an
agreement for transferring fund from one party to
another party is known as nominal interest rate.
Effective interest rate: Rate of interest ultimately
paid by the user of fund to the supplier of fund by
taking into consideration of timing frequencies and
other charges is known as effective interest rate.
6-8

Solving for PV:

The arithmetic method

Problem: How much should you set

aside now to get Tk.100 after 3 years
from now?
Solve the general FV equation for PV:

PV = FVn / ( 1 + i )n

PV = FV3 / ( 1 + i )3
= Tk.100 / ( 1.10 )3
= Tk.75.13
6-9

Finding the interest rate

and time period

Problem: What is the rate of interest by what

Tk.100 becomes Tk.200 in 4 years?
200=100(1+i)4
(1+i)4=2, 1+i=2 1/4=2.25 =1.1892, i=18.92%
Problem 3. How long time it takes to double an
amount if the interest rate is 15% per annum?
200=100(1+.15)n
(1.15)n=2, n log(1.15)=log(2)
n=log(2)/log(1.15)=4.96 years
6-10

Compounding more than

once in year

Problem: You like to set aside an amount of

money so that you get Tk.50,000 after 5
years from now. Bank One offers you 10%
annual interest rate and Bank Two offers
you 9.5% interest rate compounded
monthly. Where should you put the money?
Bank One: PV=50,000/(1.1)5=Tk.31046.07
Bank Two: PV=50,000/
(1+.095/12))60=Tk.31152.46
Bank One is a better choice
6-11

Classifications of interest
rates

Effective (or equivalent) annual rate (EAR =

EFF%) the annual rate of interest actually
being earned, taking into account
compounding.

EFF% for 10% semiannual investment

EFF% = ( 1 + iNOM / m )m - 1
= ( 1 + 0.10 / 2 )2 1 = 10.25%

An investor would be indifferent between an

investment offering a 10.25% annual return
and one offering a 10% annual return,
compounded semiannually.
6-12

Effective Annual Rate

EFF% = ( 1 + iNOM / m )m - 1

Problem 5: A Credit card charges

2% interest rate per month. What
is the effective interest rate?
EAR=(1+.24/12)12-1
=(1.02)12-1
=26.82%
6-13

Why is it important to consider

effective rates of return?

An investment with monthly payments is different

from one with quarterly payments. Must put each
return on an EFF% basis to compare rates of
return. Must use EFF% for comparisons. See
following values of EFF% rates at various
compounding levels.
EARANNUAL 10.00%
EARQUARTERLY
10.38%
EARMONTHLY
10.47%
EARDAILY (365)
10.52%
6-14

Present Value Annuity

All kinds of consumers credit schemes follow

present value annuity. A lump sum amount is
borrowed now against what payments would
be made in equal installments at a regular
interval for a definite period of time. For
example, at 10% interest rate, you can borrow
Tk.173.55 in a 2 year annuity of Tk.100
installment. The amount of Tk.173.55 is
composed of (the PV of FV1 of Tk.100 or)
Tk.90.91 and (FV2 of Tk.100) or Tk.82.64.
6-15

Formulae for Present Value

Interest Factor of Annuity

PVIFA=

1
- (1+i)n
i

6-16

Present Value of Annuity

Problem: At 10% interest rate, How much

can you borrow now against the repayment
3 equal annual installments of Tk.1000?
PV Annuity=C*(PVIFA)
=C{[1-(1/(1+i)n)]/i}
=1000{[1-(1/(1.1)3]/.1}
=1000*2.4869
=2486.90
6-17

Present Value of Annuity

Problem: You have a plan to deposit Tk.1,000

per month in a bank for next 20 years. If the
interest rate is 8.5% per annum then how much
can you borrow from the bank against that?

PVIFA={1-1/(1+.085/12)12*20]}/(.085/12)
=115.2308
PV Annuity= C*PVIFA
=1000*115.2308=1,15,230.80

6-18

Present Value of Annuity

Problem: Find the amount of installment of

a loan of Tk.5,000 to be repaid in 4 equal
monthly installment at 12% interest. Make
an amortization schedule.
5000=C(PVIFA, i=.12, m=12, n=4)
=C(3.901966)
C=5000/3.901966=1281.405

6-19

Amortization Schedule

6-20

Present Value of Annuity

Problem: You need Tk.12 lakh now to

buy a car, under the terms and
condition of monthly installments for
10 year. Interest rate is 15% per
annum. (a) What would be the
amount of installments? (b) How
much would be the accumulated
liability of interest?
6-21

Solution:
(a) Installment =PV Annuity/PVIFA
=12,00,000/61.98285=Tk.19,360.19
(b) Accumulated Interest=Total
payments Present value of annuity
=(19,360.19*120)-12,00,000
=23,23,223-12,00,000=11,23,223
6-22

Problem: In 1992, a 60 year old nurse

bought a $12 dollar lottery ticket and
won the biggest jackpot to that date of
$9.3 million. Later it turned up that she
would be paid in 20 annual installments
of $465,000 each. If the interest rate
was 8%, then what was the amount she
was deprived of in present value?
6-23

Answer to previous
problem
PV = $465,000*PVIFA i=.085,
n=20
= $ 465,000 * $ 9.818147
= $4,565,417
So, she was paid less than $9.3
million by an amount of
$4,734,583.

6-24

Future Value of Annuity

FVIFA=[(1+i)n-1]/i
FV of Annuity=C*FVIFA
Suppose, there is a 2 year annuity of
$100 installments at 10% interest. The
future value is
FV Annuity= C*FVIFA=
=100*[(1.1)2-1]/0.1=$210
This is composed of $110 and $100.
6-25

Future Value of Annuity

Problem: You like to deposit Tk.1000
per month for a period of 15 years.
Assuming an interest of 10% how much
would you get at the end?
FV Annuity=C*(FVIFA)
=1000*{[(1+.1/12)15*12]-1}/(.1/12)
=1000*414.4703
=Tk.4,14,470.30

6-26

Future Value of Annuity

Problem: You need to have Tk.1 million

after 20 years from now. Assuming the
market interest rate of 13% per annum if
you like to deposit equal quarterly
installments during the period in a bank
then how much would be the amount of
each installment? What is the interest
accumulation in the annuity?
Given, FV=Tk.1,000,000, i=.13/4,
n=20*4, C=?
6-27

Solution:

C=FV/FVIFA.
C=1,000,000/366.7164=Tk.2,726.90
Interest accumulation=FV Annuity-Total
payments
=1,000,000-(C*n)=1,000,000(2726.90*80)
=Tk.781,847.80 (This is 78.18% of face
value)
6-28

Annuity Due

Problem: You need to receive Tk.10,000

monthly for a period of 2 years to pursue your
MBA program. You make an arrangement with
a Bank that says the interest rate is 15%.
(a) How much will you have to return back to
the bank at the end?
(b) How much should you deposit to the bank
now to get the same monthly installments
throughout the MBA program?
6-29

Solution:

(a) FV Annuity=C*FVIFA
=10000*[(1+.15/12)24-1]/(.15/12)
=10000*27.78808=Tk.2,77,880.80
Since you need the money at the beginning of
the month so it is an annuity due.
In that case,
FV Annuity
Due=2,77,880.80*(1+.15/12)=Tk.2,81,354.40
6-30

Solution:
(b) This is the present value annuity due.
PV Annuity due=C*PVIFA*(1+i)
=10,000*20.62423*(1+.15/12) =2,08,820.4
Also notice: you can get answer to (b) by dividing
answer to (a) by (1+i)n or [(1+.15/12)2*12]
Or, you can get (a) through multiplying (b) by
(1+i)n factor
For example, 208820.4[(1+.15/12)2*12]
=208820.4 X [(1.0125)24]=281354.40
6-31

Definition
1. NPV: NPV is defined as the summation of the
present values of cash flows after tax in each
year over the project or investment period
minus the summation of present values of net
cash outflows in each year during that period.
2. NPV Profile: The graphical presentation of

relationship between a projects and the firms

cost of capital or discount rate is called NPV
profile. A graph that plots a projects NPV
against the discount rates is defined as the
projects NPV profile.
6-32

Definition
3. IRR: The discount rate that makes equal the present value
of a projects future cash inflows to the present value of
its total costs. Equivalently the rate that forces the net
present value to equal zero is internal rate of return.
4. Modified IRR: The discount rate at which the present
value of a projects cost is equal to the present value of
its terminal value, where the terminal value is found as
the sum of the future values of cash inflows, compound
at the firms cost of capital.
6-33

Definition
5. Net Terminal Value: When terminal amount of any

project obtained from reinvestment is discounted into

present value at a certain required rate of return and
the present value of cash outlays is deducted from the
first, then the net result is known as net terminal value.
6. Profitability Index: It measures the present value of
returns per unit of investment is called
profitability index. It is defined as the ratio that is
obtained dividing the present value of future cash
inflows by the present values of cash outflows.
6-34

Example
An asset can be purchased for Tk.7,50,000 that will
provide net benefits Tk.1,00,000; Tk.3,00,000;
Tk.2,10000 & Tk.280000 in years 1, 2, 3 & 4
respectively. Reinvestment rate is 8% and cost of
capital is 10.5%.Would it be wise to purchase the
asset under the following techniques?
(i) NPV
(ii) IRR (iii) PI
(iv) MIRR
(v) NTV
6-35

An Economic Rationale for NPV

Rule
1. It recognizes time value of money.
2. It considers all cash flows occurring over
the entire life of the project to calculate its
rate of return.
3. It is consistent with the shareholders
wealth maximization goal.
6-36

An Economic Rationale for NPV Rule

4. It does not use the concept of required rate

of return.
5. It is easily understandable to the business
executives and non-technical people.

6-37

An Economic Rationale for IRR

Rule

If the internal rate of return exceeds the cost

of capital of the fund used to finance a
project, a surplus remains after paying for
the capital and this surplus accrues to the
firms stockholders. Therefore, taking on a
project whose IRR exceeds its cost of
capital increases the value of the firms
stock.
6-38

Traditional measures of investment

worth
Payback Period Method: Payback method means
how many years will it take for the cash benefits
to pay the original cost of an investment,
normally disregarding salvage value. It
measures the number of years required for the
cash flow after tax to payback the original
outlay required in an investment proposal. If the
project generates constant annual cash flows,
the payback period can be computed by
dividing cash outlay by annual cash inflow.
6-39

Traditional measures of investment

worth
Discounted Payback Period: The length
of time required for an investments
discounted cash flows to equal its initial
cost is known as discounted payback
period. Based on discounted payback
rule, an investment is acceptable if its
discounted payback is less than some
prespecified number of years.
6-40

Traditional measures of investment worth

Example of payback and discounted payback:

Yea Cash flows

r
Undisc Disc
1
2
3
4

Cum cash flows Initial

cost is
Undisc Disc
Tk.300
000;
10000 8888 10000 88889 cost of
0
9
0
capital
10000 7901 20000 16790 is
0
2
0
1
12.5%
10000 7023 30000 23813
0
3
0
4
10000 6243 40000
0
0
0

30056
4

Payback
=3
years
Discoun
ted
payback
=4
years
(apprx)

6-41

Traditional measures of investment

worth
Average/Accounting Rate of Return: The
accounting rate of return also known as
the return on investment, uses accounting
information as revealed by financial
statement to measure the profitability of
an investment. It is found by dividing the
average after tax profit by the average
investment. The average investment
would be equal to half of the original
investment if it is depreciated constantly.
6-42

Traditional measures of investment

worth
Example of Average/Accounting Rate
of Return: Required investment is
Tk.500000 and project life expectancy
is 5 years. Expected net income aftertax are Tk.100000, Tk.150000,
Tk.50000, Tk.0 & (Tk.50000) in next 5
years. Average net income is Tk.50000
and average investment/book value is
Tk.250000. So average rate of return is
20%.
6-43

Homework
Questions & problems:
3.5, 3.6, 3.12 & 3.14

6-44